By Hamlin Lovell, NordicInvestor

Lægernes Pension, which is an independent pension fund owned by its members, has been managing Danish doctors’ pensions for 75 years since world war two. The core pension fund manages DKK 115 billion, a bank offering asset management services runs another DKK 14 billion, and external mandates mainly within healthcare take total assets to DKK 140 billion.

Active strategic and tactical asset allocation have added a lot of value, mainly through active management both in house and externally. Lægernes Pension as an organization has in June 2021 been awarded “The Pension Fund of the Year in by Finanswatch and EY” for its average returns over five years ending in 2020, with the lowest costs. This reflects improvements in management and performance over multiple years.

We interviewed Søren Nielsen, Chief Investment Officer (pictured above to the right), and Niels Elmo Jensen, Chief Financial Officer (pictured above to the left).

Outperformance

The fund has outperformed consistently, without making large deviations from its benchmark. “In 2016 we made a major change in how we manage money, which has helped to improve our risk adjusted performance to top quartile over the past five years, and also over longer periods. Over a 15-year timeframe (including the Great Financial Crisis in 2008-09) the excess return in our portfolio for 2006-2021 (April) has been 1.3 pct. point compared to benchmark (the actual return was 7.3 pct. compared to a benchmark return of nearly 6 pct.)”. Over the same time period (2006-2021) the annualized volatility has been 7.8 pct. in the realized/actual portfolio and 7.9 pct in the benchmark portfolio (SAA). The IR (Information ratio) is calculated to be 0.92 (excess return of 1.3 pct. divided by Tracking Error of 1.5). The data are calculated on monthly observations,” says Søren Nielsen, CIO.

Strategy revamp, derivatives and leverage

In 2016 the fund moved towards a more sophisticated and flexible framework for managing money. “Tactical Asset Allocation (TAA) based on the business cycle and monetary policy, taking a 6-12 month view, has been the key driver in the excess return but has been supplemented by on average positive manager selection especially regarding global equity managers,” Nielsen adds. The TAA approach was empowered by strategy changes allowing for more flexible approaches. “We also have more freedom to express views through swaps and derivatives, which can also be used for leverage. For instance, part of our equity exposure comes from futures derivatives,” says Niels Elmo Jensen, CFO.

The fund is not entirely long only: “There is also an equity sector selection model in house, which goes long of some sectors and short of others as part of a TAA process that is driven by the business cycle. This has been positive every year since we started it in 2017,” says Nielsen.

Rapid Covid response

The Covid crisis provided a good case study in applying the new approach. “Working from home did not cause any disruptions to investment decisions. It might have caused some disruption to creativity, but that was not so important at the time. We were actually more active than normal in March, April and May 2020. In terms of governance, losing 15% in a very short period required us to alert the board, but we kept to our strategic asset allocation and increased risk in the portfolio”. says Nielsen.

US Treasuries, corporate credit and equities

Asset allocation made swift active decisions. “We used derivatives to increase leverage and increase exposure to fixed income. Of course, everything seems expensive, but we could have said the same thing 3 years ago. Our dilemma in a low yield environment is that interest rates are so low there has been diminishing diversification benefit of holding bonds against equities. But rates might drop even further, so we made a bigger allocation to US government bonds, which was a relatively good decision. Our main scenario was not for interest rates to fall, that was more a risk scenario. Now there are low interest rates in both the US and Denmark but even after currency hedging, US Treasuries yield more. In spring 2020 we had high fears of defaults and downgrades, but we bought corporate credit on high spreads and tactically increased equities. We are strong believers in tactical asset allocation and see the world economy in an upswing phase increasing growth above trend,” says Jensen.

Factor modelling and factor risk

Risk modelling is based not only on asset classes but also risk factors: ”We have also added a risk tool for factor modelling, to look through asset classes to see exposure to interest rates, inflation, growth, currencies, liquidity etc. This showed very high exposure to growth, which we to some degree reduced in 2017. Our purpose is to have an all weather portfolio where we have exposure to every scenario such as low inflation, high inflation, strong growth and low growth, but growth factor is still the dominant factor,” says Nielsen.

