Thursday, February 2, 2012

World's Best Hedge Fund Actually a Pension?

Mark Cobley of Financial News reports, Danish pension fund makes record 26% return:
ATP, the €78bn Danish national pension fund, recorded its best ever financial return in 2011, despite the markets stalling in the second half of the year.

It made an overall return on assets of 26% - that amounts to Dkr125bn, or €16.8bn, it said this morning.

This impressive looking result was mostly due to a hedging strategy, which enabled it to keep ahead of substantial growth in its financial liabilities resulting from low interest rates. But ATP also took further risk-reducing steps in the middle of 2011, selling off assets such as equities, credit and commodities, which helped protect the fund against falling markets.

Lars Rohde, ATP's chief investment officer, told Financial News today: "We are currently using only a small fraction of our available 'risk budget', so we may increase our allocations to these return-seeking assets this year. But we still think we are in for a rollercoaster ride in the markets, so we will be very cautious."

Pension funds' liabilities, or the total value of all the pensions they have promised to pay, are calculated using expectations of what interest rates will be in the coming decades. These expectations are indicated through the real-time market for long-dated bonds, or prices in the related swap markets.

These markets have been dramatically affected by the ongoing eurozone crisis. Central banks have set rates low in an attempt to stimulate growth through policies such as quantitative easing - bond-buying - and investors have flocked to government bonds considered low-risk, such as UK gilts, German bunds or indeed Danish government bonds.

As a result of all these factors, ATP said its liabilities increased by €16bn during 2011 - almost as much as its assets grew. Around €14bn of this was due to falling interest rates while another €2bn was the result of a tax bill.

ATP's hedging strategy, which aims to insulate the fund's exposure to Danish interest rates, mostly through swaps, did what it was intended to last year - though not 100% perfectly. It covered the fund against most of the liability increase, but recorded a small €1.5bn loss.

This was mainly down to a technical issue, explained Rohde: "Basically, there aren't enough Danish swaps for us to buy. The vast majority of our hedging activity is therefore done with Danish government bonds, German bonds and euro swaps. This means we are at risk from any differential between Danish interest rates and German rates."

This is what happened last year when Danish rates fell below German rates, he said.

However, this hedging loss was more than offset by income from other areas. ATP's bond portfolio has been overhauled as a result of the eurozone crisis, and now consists almost exclusively of Danish and German government bonds.

The fund's equity investments made a loss, but bonds, property and commodties were all positive, and overall the fund made a "profit" over its liabilities of about €500m during the year.

Last year, ATP also set up its first international subsidiary, Now Pensions, to offer savings and investment services to UK employers. From October, all UK companies will be obliged by law to offer workers a pension over the next few years, and ATP hopes many of them will chose its service.

In December, it set up a new FSA-registered investment company in London, NOW Pensions Investment A/S, which will tap expertise from ATP's fund managers and investment officers in Denmark.

ATP's stellar results prompted aiCIO to ask an excellent question, Was 2011's Most Successful Hedge Fund Actually a Pension?:
Where would you find one of the largest and most sophisticated hedge funds on the planet? One that made an investment return of over 20% in the tumultuous markets of 2011. New York? London? Hong Kong?

Hillerød, a small city of 30,000 people some 30 minutes north of Copenhagen, would not spring instantly to most people’s mind.

Most people, however, have not heard of ATP, the Danish fund manager that looks after the assets of the country’s public pension system.

Over the last, chaotic 12 months, through a complex system of hedges, levers and ‘risk buckets’, Chief Executive Lars Rohde and his team have steered some DKK778 billion – around €104 billion - through the headwinds of the Eurozone crisis and beyond.

Rohde has been at the helm of ATP since 1998 and has overseen much of its transformation into an alpha-seeking, risk managing, public sector quasi-hedge fund.

Good humoured, happy to chat with typical Scandinavian perfect English, Rodhe is not afraid to speak his mind.

