Restructured portfolio reverses decline in returns
The sheer scale and determination with which Finland’s Ilmarinen pension fund undertook to alter its portfolio construction and managementto reverse declining returns are key to it winning the IPE Silver Award for Best Industry-Wide Pension Fund 2004, to go with the IPE awards it has already won. The investment portfolio has been developed and improved in several ways during 2003 and 2004, with the main focus firmly on further diversification, in-house sourcing of alpha generation, return distribution and socially responsible investing.
With regard to the traditional investment classes, Ilmarinen introduced emerging market, high-yield and inflation-linked bonds into the fixed income benchmark for the fist time during 2003, whilst there has been a substantial increase in its Japanese equities weightings since spring 2003 to match increases in small cap companies in its equity portfolios. This has been enhanced by the use of derivatives not only for tactical asset allocation but also in areas such as internal long/short equity portfolios and volatility trading for both fixed income and equities.
The new fixed income investments enhance diversification and have thus far yielded nine to 10 basis points as additional expected return. The new investments overall are fulfilling their main objective of bringing in beneficial correlation. Furthermore, these new potential sources of alpha have impacted on the timeliness of investments such that they are now contributing positively to returns.
Ilmarinen started in currency overlay policies three years ago and, with a 100% hedged position for fixed income and hedge funds and 50% for equities, they have reduced the overall volatility of the portfolio as well as enabled increased risk in other investment classes, thus stimulating increased returns. Furthermore, the fund’s positive view of the euro since it was introduced up to the beginning of 2004 meant it could hedge the euro against the dollar straight away and with further reductions in the hedging against the dollar and yen this year, Ilmarinen has been able actively to trade its currency positions using both forwards and options, gaining from both the rate and volatility movements. Overall this year currency overlay activity has produced about 0.2% on the aggregate portfolio level and, more importantly, basic hedging has improved annual returns of the total portfolio by about 0.5 % per annum during the past three years.
Ilmarinen has now adopted socially responsible investment guidelines which state that companies breaching international norms (eg, UN and ILO declarations) should be excluded from the investment universe. Thus, since 2003 four holdings have been sold due to unethical behaviour. Moreover, to ensure transparency, Ilmarinen has employed the services of an external consultant.
In addition to excluding companies, Ilmarinen uses active ownership to enhance portfolio returns. A part of active involvement is regular attendance at annual general meetings of domestic corporations whilst a project is under way to include foreign corporations. Ilmarinen’s intention is to influence management in advance of any undesirable motions being put forward. Ilmarinen believes that these two methods combined will reduce risks and lead to improved returns.
Ilmarinen has gradually increased its hedge fund investments to 1.5% of total assets. The portfolio consists of both funds of funds and single manager funds in a number of different strategies. Ilmarinen has independently conducted an in-depth study of the hedge fund market and, as a result, it has developed a thorough selection process based on rigorous qualitative and quantitative criteria.
Ilmarinen’s appetite for risk is independent of past performance but, after a long downturn, it has not been able to rebalance its basic allocation in equities because of decreased solvency and higher risk capital consumption. So, to streamline its expected return distribution and make risk more dependent on performance, Ilmarinen introduced a new asset class called structured products in 2003 comprising different types of call options on baskets of equity indices and zero coupon bonds which are actively managed. Ilmarinen says by incorporating these new products into its asset-liability modelling it has increased the expected rate of return without increasing the possibility of shortfalls and is confident it needn’t alter its overall investment policy and assumptions.
Ilmarinen decided to diversify its real estate portfolio in 2002 and implementing the revised strategy began in 2003. Investing in real estate is a great means of diversification and has increased expected returns. However, during the transition period, real estate exchange-traded funds, listed funds and structured products have been used to offset the reduced liquidity of real estate funds themselves and the fact they are slower to show returns, even though they have a reputation as a high-yield investment class.