Denmark’s biggest second-pillar pension provider has been building its exposure to listed equities since last autumn – an asset class whose perceived role is now undergoing a sea change, the firm’s investment chief believes.

Kasper Ahrndt Lorenzen, group CIO at PFA Pension, said: “They’re not cheap at all, but there’s a story around public equities about why it’s not a bubble.”

According to the CIO, a review of the DKK72.8bn (€98bn) portfolio carried out last autumn led to two main conclusions – that real estate and infrastructure is a good alternative to traditional fixed income assets, and that it should be cautious when letting private market investments crowd out its public equities exposure.

“We need to have a certain amount of traditional equity risk on the books and I think that’s something that in the past we maybe have missed a little bit,” he told IPE.

“We have been running a broader portfolio and then all of a sudden compared to competitors we haven’t had enough equity risk, and it’s just been a very strong market,” he said.

In order to change that, PFA has been running systematic overlays since 1 January 2020 to have more equity risk, which he said explained why the provider’s first quarter results were quite good.

Secondly, he said, the investment team has been ensuring equity risk is maintained in the overall portfolio, rather than reduced by buying different types of private market exposures.

“It really goes back to the question, what is really the risk-free asset these days? Also, when we look further into the 20s, what will the risk-free asset be?” Ahrndt Lorenzen asked.

Government bonds have traditionally been seen in that role, but with sovereign debt issuance now so high, the quality is poorer and the recurrence of inflation is eroding real yields, he said.

“The risk-free asset has to provide something else. It doesn’t have to be one single security, it can be a mix of securities, and it has to be scalable,” he said.

“And I think with equities, they are easy to invest in, they are scalable, diversified – you are typically exposed to 500 strong corporate balance sheets,” the CIO said.

Crucially, according to Ahrndt Lorenzen, the perception of investors is now changing in this regard.

“The more investors there are who believe that equities are to some degree the risk-free asset, the less equity risk premium you will see,” he said, predicting that this compression of equity risk premiums has further to go.

“We need to make sure we have a decent exposure to what might be the new risk-free asset when we look further into the 20s,” he said.

In the first half of 2020, Ahrndt Lorenzen spearheaded the mapping of PFA’s unlisted investments in terms of public-market risks, allowing comparability of all assets from a risk-exposure perspective – not unlike the risk-factor portfolio construction work done at ATP, where he was CIO until he joined PFA in September 2019.

The subsequent portfolio review of how the various components were performing has had implications for the type of real estate PFA prefers, as well as its desired degree of listed equities exposure.

“The conclusion is that the role of real estate is particularly as an alternative to fixed income investments to government bonds and credit,” Ahrndt Lorenzen said.

Kasper Ahrndt Lorenzen

“I do now believe now that interest rates have hit the bottom”

Kasper Ahrndt Lorenzen, group CIO at PFA Pension

But while some real estate funds and other property investments could be very equity-like, he said it was tricky for real estate to compete with the broader equity space.

“We have plenty of appetite for real estate, in particular core and core plus, and room for more, but the very high-risk end of property investments is not really where we see real estate has an edge in our portfolio construction,” he said.

While PFA is happy to use its illiquidity capacity to let private market exposures crowd out government bonds, he said unlisted assets should not use up any risk budget that could go to listed equities.

“I do now believe now that interest rates have hit the bottom,” he said.

“I always believed in the value of government bonds, and at ATP too, we kept the position as the yields when down and down, but now I think things are changing, inflation is picking up and nominal rates are just low,” he said.

In the portfolio review following the risk-mapping of unlisted investments, he said it became clear some equity factor was missing in what was a broad-based portfolio consisting of lower-risk investments.

“So we concluded we needed to balance our risk up on the equity side, and that’s why we’ve been running systematic equity overlays in 2020 and 2021 – and that has worked well,” he said, adding that with the privilege of hindsight, these should even have been double the size.

There is a risk transition going on in international financial markets, Ahrndt Lorenzen said, with central banks facilitating risk and a huge supply of savings currently looking for a home.

“As an investor you need to be careful that you have your risk on,” he said.

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