Diversification, globalisation, specialisation

Although the Nordic countries differ in terms of their linguistic and geographical landscape, their institutional investment set-ups share many common themes.

After a heavy 70-80% allocation in fixed income over many years, it was equities that ruled the past decade in the Nordic markets, according to Jens Bjorheim, director of sales and business development in Switzerland and the Nordic region at Baring Asset Management.

"As long-term investors, pension funds profit from a high equity exposure. And so an equity allocation of 30-60% is typical for Nordic pension funds. The longer their liabilities, the more they tend to allocate to equities, with Finland in my view having a slightly higher risk appetite than its Nordic neighbours. While the solvency regulations - called traffic light systems - of Denmark and Sweden take the pension fund's risk buffer into account, the restriction on asset allocation in Finland has been eased up through recent regulations, of which pension funds and other institutional investors are taking advantage," says Thomas Berglund, head of Nordic distribution at Threadneedle.

"Traditionally Sweden had the highest equity allocation and Denmark and Finland the lowest. However, there has been a certain convergence over time. And now it is within relatively low interest rate environments, where pension funds can afford to take more equity risk, that the allocation to equities is highest, in particularly in Norway, Denmark and Finland," says Peter Preisler, head of EMEA at T Rowe Price.

"The bull market has helped the performance of domestic as well as global equities over the past five years. And the allocation of institutional investors in the Nordics has been sound. After all, pension funds have long-term liabilities so it makes a lot of sense to match these with long-duration assets," adds Hans Danielsson, chief investment officer for external clients at AIG Investments. Domestic equities in particular have played a very important role, outperforming their European counterparts over the last number of years.

Around one third of the equity allocation of Nordic pension funds is domestic, while the other two thirds are foreign, according to a couple of asset managers. "Having had a stellar domestic equity performance for five consecutive years makes it very difficult to suggest smaller weightings to Finnish equities," says Mikael Simonsen, chief investment officer at Finland-based Icecapital Asset Management.

"On top of that, Finnish company boards and labour unions want higher weightings into Finland, albeit for different reasons. CEOs want pension companies to buy more Finnish equities because it is likely to increase their share price, while unions want to gain more power over companies by allocating Finnish pension fund money to them. The only counterforce is investment management that points out the high risk arising from a high exposure to Finnish equities.

"The change in the solvency framework regulation at the beginning of 2007 also makes a lower equity allocation difficult, as it allows institutions to increase their equity exposure from 30-40%, staggered over five years," he adds. But has the turmoil in the financial markets over the summer months made Nordic investors stop and pause in their pursuit of domestic equities?

"Finnish equities tend to outperform all
other equities in both up and downturns. And that has assured pension fund boards even more in their ambition to have a very high exposure to Finnish equities. These equities tend to take a hit during liquidity crises, when people sell emerging markets and buy into the more liquid markets.

But although the credit crunch was a liquidity problem it failed to hurt the Finnish equity market, as it would normally be expected to do. To trigger a change, we would need to have a severely underperforming year or even quarter for the Finnish markets. At the moment, people accept the volatility that comes with a high domestic exposure, which so far has been purely on the upside."

"And the ones that have focused on risk concentration with a smaller allocation to Finnish equities have been hit for so many years now, their voice is not that strong anymore. However, a big problem with the Finnish equity index is that it is very concentrated, with three or four stocks forming more than 30% of the index," adds Simonsen.

Bjorheim is equally wary of the high domestic equity exposures in the Nordic markets, because they offer no significant diversification.

But the good domestic equity performance of recent years helped build up pension fund reserves, which in turn has helped pension funds manoeuvre through difficult situations, says Lars Eigen Moller, head of asset management at Danske Capital.

Preisler believes that the subprime crisis has led investors to review their asset classes and risk levels. But he says that Nordic pension funds with their established buffers do not react to every small correction and can afford the equity risk.

"The drivers behind the recent domestic equity performances in the Nordic markets have been the strong oil-price driven economy in Norway as well as firm demand for services and infrastructure from high-quality industrial companies in Finland and Sweden. These have also benefited from global growth and demand, in particular from emerging markets," says Berglund.

"And Denmark has been helped by the performance of its small- and mid-cap companies, which make up a large part of the Danish market," says Moller.

Iceland, according to Berglund, differs from the other Nordic countries due to its economic exposure to banking and fishing, its smaller economy, budget deficit problem and high interest levels.

However, many asset managers believe that the Nordic markets will not be immune from a global slowdown.

"Looking at the global economy we cannot expect to have similar growth rates to the ones we have had over the past few years. Eventually they have to slow down and equity prices will be dominated by the underlying companies, sectors and individual stocks in a lower return environment, creating a more difficult market for the asset managers. The good asset managers will probably shine in the next period, whereas the more momentum-driven managers will face problems," says Preisler.