In 2008 he told me that the European pensions industry needed something like the potential game-changing regulation Solvency II, which was initially formulated for insurance companies, to get them thinking about funding and liability matching.

At the time, he was a lone voice. This does not seem to have changed.

Fast forward four years or so, and Rohde still stands out from the crowd. The strategy ATP runs is more like that of a hedge fund than a pension plan. The portfolio is divided between return-seeking assets and a collection of hedges designed to protect the scheme in all economic weathers.

Last year the investment portfolio made a 20% return. The aggregate hedge fund return over 2011 was a negative 4.9%, according to hedgefund.net.

When I spoke to him about these results published this week, Rohde, in typically understated tones said: “Yes, I suppose we had quite a good year.”

ATP’s results bear out the long-term success of its risk-aware approach. In 2005, it made an investment return of just over 6%, in 2006 around 4.2%, and in 2007, 2%. A 6% loss in 2008 was followed up by a return of 4.3% in 2009 and 6.8% in 2010.

All this time the hedging portfolio has managed to maintain, if not improve, the already 100%+ coverage ratio of its liabilities.

Out of habit, I ask him about what asset classes worked well in 2011? He laughs and says: “Liz, you know it’s not about the asset classes, but the risk allocation…”

The investment portfolio has five ‘buckets’ which are invested according to a risk budget, rather than a propensity for a certain asset class.

I ask him why so few others take this ‘risk allocation’ approach, at least in pension investing.

“I’ve been wondering that too for many years,” he says, laughing.

“Maybe it’s a case of bad habits, maybe peer pressure. As John Maynard Keynes said: ‘It’s better to fail conventionally than to succeed unconventionally’. As long as people are being seen as doing what they are meant to be doing, for some of them that’s the correct behaviour.

“As they used to say: ‘no one gets fired for hiring IBM’.”

Over the past decade Rohde and his team of experts have built up what he calls a ‘unique business model’.

“We have not kept it a secret – we have been very clear that half of it is like liability-driven investment (this is a concept most people understand) and the other is based on absolute return-seeking assets to build up better pensions.”

And longevity, the risk that terrifies most pension scheme investors, how does ATP hedge it?

“We don’t.”

I should have known it was too conventional an idea. Instead, ATP keeps a portfolio of DKK18 billion which it manages to keep up with the increasing longevity of the OECD countries.

“Maybe the ATP model is too complex for the rest of us to understand?” I venture. I speak from experience, having spoken with Rohde at least annually for the past five years on ATP’s structure and visited Hillerød for a private tutorial - I am still less than 100% sure how his ‘risk buckets’ work, but would not mind being a Danish citizen in my old age.

Again, he laughs and says that I will soon be able to benefit from this expertise in the UK.

ATP announced last year that it would be going head-to-head with the UK government-backed National Employment Savings Trust, the pension scheme set up for workers without occupational pension provision.

“With the concept of auto-enrolment, it is an outstanding opportunity for outsiders to get a share of the UK market,” he says.

“We are bringing a proven concept of pension provision that is transparent, forward-looking and is a lifelong product.”

ATP had bid to work with NEST as administrator to the scheme, but pulled out before the winner was decided citing too many uncertainties over the timing of implementation and the size of the scheme.

Now, as auto-enrolment continues to be pushed back by the government, does that make the UK market less attractive?

“Not knowing what the timeframe is does add some risk going forward, but we are sure we will stay and go for it. Britain needs auto-enrolment – companies can no longer afford defined benefit schemes and people need to build up pensions.”

So what’s next for Rohde and ATP?

“All the time we are trying to enhance our understanding of investment models, adding new asset classes and improving our risk management – our core business model is based on risk.”

So more of the same for Denmark’s largest hedge fund – I wonder if the UK is ready for it.

Tell you one thing, while the media is praising Canadian public pensions funds, the best pension fund in the world is being run out of a small city just north of Copenhagen. ATP is obviously doing something right. Wish they came to offer their services in Canada and the United States.

