New diversity in assets brings high returns
Over the past five years, the State Pension Fund of Finland (VER) has consistently developed its portfolio allocation and its asset management, bringing them up to international standards.
Under this policy, a new neutral allocation and an alternative investments segment has been introduced to the portfolio. Other innovations include a new benchmark-driven investment approach, as well as a high standard of performance and risk reporting. Furthermore, a large part of the administrative function has been outsourced, while the in-house team has been strengthened by new additions.
This evolution of VER’s portfolio and the way in which it is supervised have enabled VER to achieve the highest return on assets of all the large Finnish pension funds between 2003 and 2005. In addition, this outstanding return was achieved at a lower level of risk than the market average and with a positive alpha.
The €8.2bn State Pension Fund was formed in 1990 by the Finnish government. During its first 10 years, VER invested solely in Finnish government securities. However, in 2000 the law governing VER was changed to allow it to hire an independent organisation to run its assets and to diversify into equities.
So the same year as part of its strategic asset allocation, VER decided to increase its equity exposure from zero to 40% by the end of 2004. The rest of the portfolio was to stay in fixed income securities.
The first equity investments were made in December 2000, and equity exposure has increased consistently since. The move was well timed because it came after the domestic equity market had fallen by around 30% from its peak levels.
The equity market began a rally in the spring of 2003 after a two-year bear market and the new asset allocation proved to be very successful on both a strategic and tactical basis between 2003 and 2005. Between 2001 and 2005 VER achieved an internal rate of return of 7.6% across its entire portfolio, with an internal rate of return of 13% for the equity segment.
As a result, its assets nearly doubled to €6.9bn in 2004 from €3.8bn in 2000. Over the same period the equity segment of the portfolio was created, reaching a value of €3bn.
To run its equity portfolio, VER uses both in-house and external asset management.
The in-house function concentrates on geographical areas which are close to home, while investments in more far-flung regions has been carried out through mutual funds. At present, half the fund’s equity investments are made through mutual funds. VER has found it easy to move into new equity markets quickly using pooled vehicles.
At present, VER’s portfolio is invested in approximately 50 pooled funds including small cap (it has been heavily overweight in this sector), value, active, index, enhanced index, and specific regional and industry funds.
From 2003 to 2006 VER diversified its portfolio even further, using a number of external consultants to help develop strategies for these new areas. It has also been actively involved in the development of new investment products in the marketplace.
It now has 2.5% of its portfolio invested in alternatives - private equity, absolute return strategies and real estate - and is planning to increase the allocation to 10% by 2009.
As part of this, all its real estate investing is carried out through indirect private and public real estate funds. Over the next few years, VER plans to diversify its portfolio, particularly into real estate markets.
These changes to the composition of VER’s portfolio have led to a much better investment performance.
And hand in hand with these developments there has been a significant improvement in the level of risk reporting, which has risen significantly between 2003 and 2005.
In 2003 VER decided to improve its investment performance reporting having previously based the quality and frequency of its annual reporting on internal reports. It had previously used normal investment return and risk yardsticks as internal measures but had kept external reporting to the minimum formal requirements. Further, the published return figures only included the total fund return and asset allocation breakdown; no risk numbers were given.
The change was introduced in its 2003 annual report. On the appointment of a new chief executive officer VER hired an external investor relations company to help with the design and production of the annual report. In addition, investment portfolio reporting was outsourced to a local asset management company. Meanwhile, the reporting of investment returns complies with Global Investment Performance Standards (GIPS) and is done on a monthly basis.
Highlights and achievements
Many state pension schemes might be considered unwieldy and be seen as slow to change. But VER, with its 180,000 members, has made such a success of restructuring its portfolio that it has enjoyed the highest returns of any large Finnish pension fund for the past three years.
It has radically restructured its portfolio, from a 100% investment in government securities to a 40% equity exposure, with a highly-diversified mix of both domestic and overseas stocks, held both directly and through pooled vehicles.
VER also holds 2.5% of its portfolio in alternatives, and plans to raise this percentage to 10% in the next few years. In particular, it plans to extend and diversify its real estate exposure.
It has also improved the level of its external investment reporting, using outside agencies to help with the annual report and the investment portfolio reporting.
There is now more detail on risk, and its monthly reports on returns comply with international standards.