Inflation and credit spreads

Inflation is a growing concern in 2021, and is one of the scenarios that Lægernes Pension considers. “We have inflation swaps on European inflation and some commodities in a basket designed to hedge Danish inflation as closely as possible. Real estate is also a medium to long run inflation hedge because rents can be raised in line with inflation, though in the short run interest rates can reduce valuations. The property allocation has been stable at around 10,” says Jensen.

Strategic asset allocation increasing diversification

Strategic asset allocation has also changed. “We had previously focused more on bonds but now have more strategy categories, including listed equities, and unlisted private equity. In 2016, we had 50% exposure to equities and wanted to be more diversified so we increased credit, illiquid and inflation related assets. We thought it was late cycle in 2016 but now we think it is early cycle. Now credit spreads are rather low given the central bank support and the high profit margins, with rather low risk premia in high yield and investment grade. We still see some premia in emerging market   debt,” says Nielsen.

Illiquid alternatives

Low yields are pushing asset owners into illiquids in search of yield pickup, and Lægernes Pension has outperformed in this area as well. “Lægernes Pension has since 2006 been one of the top 3 out of 17 Danish pension funds investing in unlisted assets . We started investing in infrastructure in 2014, and now have 5 pct., close to our target of 6 pct. This is mainly in renewables and digital infrastructure. In private debt, we have 2 pct. in a mix of investment grade and high yield. Private equity has grown from 4 pct. to 6 pct. Illiquids in total add up to around 22 pct.

This programme also increases internal operational resources. “A specific regulatory challenge is the requirement to carry out daily mark to market valuations on illiquids, which is a real struggle,” says Nielsen.

In house and external

All of this strategic and tactical asset allocation is done in house.  Security selection is all external, with the exception of some Danish bonds and inflation linked paper.

Active versus passive

Danish bonds are actively managed, while US Government bonds are passively managed, and inflation is semi-active.

In credit in general active managers are used. In equities there is more passive exposure, using indices such as S&P 500, STOXX, FTSE 100, and Nikkei.

“We have no active large or small cap managers in the US where we prefer to be passive. Active managers are the cornerstone in European and emerging market equities,” says Nielsen.

Future returns

“We have to live with negative rates, even in Danish bonds. Lower expected returns are the main big picture challenge,” says Jensen.

Solvency II

Valuation rather than regulation explains why the return outlook is modest. Solvency II has been a low priority, because the commitment to minimum guarantees changed. “We reduced our minimum interest rate guarantee from 4 pct. to minus 1.5 pct. to match negative bond yields. It is the 20 year Euro swap rate, minus a cushion of at least 100bps. This gives us more freedom to take more risk. But we do find Solvency II places a very high risk weight, of 50 pct., for equities,” says Jensen.

Lægernes Pension would appreciate more ESG regulatory support for Solvency II. “We would like to get relief on solvency II when investing in green investments. There is now a soft commitment to DKK 350 billion in green investments,” says Jensen.

ESG

Integrating ESG is now a much bigger project than 20 years ago, when it was just about excluding certain sectors and companies. Lægernes Pension has had no tobacco for 20 years, and was one of the first firms to stop investing in drug companies that manufacture substances used for capital punishment. In 2021 and beyond, climate risk and transition to a low carbon economy are key priorities that could lead to radical change: “We could see a green tidal wave in markets if investors, companies and regulators live up to their commitments,” says Nielsen. Lægernes Pension is prioritizing carbon reduction, pursuing impact investing, integrating ESG everywhere except for derivatives and is steadily moving towards ESG benchmarks. All of this needs to be within the evolving EU Sustainable Finance regulatory framework, as well as being consistent with Lægernes Pension’s risk and return targets.