ATP: Rebalancing the risk diet
Denmark’s supplementary labour market pension fund has revamped the risk-based investment strategy it applies to its investment portfolio. Rachel Fixsen reports
• Total member assets end 2015: DKK705bn (€94.5bn)
• Membership end 2015: 4,970,800
• Type of pension fund: Mandatory contributory supplementary labour-market pension fund
• Chairman: Jørgen Søndergaard
• Chief executive: Carsten Stendevad
• Headquarters: Hillerød, Denmark
• Established: 1964
Until 2006, Danish pensions giant ATP divided all the investments in its investment portfolio between just two asset classes – equities and bonds. But the DKK705bn (€94.5bn) statutory pension fund, which manages the nation’s labour-market supplementary fund, then made sweeping changes to the way that portfolio was built.
The early pioneer of risk parity Ray Dalio, founder of the US-based investment management firm Bridgewater Associates, inspired at least part of this change. Dalio’s All Weather fund, which was launched in 1996, formed an intellectual underpinning for the strategy of ATP’s return-seeking investment portfolio, which contains the pension fund’s bonus reserves.
The bonus reserves amounted to DKK101bn (€13.6bn) at the end of 2015, while most of ATP’s assets are managed in its much larger DKK604bn hedging portfolio, designed to underpin the pension guarantees it gives.
Back in 2006, ATP’s transformation of its investment portfolio construction resulted in the division of investment assets into five risk classes – commodities, inflation, credit, equities and interest rates.
This approach held officially until the beginning of this year, when the latest evolution of ATP’s portfolio construction thinking was implemented, although the pension fund’s investment team had been working on changes to the approach for as much as two years before that.
Having been concerned that the five-risk-class system was no longer working well enough in today’s changed market environment, ATP moved to introduce a construction involving just four different categories, this time terming them ‘risk factors’.
The four factors are:
• equity; and
• other factors.
ATP has explained that the new portfolio construction lets it improve its understanding of the underlying risks in its investments, as well as putting in place a portfolio composition that is more robust and flexible.
In its explanation to local and non-financial media of the rationale behind the new method of labelling the elements within the portfolio, ATP likened the portfolio makeup to a healthy diet.
Whereas, since 2006, ATP’s investment portfolio had corresponded to a diet defined by specific proportions of different foodstuffs such as grains, meat, fruit and vegetables, from January 2016, it likened the new portfolio construction to a diet divided up into recommended percentages of the nutritional content of food types, such as fibre, carbohydrate, fat and protein.
Carsten Stendevad, chief executive of ATP, says the change to the new risk-factor approach is now fully in place. “Today, all our governance, all our investment processes, all our risk framework and our analytical platforms are aligned with this new approach,” Stendevad says. “Although we officially switched approach at year-end, we had been using a beta-version for a while internally, so the switchover was fairly seamless.”
The new portfolio construction approach has allowed ATP’s investment staff to compare risk in a more straightforward way.
“One great benefit is the common language that it has created across our investment organisation which makes it easier to collaborate and also makes it easier to evaluate risk and risk-adjusted returns across different asset classes and different investment ideas on more of an apples-to-apples basis,” Stendevad says.
But he says it is still early days for the new risk-factor approach. “Although we increasingly have had the mindset for some time, it is still just for one quarter that we have been up and running full scale,” he says.
Has ATP’s move to a risk-factor approach increased the dialogue with other institutional investors, and are there more investors now considering this approach, as a result of ATP unveiling its new way of working?
“As we developed our own thinking on this over the past few years, we benefited tremendously from a close dialogue with a few like-minded global investors,” Stendevad says. “That dialogue is continuing, and I am sure we will continue to refine our approach based on this. We have also received many inquiries from investors who are in earlier stages of making similar changes, and we enjoy these discussions also.”
In its 2015 annual report, ATP said that, over the course of last year, it had undertaken the change as part of a thorough process of strengthening its investments and risk management in the face of big challenges it was facing.
It said the financial markets had been marked by historically low interest rates, lower trading turnover and big movements in market prices, which means that investors would have to prepare themselves for lower returns and a less predictable correlation between different types of investment.
ATP said its starting point for last year’s process had been to work towards getting a better understanding of the underlying investment risks it ran, in order to be able to achieve the highest possible risk-adjusted return.
Looking at it in this way, alternative investments such as private equity, infrastructure and so on, presented a particular challenge, because the risk picture in these investments was less transparent than for more traditional investments, such as bonds and quoted equities.
The pension fund said it decided to invest in a way that continued to focus on the risk of assets, but change the way that risk was calculated.
The new long-term guidelines for ATP’s investment portfolio allocate 35% of its investment risk each to the equity and interest-rate factors, with 15% allocated each to the inflation and other factors groupings.
This new mix does not represent a radical change from previous weightings, ATP has said, although it is slightly lighter on interest-rate and inflation factors and heavier towards alternative risk premia.
Because the new benchmark represents risk weighting, ATP points out that this cannot be seen in terms of traditional asset allocation percentages. ATP has said that one of the benefits of the risk-factor approach is not only that it gives more investment flexibility, but also that it provides the investment team with a better understanding of risk.
“As we developed our own thinking on this over the past few years, we benefited tremendously from a close dialogue with a few like-minded global investors. That dialogue is continuing, and I am sure we will continue to refine our approach based on this”
Because the work it has done has thrown light on the risk factors at play behind the actual investments the pension fund takes on, ATP has been able, for example, to reject certain infrastructure deals because the pricing was not attractive.
In general, the approach makes the fund more comfortable with illiquid investment types, because these asset types are, in fact, made up of multiple elements of risk.
The more complicated transactions involving such investments sometimes involve all four types of risk, it has said, adding that the new technique can be used to separate the risk into these individual components.
Once it has decomposed potential investment opportunities into these four risk factors, ATP can then see more clearly how it might be able to achieve the same risk factor exposure in a different way – and possibly at a more appealing price.
The ability to break down an investment into a standard set of risk factors lets the pension fund determine the expected return on that investment by comparing it with the return on other assets with the same underlying risks.
And the work the pension fund has done around the new portfolio construction has also thrown up some important insights. For example, ATP has been able to see that as much as half of the portfolio’s current risk from the interest rate factor comes from its infrastructure and real estate portfolio, rather than from bonds, as might normally have been thought.
ATP’s risk factor categories
From 2016, risk in ATP’s investment portfolio is allocated to four categories of risk factor. The categories are:
• Equity factors (including, for example, quoted shares, elements of private equity, corporate bonds and other illiquid assets);
• Inflation factors (including commodities, elements of other illiquid assets and index-linked bonds);
• Interest-rate factors (including government bonds, elements of corporate bonds, index-linked bonds and other illiquid assets);
• Other factors (including elements of private equity and other illiquid assets)
• The long-term benchmark for the risk factor allocation has been set at 35% of risk in equity factors and 35% in interest-rate factors, 15% in other factors and 15% in inflation factors.