The seriousness with which the Danish pension fund ATP takes hedging paid off last year, with the fund recording its best ever return. A combination of the hedging activity and a deliberate move to substantially reduce its risk meant the fund weathered the European storm despite the fall-off in interest rates.
The 579-billion-Danish kroner ($98.4-billion) fund is managed in two distinct portfolios, a hedging portfolio and an investment or return-seeking portfolio.
The investment portfolio is divided into a beta and alpha portfolio, with about 97 per cent of the risk in the beta portfolio managed according to five underlying risk factors.
But it is the hedging portfolio that remains the main focus and indeed the main driver of the fund’s ability to pay its beneficiaries. The role of the hedging portfolio is to hedge, as precisely as possible, the interest-rate exposure of the fund’s pension liabilities, which last year was adversely effected by the fall in interest rates.
Chief investment officer of ATP, Henrik Jepsen says 2011 really demonstrated the importance of hedging against risks.
“There was a very substantial fall in interest rates in 2011, which meant being hedged was extremely important,” he says. “We made a total return of 26 per cent and the bulk of that came from hedging activity.”
Last year the total pre-tax return was $21.18 billion, with the hedging portfolio contributing about $18.3 billion, enabling it to pay its pension promise as well as add $679 million to its bonus reserves after tax.
The investment portfolio also contributed in a reliable way, with the fund realising returns regardless of what financial markets were doing.
“Effective risk diversification proved its value in our investment portfolio again in 2011,” Jepsen says. “And noticeably we made positive returns in all four quarters of the year despite the big differences in conditions – quarter one was optimistic, quarter two more wobbly, quarter three saw an extreme flight to quality and quarter four rebounded somewhat.”
Last year four of the five risk classes within the investment portfolio contributed to returns, with equities the obvious anomaly. The investment portfolio gave a return of $3.2 billion.
Hedging in Denmark
However, while the fund outperformed, particularly given wider market volatility, changes in the guarantee benefits – due to declines in interest rates – negatively affected hedging activities by $17.5 billion. The changes in the guaranteed benefit were higher than the return on the hedge (after tax) because Danish interest rates fell more than German interest rates as Denmark experienced flight to quality during the autumn, he says.
This meant that overall the results for 2011 came in at $441.6 million – lower than the performance target of the hedging and investment activity for that year.
In the context of the five-year performance target, however, the fund was above its target.
ATP has changed the way it quantifies the market value of its future pensions. Until 2011 the Danish swap rate was used to calculate pension liabilities but that changed last year.
“We have now changed the discount rate so it is a mix of Danish and German interest rates, which reflect the way we actually can hedge the liabilities and will result in a more stable hedging result. It means the hedging portfolio and value of liabilities will move more in sync.”
Dynamic risk allocation
Another example of how seriously risk is taken is that the $52.5-billion investment portfolio is driven by dynamic risk allocations.
At the end of March this year, the beta portfolio had an asset allocation (and risk allocation) as follows: commodities 3 per cent (11 per cent risk allocation), inflation 16 per cent (24 per cent), equity 15 per cent (42 per cent), credit 15 per cent (8 per cent) and interest rates 52 per cent (15 per cent).
The investment portfolio’s risk allocations have been stable for the past five years and, while there isn’t a benchmark per se, the fund has a long-term risk allocation, which includes 35 per cent in equities, 20 per cent in government bonds, 10 per cent in credit, 25 per cent in inflation-linked assets and 10 per cent in commodities.
“The long-term risk allocation was determined on the basis of a qualitative and quantitative study including data for the last century,” Jepsen says. While the fund can diverge from this risk allocation, he says it must always be within the limits of effective diversification.
In addition to diversification paying off, Jepsen says the fund had a focus on tail risk protection and reduced the absolute portfolio risk markedly during the second quarter.
“We are now using about half of our risk budget,” he says. “We kept the same relative-risk allocation, but did the risk reduction in a balanced way. We don’t bet on markets but have a risk-based decision model.”
Certain and small
Jepsen says the fund sold a lot of exposure in all five risk classes including equities, index-linked bonds and its oil exposure.
And, given the volatility in Europe, Jepsen says the focus will remain on defence, rather than offence, in the fund reaching its performance target.
“We lack visibility about the deleveraging process and the debt crisis so it is hard to be offensive. It is not any easier this year, as we see a lot of different equilibria depending on how the euro situation turns out. The biggest mistake to make would be to move to risker assets because safer assets are yielding so low,” he says. “We have stayed liquid and taken risk off the table.”
While the fund doesn’t use asset-class descriptions, by way of demonstrating the fund’s current risk tolerance Jepsen says if, conceptually, the fund was invested in equities, then about 20 per cent of the money would be in equities right now.
He says ATP has consistently taken a risk approach to the volatility in markets. Among other things the fund sold almost all its exposure to peripheral governments long before the crisis evolved.
“We look at tail risks rather than the most likely expected outcome,” he says. “We are not putting money on what we think will happen but rather making sure that the portfolio will perform well no matter the economic outcome.”
Jepsen is not afraid of losing short-term opportunities.
“It is much more important to avoid a black hole than miss a small rally,” he says.
Given the size of the fund, its investment team is quite small.
In the investment department, it only employs 20 people to manage strategy and implementation of fixed income, hedging, Danish equities and tail-risk management.
The specialised investment areas such as real estate, private equity, venture and alpha have been put into wholly owned subsidiaries owned by the fund, but not based at the headquarters.
“It means there is a smaller organisation here and management can focus on the broader issues,” he says.
Jepsen is responsible for the broader team, including the actuarial team, which together numbers about 80.
