Practical approach to alpha ensures A-list status
What sets some pension schemes apart from others is the ability to take a fad and adapt it perfectly to their own operations. This is what Finland's €21.6bn multi-employer Ilmarinen fund has done with ‘alpha', one of the investment management world's latest trendy by-words for extra returns.
"We have developed our investment strategy further during the past year," Ilmarinen says. "Previously, our focus was on diversifying across markets and sectors globally, and we seem to have more than adequately achieved our objectives with this strategy. So now we are looking at how we go forward. The fashionable term alpha seeks to define all the attributes a scheme would like to add to its portfolios in one word, but what is alpha? In adapting our investment strategy to accommodate alpha, we have tried to define some of the nuances behind the concept," it adds.
According to Ilmarinen, true alpha, as defined by one academic, is "zero at an aggregated level and statistically impossible to spot." The drawback of the word beta is in its very definition: why compare yourself against an index as the index by definition is biased and flawed?
Ilmarinen explains its new strategic objective as being to exploit emerging parts of a continuously expanding investment universe, defining new opportunities while identifying assets that are becoming the ‘pink elephants' of its investment universe. "New opportunities are typically assets that have recently become traded, or risks that have become transportable, for instance, risk premiums in different segments of the corporate capital structure or correlation/variance risks in the balance sheets of banks," the scheme says.
Another area that Ilmarinen identifies as its competitive advantage is its ability to carry risk in the more remote areas of its return distribution. "With a 30-year investment horizon, we are able to weather more frequent and more severe setbacks in exchange for a higher return expectation than the average investor. The capacity to carry this risk enables us to capture excess returns from different derivatives or trading strategies," the pension provider says.
Ilmarinen adds that its decision to focus on analysing beta by looking at how it evolves in scenarios based on different timeframes has resulted in changes in its risk and investment processes. The fund's risk management has focused on how practical it is for it to add strategic allocations to non-linear investments or trading strategies. It has also enhanced its approach to active risk management, such that it can efficiently spot and use active risk to the full. It claims the process of limiting active risk through tracking error leads to a more optimised and diversified attribution and management of active risk.
Elsewhere, the hedge fund portfolio has also undergone some change. The split between single managers and fund of funds in the hedge fund portfolio has evolved towards a single-manager bias. Ilmarinen says this has been made possible by enlisting the help of specialist hedge fund consultancy firm, Albourne, which not only assists in screening during the due diligence phase of manager selection but also in the ongoing monitoring of performance.
On a strategic level, this realignment has seen Ilmarinen incorporate the notion of alternative beta into its hedge fund portfolio. This has resulted in it investing in more esoteric markets or areas, which are hard to access from the more traditional approach to hedge fund investing that it previously advocated.
In line with its overall strategy, Ilmarinen has also started seeking new sources of adding value by being more active in volatility and variance trades. This is not a new approach for the scheme, it has been active in this area for several years, but last year it increased the risk it was prepared to take in volatility to a "meaningful level".
"These trades provide us with positive returns, which are totally uncorrelated with any other asset class. In addition, the conditional correlations have even proved negative during stress testing," the scheme says.
Finally, Ilmarinen has made changes to its domestic equities team. It has added new staff to its Finnish equities portfolio management team so it can invest more actively in its home market. Ilmarinen points out it is a shareholder of almost all companies on the Helsinki stock exchange and this gives it a further edge. "Focusing on the domestic market where we are prominent investor enhances our competitive advantage," it adds.
Highlights and achievements
Two developments make Ilmarinen stand out from the crowd: its understanding and practical use of alpha and its proactive and positive approach to hedge funds.
Questioning the very concept of alpha has allowed it to adapt its investment strategy to identify the best up-and-coming opportunities and tweak its active risk management accordingly. All this while most pension funds are still trying to come to terms with what alpha and beta mean, let alone implement a strategy based on them to maximise returns.
Most pension funds still view hedge funds with extreme caution and invest minimal amounts in them through safe funds of funds. But Ilmarinen understands the value that hedge funds can add to its portfolios and how single-manager funds are fine as long as a scheme picks them carefully and monitors them consistently. Not having the in-house expertise did not deter Ilmarinen, which instead sought the assistance of a specialist consultancy and is now reaping the rewards.