Inflation hedge drives ATP’s investment implementation

Denmark’s largest pension fund and the 29th largest in the world, ATP, is not leaving anything to luck when it comes to providing a guaranteed return for its members. Kristen Paech talks to chief investment officer, Bjarne Graven Larsen, about the various risk management methods the fund has implemented across its portfolio.

The DKK400 billion (US$71.1 billion) believes the risk of inflation when the world emerges from recession is higher than ever before.

It is for this very reason that the fund has begun ramping up its exposure to assets that protect against inflation, recently allocating up to DKK3 billion to forestry investments for the first time.

The DKK180 million acquisition of the Upper Hudson Woodland in New York State, which covers 38,000 hectares of forest, was made through new subsidiary ATP Timberland Invest K/S.

It represents the fund’s first investment in timber, and marks the start of what will be a series of investments in sustainable, FSC-certified forestry through ATP Timberland; Forest Stewardship Council (FSC) certification is a voluntary, market-based tool for forest conservation, which encourages more responsible forest management.

Bjarne Graven Larsen, chief investment officer at ATP, says since timber is a real asset, it acts as a good inflation hedge.

“If inflation in society goes up there’s reason to believe that the price of paper and pulp timber will follow,” he says.

“If you’re a long-term investor and if you are concerned about getting a good return long term it gives you some flexibility to decide not to sell the timber if prices are too low and to let the asset grow organically.”

Forestry will sit within the ‘inflation risk class within ATP’s portfolio. Two years ago, the fund split its investment portfolio – which is managed separately to its hedging portfolio – into five risk classes; equities, interest rate risk, credit, inflation and commodities.

The largest portion of the inflation risk class is in index-linked bonds, however real estate is also included, as is
infrastructure and now timber.

“We have increased our investments in infrastructure, we’ve started to invest in timber and we have been trying to find other ways to hedge inflation by using derivatives, like inflation caps and even swaptions in that part of the portfolio,” Larsen says.

“So that has been the other big focus for the strategy: because of the liquidity, because of the significant increase in the monetary base around the world, we think the risk that there will be inflation going forward is higher than ever, so we want to be able to hedge that risk as well. That’s why we’ve been so focused on building an inflation exposure in the last two years.”

The purpose of the hedging portfolio is to hedge the pension fund’s liabilities, which Larsen says have a “nominal long
duration”.

“It’s a guaranteed amount, so we decided we wanted to hedge away the unwarranted and uncompensated risk we had on the liability side,” he says.

This has historically been done using interest rate swaps, but during 2008, ATP closed down a lot of its swaps and
instead bought 30-year government bonds, which it repo’d to finance the purchase.

“2008 has been a year of transformation, and 2009 as well, where we changed our hedge portfolio from a pure interest rate swap portfolio and into a more diversified portfolio where we have interest rate swaps and we have 30-year government bonds,” Larsen says.

“The strategy is unchanged in the sense that we hedge our liabilities 100 per cent, but the strategy has been implemented in a different way.”

On the investment side, the fund’s aim is to create a real return that makes it possible to pay out pension liabilities over a long time horizon, which grows with life expectancy, and increase the yearly nominal amount so that members maintain the purchasing power of their pension.

The equities risk class contains both public and private equities, and was altered in 2007 and 2008 to remove the tail
risk in the portfolio by buying put options when market volatility was low.

“We didn’t reduce our equity holdings – of course markets helped us reduce the equities because prices went down – but we didn’t sell equities, we just protected our reserves by having huge gains in our put option portfolios,” Larsen says.

In addition, ATP began building a credit exposure in 2008 from a very low base.

“We decided during 2008 when the bank crisis started there would be opportunities in the credit area so we allocated quite a substantial amount to bank loan funds,” he says.

“Even though it’s risky, we think the risk/reward trade-off is better in credit than in other risk classes.”

Of the five risk classes, ATP achieved positive results in 2008 in three of them, with the biggest return coming from
the interest rate bucket.

According to Larsen, prudent risk management and targeted use of financial instruments protected ATP’s portfolio and prevented the fund from having to draw on its reserves.

The overall return including the hedging portfolio, which produced a profit of DKK76 billion, was 19.6 per cent. Excluding the gains from the hedging portfolio, which is how ATP presents the results in its annual report, the return on the investment portfolio was -3.2 per cent.

In 2009, ATP’s priorities are two-fold: to make sure that the pension fund remains robust even in a high inflationary environment, and to implement its strategies effectively.

“One priority is to ensure we are not vulnerable to big increases in inflation, and [the other] is to implement the strategies and execute them in the market in the smartest ways we can,” Larsen says.

“With the credit or bank loan funds and derivative structures we’re using, we want to make sure we focus on good execution.”