I don't see them getting eaten alive by hedge fund fees. In fact, they can teach hedge funds a thing or two about hedging, dynamic asset allocation and risk budgeting. And unlike hedge funds, ATP is not charging 2 & 20 to manage assets, which means they won't be competing with hedge fund managers outspending bankers on London homes (meanwhile where are the customers' yachts?)

Interestingly, while North America's largest pension funds are delivering paltry returns, waiting 52 years to achieve fully funded status, following endowment funds still betting on hedge funds and struggling to recover from the 2008 crisis, this Danish super fund is humming along nicely, delivering outstanding results and remaining fully solvent.

I love it for several reasons. First and foremost, it proves that large, well-run public defined-benefit plans can deliver outstanding results even in the hardest, most punishing years. It also shows you that the world's best fund is not charging 2 & 20, not following the pension herd paying 2 & 20 for hedge funds, and knows how to dynamically allocate risk to add alpha where it ultimately counts -- on overall fund returns!

Jim Keohane, President and CEO of the Healthcare of Ontario Pension Plan (HOOPP), the closest thing to ATP this side of the Atlantic, shared these comments with me:

I would agree with you that ATP is one of the best run pension organizations in the world. We have spent a lot of time studying how they run their fund and have learned a lot from them. ATP is very open about how they manage their money and have been quite willing to share information with us.

Our liability stream is quite different from theirs so our investment portfolio is not exactly like ATP, but we have adopted many of the ideas that they originated. We have divided our portfolio into a liability hedging portfolio, and a return seeking portfolio following ATP’s approach and we have moved to a risk based approach to asset allocation which is again an idea that we can trace back to meetings with ATP.

Many funds talk about using a liability driven approach but very few have implemented it as successfully as ATP. Their excellent results in 2011 are largely driven by their LDI approach and when you see more funds report their 2011 results it will be quite evident which funds are liability hedged and which ones aren’t!

Jim added:

I watched the CNBC interview with Lars that you posted which points out another similarity between our funds is that if you look at our return seeking portfolio it looks like a multi-strategy hedge fund managed internally. Our rational for this approach is exactly the same as the reasons Lars cited in the interview.

I would echo his comments on the cost structure and the poor risk distribution between hedge fund manager and client and I would agree that we can control the risk much more effectively when these strategies are managed internally. I would also point out that we have structural advantages (such as a large balance sheet, we are highly credit worthy and we are not taxable) that allow us to pursue a number of low risk strategies that hedge funds could not undertake.

Our results won’t be released until April and they won’t match the spectacular results of ATP but they will be solid positive results. When gauging the success of a pension organization it is important to focus in on the correct metric which is surplus. Our objective is to make sure that our assets grow faster than our liabilities (which is ATP’s objective as well).

On this metric we were successful in 2011 in that our surplus remained constant. Because of the significant decline in long term interest the present value of liabilities grew significantly in 2011. Most funds will post a small positive result in 2011, but will have lost significant ground in their funded status due to the large growth in liabilities.

The best returns in 2011 were in long bonds, real return bonds, real estate and private equity. These are all asset classes which are employed heavily in an LDI portfolio. That is why I believe that funds employing LDI will differentiate themselves in 2011.

Below, a February 2010 CNBC interview where Lars Rohde, CEO of ATP, discusses why he decided to invest $1 billion into a series of in-house hedge funds instead of investing in existing ones. Listen carefully to his comments on why he took this decision and how they use swap overlays to hedge their portfolio.

Finally, on risk, it seems that not all hedge funds are bracing for disaster. Below, Michael Novogratz, principal and director of Fortress Investment Group LLC, talks about investment strategy and Facebook Inc.'s initial public offering. Novogratz, speaks with Erik Schatzker and Stephanie Ruhle on Bloomberg Television’s “InsideTrack," also talks about global market performance, central bank monetary policy and hedge funds taking on more risk. Guess some hedgies have been diligently reading Pension Pulse! -:)


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