Denmark’s Sampension: Liquid markets signpost illiquid dangers

Institutional investors are embedding illiquid alternatives ever more deeply into their portfolios in the hunt for returns. But Henrik Olejasz Larsen, CIO of Denmark’s DKK354 billion ($47 billion) Sampension, the country’s fourth largest pension fund, counsels on the importance of waiting for liquid markets to recover before adding more to alternatives.

For sure, Sampension’s alternative allocations continue to outperform listed instruments (particularly real estate and energy and transport infrastructure) and long-term, the fund will continue to allocate more to illiquids.

However, the portfolio is now un-balanced relative to set targets, and until listed markets recover, Larsen is planning to slow the build-up in alternatives. “Returns on some of the alternatives are inconsistent with moves in liquid assets,” he says. “When listed assets fall sharply and illiquid allocations don’t, we worry that less liquid markets haven’t built all that information into their pricing.”

The price differential manifests particularly in private equity fund valuations, he continues. In a bid to better measure what is really happening in its 4.7 per cent allocation to private equity, Sampension takes the last quarterly NAV from its fund managers and compares it to liquid reference indices over the same price point. “If there is a drop in liquid markets, we make a top-down adjustment in the value of our illiquid investments,” he says.

Although a crude measure of what is going on, he says this approach offers an insight into what would be the true valuation if the asset was sold today. “Private equity has a direct link to what is going on in listed markets,” he says. “I am concerned that the value set by our managers is a market transaction price that wouldn’t be realised.”

Positively, the concept applies the other way around too. It leaves him anticipating an upward spike in illiquid valuations that have still to mirror positive moves in liquid markets. None more so that Sampension’s holdings of renewables infrastructure (part of an 11.4 per cent allocation to real estate, land and infrastructure) set to benefit from sharply higher electricity and gas prices.

Tactical tweaks

Larsen espouses the importance of building a portfolio that can withstand large movements without necessitating short term corrections in an investment approach that draws on a rich store of experience. He joined Sampension in 2007 on the eve of the GFC. Back then the fund had traditional defined benefit guarantees and the crisis triggered a swathe of portfolio adjustments.

More easily said that done, avoiding all forced liquidation at the worst time is now deeply carved into his construction philosophy. “When markets go down you should not retain your risk. But you should have the option to be fully invested and increase your exposures.”

Nonetheless, the current investment climate is prompting a few tweaks here and there. Over recent years he has steadily added inflation protection. Linkers have been included in the strategic asset allocation since the start of the year and he’s gradually shifting a portion of the low-risk bond allocation to global real estate.

The process has required manpower and careful consideration around not concentrating investments in particular yields, he says. “We will continue with the strategy, but it does depend on where you enter the market so we want to spread this over several years.”

The fund has also moved towards less liquid instruments in the traditional bond portfolio in response to elevated spreads. Favoured allocations include AAA CLO tranches over investment grade corporates or European government bonds, for example. “The spread between mortgages and Danish government bonds has widened, as it has for asset swaps and Danish vs German government bonds,” he says.

Value bias

Larsen continues to favour Sampension’s value bias as a fundamental driver of equity returns at the fund. The allocation has become closely linked to interest rate movements where rate rises continue to cause value to outperform growth, thanks in the main to rate rises tending to hurt growth companies more because their cash flows are longer duration.

“It’s benefited us,” he reflects. Still, if the value allocation continues to perform as well at the end of this year as it did in the first half of 2022, he may begin to take the allocation down.

That decision will also be informed by the fact today’s underlying driver of the value allocation doesn’t fit with Sampension’s overarching philosophy: to find out-of-favour investments that provide value for money in the listed space. It’s why, for example, Larsen doesn’t like crypto or gold, both assets that lack strong underlying cash flows and rely more on market increases.

“Our value strategy is not about buying everything indiscriminately,” he continues. “In equities we use statistical key numbers derived from equity valuations as an investment guide and we assess if structural factors could give rise to numbers being skewed.”

In a final reflection, he advises on the importance of board and senior management buy-in to the thought-process underlying value investment. At Sampension this proved key when the pandemic struck. “This saved us a lot; we weren’t forced to sell in the spring of 2020,” he says.

ESG

The value bias also helps protect the portfolio from the risk of over valuations in ESG and companies puffing up their green credentials. Sampension is pouring more resources and time into ESG data collection and analysis (using internal and external expertise) than any other investment process in a bid to measure its 2050 net zero progress.

“ESG is where we are doing most new stuff. We want to use granular ESG data in a more systematic fashion that will give insight on the portfolio at an aggregate level. We are spending money on this, putting in manpower and buying data and systems.”

In a whole portfolio approach, strategy is focused on buying and engaging with companies it thinks it can improve and only screening out those it doesn’t believe will change. “We stay invested in the sectors that matter the most,” he says.

Emerging equities

Of late Larsen’s focus has also honed on Sampension’s 15 per cent, externally managed allocation to emerging market stocks. For years he’s favoured a structural overweight to emerging markets on the basis that economies that grow fast experience high returns in equity markets – but now he’s not so sure.

“I see no evidence of a link between the growth of an emerging market economy and the listed market – this is not something I am optimistic about anymore,” he says.

He is also wary of large China weightings in emerging market equity allocations given governance issues in Chinese corporates and geopolitical tensions. Instead, he favours allocations to developed market corporates with exposure to emerging markets. “We are tilting the portfolio this way,” he concludes.