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Revaluation boosts real estate

Danish pension funds experienced a bumper year as domestic stocks outperformed, like elsewhere in the Nordic region. In addition, real estate was the top contributor for many funds as a result of revaluation of the assets.

Judging by preliminary calculations, the weighted average performance numbers for the Danish life and pension sector were 3.8% before tax and 3.4% after tax, according to local consultancy Kirstein Finans.

Michael Wendt, partner at Invensure, an investment consulting company, says that the Danish stock performance was driven by extremely strong small-caps. "Small caps only represent around 15% of total listed stocks but outperform even emerging markets in some cases," he says.

The small-cap rally was a result of growing exports to the US as well as the EU, particularly Germany. In addition, the small-caps that have outperformed are in ‘hot' industries such as wind-energy and environmentally friendly products, which have seen phenomenal growth.

However, Wendt cautions that the rally was unlikely to continue. "In local currency terms the MSCI World is basically flat so far this year and the Danish market is already up 11.5% but it has mainly been lead by large caps."

PKA, the administration company for eight of the country's occupational pension funds for the social and private healthcare sectors, returned 7.7% but its property investments increased 61% last year.

This return was due to a revaluation of the portfolio. At the end of 2006 approximately 14% of total assets were invested in real estate. Danish equities also boosted performance with a return of nearly 23%, and international equities returned 10%.

At the end of last year the fund was invested 51% in fixed income, 23% in international equities, 10% in Danish equities and 2% in private equity and the remainder in real estate.

Claus Jørgensen, head of equities, says that PKA does not invest in hedge funds but that it has some external managers with 130/30 mandates. He adds that so far the risk/return-profile of hedge funds has not been found attractive. "The allocation to fixed income last year detracted from performance due to higher interest rates," Jørgensen says. "PKAs fixed income portfolio returned 1.2%."

Industriens Pension also returned 7.7% last year. "This high yield has been achieved by adopting a successful and active investment strategy, with more than 40% of our portfolio in equities, and a large proportion of this in Danish equities," says chief investment officer Jan Østergaard.

"This has proved to be a sound decision since the Danish market has generally been doing well. On bonds, too, our strategy has proved successful. Our bottom line came out at 1.6%, whereas the market in general yielded a mere 0.7%. Moreover, our choice of geographical areas was right and both external and internal portfolio managers have handled their tasks most satisfactorily."

At the end of 2006 the fund's allocation was 40% in Danish bonds, 9% in Danish index-linked bonds, 5% in emerging markets bonds, 3% in corporate and high-yield bonds, 27% in international equities, 10% in Danish equities, 4% in unlisted investments, 2% in cash and the remainder in real estate.

Søren Andersen, CEO and founder of Invensure, which has a co-partner agreement with Mercer Investment Consulting, agrees that funds, and in particular insurers, with heavy allocation to domestic equities, benefited last year, whereas some of the newer funds, with hardly any weighting to domestic equities suffered. "Some new funds have a global portfolio in which Denmark only has an MSCI World weighting of 0.4% or less," he says.

Historically, insurers have a high proportion invested in Denmark. "Especially after 9/11, Danish insurers were forced to sell their international holdings because, had they sold domestic ones, the size of their holdings would have moved markets and destabilised it."

Andersen says that, although performance was good for the majority of the funds, funds also suffered because of the use of derivatives to protect against interest rate falls. Up to 15% of assets are invested this way. "These are not managed as separate asset classes by investment managers," he says.

"Funds use tools provided by investment banks as a way of protecting assets against falling interest rates in order to be able to pay the required guarantees. In a market where interest rates went up these instruments were possibly not the best choices."

Andersen says that 95% of funds use some type of liability-driven investment vehicles in this way.

He notes that a performance comparison between Danish funds is difficult because some - notably ATP, the Danish labour market fund and the largest in the country - do not show the use of derivatives as part of investments, and instead show returns on the liability side.

However, ATP's returns reflected the rest of the market with equities and real estate performing well. ATP separated its alpha and beta portfolios and both outperformed, according to the fund's annual report.

During 2006 ATP increased the risk diversification of the beta portfolio by investing in infrastructure, international real estate, foreign index-linked bonds and commodity-related equities.

Jesper Kirstein, chief executive officer of Kirstein Finans, agrees that the use of derivatives to cover liabilities and influences the results of those with high guarantees. He adds that alternatives such as private equity also performed well. "Because of the relatively small proportion of total assets invested in private equity it does not influence the overall performance numbers significantly," he says.

Andersen says another problem with comparing Danish fund performance is that real estate valuations can be done by the board and may not have any official valuation. "These numbers can then be used for marketing purposes," he says. "It does not show the reality - ie whether or not someone is a good investor or not. I am not saying they aren't, but it is a subjective valuation and can be done at a time when the board feels that numbers need boosting."

Andersen says the regulator, Finanstilsynet, is aware of these practices. "Last year one of the larger funds sold a substantial real estate holding and the regulator immediately compared the book-value and the returns they received," he says. "But it does not seem to be able to do anything about it."

Kirstein agrees that valuations of real estate portfolios can be haphazard but adds that experts are used to value and audit the holdings. "Last year, for instance, one of the largest funds had an 80% return on their real estate portfolio as a result of revaluation."

Andersen adds that performance comparison is also complicated by the fact that insurance companies and pension funds are seen to be the same from a legal perspective and that many insurers, such as Danica and PFA, have a small allocation to equities. "On top of that, the liabilities and guarantees are very different between old and new funds," he notes. "Newer funds tend to have higher solvency ratios, which affects asset allocation. And they are different so they should have different allocations and therefore returns."

Going forward, industry professionals agree that there is a likely shift out of Danish equities, albeit slowly. In addition, the continuous quest for alpha is broadening the investment horizon to include more alternatives.

The new Europe-wide solvency requirements are likely to change allocation Andersen says. " Since 2000 pension funds have spent a lot of time and effort in understanding interest rate-based derivatives products and are now behind other countries in the region in terms of alternative investments such as hedge funds. We are likely to see more and more allocation into alternatives such as international indirect real estate investments." He says the changes would not necessarily bring about an increased equity allocation because of the high guarantee requirement of 4.5% that many funds have.

"Those with high guarantees are trying to persuade members to move to lower guarantee products so boost solvency capital and then take more risk," he says.

Danish funds tend also to follow each other, and many are moving into infrastructure, timberland and commodities. Further ahead there may be a move towards internationalising the fixed income portfolios as well."

PKA is one of the funds considering changes to its allocation. It plans to fund new investments in private equity, to be raised to 5%, and infrastructure to 3%. In addition, there are plans to expand the investments in forestry. The allocation to fixed income will be reduced, Jørgensen says.

ATP is ahead of the curve with changes made last year, and expects its diversification to continue. During 2007 the portfolio will be further adjusted and is likely to focus on other asset classes than equities, according to its annual report.

PensionsDanmark, a pensions insurer that returned 7% last year, is also considering boosting its infrastructure assets to 5% of its DKK8.3bn (€1.1bn), from the current 0.5% and is planning to internationalise its real estate investments, says CEO Torben Møger Pedersen. However, some funds, such as Industriens Pension, are satis fied that their allocation is doing the job and does not expect any changes to allocation over the next year, according to Østergaard.

Kirstein agrees that the solvency ratio among Danish funds looked better but says that if the current market volatility translates into falling markets and interest rates it may cause concern. "But the funds are not really exposed to the sub-prime market, and if in any way it is through CDOs in a very small way."

He adds that a change to the country's tax regulations governing pension funds is on the cards but decisions are yet to be finalised.

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