"The growth cycle has lifted all equity markets, and some markets like our domestic market have had a very strong performance. The Oslo stock exchange has bene-
fited strongly from growth in developing countries and the implications for the energy and oil service sector but also commodities and shipping markets. Returns going forward hinge on the growth cycle. Our tactical view is that growth in developed economies is definitely slowing. However, growth in the developing countries such as China, India and others seems well supported and we currently recommend a normal strategic allocation to equities," adds Jan Erik Saugestad, chief investment officer at Norway-based Storebrand Investments.

And Bjorheim believes that only a recession of the US economy, not a slowdown, will affect emerging markets.

Because of their recent performance, domestic equities still play a large part - around 10% - in the asset allocation of Nordic institutions, says Berglund. But, he adds, that their rate is falling as investors seek more diversification.

Preisler says that asset allocation trends depend on the individual country. He sees increased equity allocation in Finland, a mixture in Denmark including alternatives such as forestry and infrastructure on top of international private equity and real estate, in particular listed real estate, and an even greater, individually and tactically-driven mix in Sweden. Hedge funds, he says, are more popular in Finland and Sweden, although demand for them in the latter is easing.

"The introduction of the traffic light systems meant a lot of new initiatives on asset allocation were put on hold because investors did not exactly know what that system implied for them as a pension fund. But every pension fund was fairly well into green light and there has been no cause for major changes such as a reduction in equity risk. Alternatives are being used as good liability matches because they are long-term and uncorrelated to the traditional asset classes," he adds. The trend to diversification in Denmark is also supported by the lack of liquidity in the Danish equity market, according to Moller.

In Sweden, the Nordic region's largest market, Danielsson sees a growing interest in foreign, non-Swedish equities, alternatives as well as a relatively high allocation to higher risk and return assets.

In Norway the tendency has been to increase international equity at the expense of domestic exposure after the high returns of the past years, according to Saugestad.

"When the markets go down like they did over the summer, it refocuses investors attention on risk. But there have only been tactical changes because the downturn was neither long nor severe enough to change the strategic allocation of long-term investors. However, Nordic pension funds are monitoring the situation," says Berglund.

And Moller adds that although some investors were hit by the increased spreads in the credit market, others saw it as a buying opportunity to increase their exposure. Danielsson has observed the same trend, explaining that some of AIG Investments' Nordic clients increased their allocation to emerging markets over the summer months.

"A few large investors have gone very aggressively into alternatives or hedge funds. But hedge funds, for example, still need to be proven. If this quarter shows a good performance, then investors will probably reduce equities and buy into hedge funds. If hedge funds have taken a severe hit, then people might even be selling away from hedge funds in 6-18 months time. However, following the change in the regulation, we still expect an increasing equity allocation. The question is whether Finnish pension funds will add to their international equity exposure. But I believe we need a very bad quarter or year to take away the euphoria for Finnish equities," says Simonsen.

He adds that diversification is best done internationally because it is impossible for a Finnish pension fund to hedge itself in the Finnish market. Particularly on the bond side, Simonsen says, there is a strong European bias.

"One of the difficulties in all Nordic markets has been that the domestic equity performance has been superior to the international performance. But the highly sophisticated investors of the Nordics understand the need for diversification. Some investors, particular Swedish and Finnish ones, seem to have a strategic overweight in emerging markets. They are willing to invest in the growth of the new markets and often do it at the expense of a high domestic allocation," Preisler adds.

Bjorheim also notes a strong interest for emerging markets but says for diversification purposes the Nordic investors' allocation to emerging markets is still not high enough."Our view is that, to have superior performance, investors have to do something different from the majority. But they tend to be cautious of being different," he adds.

AIG Investments' Nordic clients are particularly interested in specialised high-alpha mandates such as global emerging markets, high yield, specialised real estate and infrastructure. But Danielsson also notices a hunger for international equities in their strive for diversification and reduction of volatility.

But Berglund likens Nordic institutions approach to alternatives to dipping a toe into water. He says many Nordic pension investors have already invested in alternatives but their allocation remains relatively small. The most popular alternatives to date, he says, are private equity and funds of hedge funds. Many pension funds are looking to expand their alternative portfolios with single strategy hedge funds, infrastructure, commodities, timberland as well as overlay products, he adds. On top of an allocation to equities, which typically ranges from 20-30%, Saugestad says that typical Norwegian pension portfolios also have a 30-50% exposure to bonds including hold to maturity bonds. Fixed income exposure has been reduced in favour of equities in recent years, he says, while alternatives like hedge funds still play a minor role, if any, in many pension fund or municipal portfolios.

