September 2008

PENSION FUNDS: how to make a hedge fund

In 2005, the Danish pension scheme ATP started to build its own hedge funds. Success means the number of teams will increase to twelve by the end of the year. Angele Spiteri Paris talks to Fredrik Martinsson, CIO ... Fear of the unknown could be blamed for putting pension schemes off hedge fund investing. Historically, these conservative institutional investors have been apprehensive about hedge funds, often on the grounds that they lack transparency.

Danish pension fund giant ATP, however, has taken matters into its own hands and created its own internal hedge funds in an attempt to provide the scheme with a source of uncorrelated alpha.

“The business model we run is very different from the mainstream [pension fund],” explains Fredrik Martinsson, CIO of ATP’s alpha portfolio.

The conventional model assumes schemes will not be able to attract skilled managers to work in-house and therefore funds are forced to  seek funds of funds (FoF).

But in 2005, ATP undertook an alpha-beta separation exercise and redefined the words ‘alpha’ and ‘beta’, which led to the launch of its own hedge funds.

“When we were looking to carry out the alpha-beta separation we understood that the concept of these returns as derived from the CAPM [capital asset pricing model] is probably not right,” Martinsson says. “The idea of alpha being some form of active management and beta being passive is totally wrong.”

He adds: “Beta involves a lot of skill – skill in putting together a portfolio that makes sense and implements exposures in an intelligent way.”

But whereas many pension funds looked at returns academically, Martinsson says that by building its own capability, ATP was going further.

In-house alpha
However, unlike other pension funds that did something similar the Danes internalised the bulk of their alpha-generating activities, with some two-thirds of alpha portfolios managed in-house.

This has many advantages. In a conventional tender process, a pension fund issues a tender with a specific return target and then has to sift through the mountains of information submitted by managers. The next step is to throw themselves at the mercy of the manager with the seemingly more robust investment process and hope for the best.

This is not so within the ATP alpha portfolio. Carrying out hedge fund management internally allows ATP some peace of mind in that there are no transparency or lock-in issues. The practice essentially cuts out the middleman and provides a more cost-efficient route to alpha generation.

“We obviously have full transparency since all the positions are within our systems,” says Martinsson. “We also have the ability to quickly change the risk budget we allocate to any team. This therefore gives us the real-time opportunity to change the positions, which third-party structures are not capable of offering.”

Due to this, the ATP hedge funds are therefore ready to take action if things go awry. According to Martinsson, all of these factors endow the fund with the ability to build what he calls “strategic value over time”.

“With a fund of funds, strategic value is generally built around the selection process,” he says. “Within our hedge funds, however, we build value into the whole of the platform – the risk management, the allocation of risk to the different teams, etc. It is simply a totally different standard of strategic value for the pension fund members rather than simply picking a fund of funds.

The aim of the alpha portfolio is to deliver DKr3bn (£319m) worth of alpha by 2009 and Martinsson says everything is going according to plan, in spite of a few bumps along the road.

“We had a tremendous start in 2006 and we continued to make money in 2007,” says Martinsson. “The first quarter of this year was tough as we lost money for three months in a row, but we closed Q2 in style, generating positive results for three months in a row.”

The fund’s financial results in fact reveal that the loss in Q1 of 2008 was of DKr2.2bn. However, the fund says the loss could have potentially been much greater had it not been for certain investment decisions that were able to contain it.

Official figures for Q2 2008 are due for release in the last week of August when it will be interesting to observe the recovery Martinsson describes.

The next step for the CIO of the alpha portion of ATP is expanding his organisation’s operations by bringing more teams on board. “By Q4 2008, ATP alpha will have twelve teams running equity long-short strategies, fixed income arbitrage, global macro and foreign exchange trading strategies – all managed by us.”

Going for growth
The CIO explains that the expanded teams will help achieve the alpha portfolio’s mission – to change the odds and provide the fund with a significant source of returns independent from the beta portfolio.

Martinsson says that although the fund is making good headway, it still has more work to do to achieve the goals set before it.

“We need to start making billions rather than millions,” he states. When seen in a vacuum, as a standalone portfolio, ATP alpha has been performing very robustly. However, due to the sheer size of ATP’s assets under management (DKr440bn as at Q1 2008) the return has to be exceptional to make a dent in the overall portfolio.

“If we were to deliver DKr200m to DKr300m with a Sharpe ratio of 2.5, it would be a pretty good result,” Martinsson says. “But seen in the context of the size of the funds’ assets it becomes less significant,” he adds.

Martinsson explains that in order to achieve the targeted returns, the portfolio will need to grow substantially. However, he is in no hurry to jump the gun and risk taking a misstep that could cause endless grief.

Stability and profitability are key factors in generating sustainable growth and Martinsson says the ATP alpha portfolio is half way through garnering them.

“Before going for growth you aim for stability. This means having the teams knowing that their investment processes are state of the art and that their platform is stable and provides all the necessary data information,” Martinsson says. “Then based on that stability, we can develop a track record of profitability.”

The portfolio is therefore on its way to growth and the CIO is certain that within the next two years, at the latest, the mission to become a significant source of uncorrelated returns will be achieved. © 2008 Funds Europe

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