At the end of 2015 ATP, Denmark’s statutory DKK 806 billion ($120.2 billion) pension fund, announced plans to switch to a new risk-based investment approach. One year on, and new chief investment officer, Kasper Ahrndt Lorenzen, one of the architects of the strategy in his previous role as head of portfolio construction, explains how the factor approach offers real diversification and flexibility.
“Factor investing allows us to look at all assets through the same lens and compare all types of investments; it is easier to make decisions based on a comparable characteristics. It feels good to now be implementing so much of what we previously worked on,” he enthuses, speaking from the fund’s Hillerød headquarters.
ATP divides its assets into two portfolios: a hedging portfolio composed of long-dated fixed income instruments, which insulates the fund’s liabilities against interest rate risk, and a return-seeking investment portfolio based on the risk parity approach put into action at the beginning of 2016.
The factor strategy is only applied to the return-seeking part of ATP’s overall assets which consist of its bonus reserves worth approximately DKK100bn ($14 billion). The bulk of the pension fund’s assets are held in the hedging portfolio, designed to meet the fund’s pension guarantees.
At the end of last year the fund swapped its allocation to the conventional risk classes it invested in over the preceding decade, to focus instead on four specific risk factors.
The return-seeking portfolio is now split between an ‘equity factor’ (49 per cent of assets) ‘interest rate factor’ (22 per cent) ‘inflation factor’ (12 per cent) and ‘other factors’ (18 per cent and comprising alternative liquid factors – alternative risk premiums – and alternative illiquid factors.)
Given the number of different factors to choose from, choosing the right ones was challenging. ATP’s answer was to keep it simple.
“We built on academic insight on what constitutes high level risk sectors; equity and interest rates were always going to be the two big factors. Rather than squeeze in 10 different risks we went for four distinct risk dimensions which capture real diversification at the top level.”
Now assets are chosen according to the extent to which they “load to the right factors” and meet the return hurdle based on the fund’s understanding of risk.
The clear sight of the risk factors at play behind investments has led the fund to reject some deals through the year.
“If the investment doesn’t meet the hurdle it’s easier to say ‘no’. We walk away from investments all the time because they don’t meet our required hurdle rate,” he says.
Lorenzen also believes the approach has been most helpful in scrutinising the underlying risk in alternative, illiquid assets where there is less data available compared to bonds or listed equities.
Real estate, and often infrastructure too, can contain all four risk factors with a single asset holding inherent interest rate and inflation risk on rental income, equity risk and illiquidity risk.
The approach allows the fund to compare the expected return on a real estate investment with the return on other assets with the same underlying risks.
“It makes it easier to compare the compensation for locking up capital long-term,” he says.
Beneath the four main factors lie sub factors within each allocation.
“We have our four main factors at the top and then sub factors below that add onto them as you drill down. It is like an iceberg.”
For example, within the equity factor lie a host of factors, including regional beta and credit spreads that are benchmarked against various indices.
“As we drill further down, indices give us our reference benchmark.”
It’s much cheaper than active management, although slightly more complex.
“The complexity is justified but it is hard work, and the work is ongoing. It takes up human and IT resources.”
A key element in the process has been the adjustment of ATP’s risk modelling and return reporting to the new investing principles. ATP has around 60 people in its internal investment team, and the new approach has engendered a cultural shift at the fund.
“We are no longer divided by asset class. Our teams still work within their own asset classes but they produce the factor loadings for the whole fund. It is a common framework that is both motivating and uniting.”
His advice for other funds: “What works for one institution may not work for another. What may be justified complexity for one, may not be for another.”
He is also aware that the approach doesn’t wholly solve diversification and performance issues.
“The fact that several risk factors have performed well is nice, but it is also disturbing.”
His solution is to regularly review the current factors.
This is an ongoing learning process, where one can always refine and deepen the level of understanding. We will still have to think about whether we’ve got it right and make sure for the next quarter, over the next year and into the future, that we have the right set of factor exposures.”