"With regard to our domestic bond market, the government does not actually need to issue bonds. However, for pension funds and life insurers it is important to have a domestic, duration-offering bond market so the government issues paper to support the market. But for large portfolios the small size of the bond market is of course challenging. That is why we run international bond portfolios and have been doing so for a long time," says Saugestad.

"The introduction of the traffic light systems meant that Nordic pension funds now have to mark liabilities to market which in itself is sensible. And that has forced a lot of pension funds to go back to the asset allocation of the past, so we now see a swing back to fixed income, particularly longer duration fixed income, but not necessarily straight government bonds. In the past, the fixed income market was marred by the lack of longer duration bonds. But with the shift to a higher equity allocation, there was also a shift away from, for instance, Swedish 10-year bonds to European government bonds and swap-based transactions," says Bjorheim.

Preisler believes that fixed income in the form of global aggregate bonds may return to its old popularity as the subprime crisis reminds investors of the relation between risk and return. But in general he does not expect fixed income products to seriously come back into fashion any time soon.

"Both within fixed income and equities there is a lot more exposure to new specialised types of assets such as high yield emerging markets and senior secured bank loans. Specialised mandates with an allocation to Eastern Europe or emerging markets are also growing in popularity. But in general, fixed income depends very much on the asset liability management. Some pension funds focus on handling the yield and the liabilities as one exposure and allocate some of the risk to other types of more alpha-generating exposures. The introduction of the traffic light systems has also led to a focus on derivatives for the management of exposures," says Moller.

He also says that products such as 130/30 are also receiving considerable attention. But Preisler of T Rowe Price, which has eschewed the area of 130/30, notes oversupply and says they may not be able to deliver what they promise. And while Danielsson sees pockets of interest for structured products, he cannot see a major drive behind them at the present time.

Many Nordic pension funds invest in their own domestic market as well as global equities. However, few will have a portfolio that covers the whole Nordic region, says Preisler.

"The Nordic market is probably more interesting for investors outside the Nordic region because it allows them to get exposures to all markets. It could, for example, be expatriates living outside the Nordic region that are buying exposure like this on the retail side," says Moller.

International competition in the Nordic markets is still increasing, according to many asset managers. Preisler says as a result of the excellent performance over the past few years, investors have now more money for expansion, which has led to more asset managers in the region.

"Because more risk is taken and more mandates are offered, there is also more business to be won. And the competition is based on quality rather than quantity. A lot of the domestic asset managers have reacted well to the rising number of competitors by concentrating on their strengths. In some asset classes we see Nordic competitors that are just as strong as the top international houses because they have decided to focus on one or a few areas and then invite competitors to manage some of the other asset classes," Preisler says. Saugestad says that for specific areas, such as emerging market debt and emerging market equities or other specialised areas, Storebrand brings external managers into the total solution for clients.

"Plenty of international products are being offered and we have an open structure in order to incorporate both our own products and the ones from international providers for client solutions," he says.

The Nordics are generally important markets to asset managers because of their size and also because their institutions have always looked outside their own region for ideas, says Bjorheim, adding that companies and products come and go in the Nordics. To compete in that market, he says, transparency and a long strong track record in the relevant asset class are necessary.

"At Danske Capital we realised four years ago that we could only be internationally competitive by focussing our resource on key products, such as European equities and investment grade, Eastern European equities and all our domestic fixed income and equity products, because they are the areas where we can be strong in the very open and international Danish market. And in areas where we have chosen not to produce it ourselves, we will work with external sub-suppliers," says Moller.

"Many Swedish pension funds decide to manage Swedish and sometimes Nordic equities and fixed income in-house, whereas they outsource a fair amount of international equities. And the pattern seems to be that the more foreign the equities are - such as Asian and emerging market equities - the more they rely on outsourcing. As alternatives such as private equity, fund of hedge funds and international real estate gain in importance so does the interest in outside providers. Typically, domestic providers have an advantage with regard to domestic asset classes while foreign entities often have an advantage in non-domestic asset classes," says Danielsson.

According to Saugestad, Storebrand was one of the early adopters of ESG (environmental, social and governance related) investing. He says that since Storebrand's introduction of ESG in the mid-1990s, the Nordic markets have become more aware of these issues.

"From what we see, ESG or SRI (social responsible investment) is definitely gaining momentum, and an increasing number of pension funds and municipalities are adopting ESG criteria. We believe that the trend will continue and is likely to move into the alternative space such as hedge funds as well. We have been doing a lot of research in various portfolios to find a positive or negative effect of ESG on investments, but as far as we can see it is hard to identify any impact."

Above all though, Bjorheim says, the typical ESG approach by Nordic investors is via an engagement policy.