To claim that a unique Nordic investment model exists is a bit of an exaggeration, Antti Ilmanen says to AMWatch.
"There are, however, some commonalities in the way Nordic institutions invest," he notes referring to fee-consciousness, a strong emphasis on responsible investing and transparency as well as a higher allocation to fixed income compared to global peers.
AMWatch meets the AQR Principal and Head of Portfolio Solutions ahead of his presentation entitled "The Low Expected Return Challenge and the Nordic Answers" at the first Nordic CFA Investment Forum.
"I think that the low expected return challenge is serious and even underappreciated because we haven't experienced real pain from it yet. It will become sort of a generational challenge and, as an investor, you will need to modify your expectations for the future," Ilmanen says.
He refers to the fact that the real annual return from a traditional 60 percent US stocks and 40 percent US bonds portfolio has been 5.4 percent in the past 65 years, while the realistic expected return for a similar portfolio in the next 30-40 years will be, perhaps, 3.5 percent annually, given today's low yields.
Nordics favor fixed income
One of the similarities between Nordic investors is their higher allocation to fixed income.
According to a survey by investment consultancy Kirstein, the fixed income exposure of Nordic pension funds and life insurance companies stood at 64 percent between years 2016-2018.
Norwegian investors rank highest in fixed income exposure with an allocation of 74 percent of all assets, while Finnish investors keep only 48 percent in bonds.
In comparison, the 2018 allocation towards fixed income and cash was 34 percent in development markets such as Australia, Canada, Japan, the U.K., the U.S. and Switzerland, according to Ilmanen's presentation.
"The reason for the higher allocation towards fixed income is the emphasis on liabilities in the Nordic pension industry and the fact that the pension system is dominated by defined benefit plans," he explains.
Ilmanen adds that Danish pension savers should thank their legislators for having forced them to interest rate hedge, when the rest of the world refused to.
"While the low yield environment hasn't hurt Danes yet, low interest rates will eventually affect them, too. In the future, the tailwinds of capital gains on bonds and equities will no longer be available and investors will receive tiny dividends from equities, and even negative coupons from bonds," he says, adding:
"When markets don't offer returns, investors need to investigate other ways to build a properly diversified way to enhance returns."
Three paths to meet the challenge
Ilmanen, who holds a Ph.D. in Finance from the University of Chicago, describes three possible solutions to address the low expected return challenge: More equities thus harvesting an equity premium, more private assets and finally, adding factor tilts and alternative risk premia to the portfolio.
Each solution, however, presents a set of challenges. Equities are expensive and already the dominant risk factor to many large institutions, the private assets are illiquid, and the illiquidity premium is overrated, and multi factor strategies often require leverage to meet return targets.
For Nordic institutions, all three potential solutions will increase the capital flow into riskier asset classes compared to fixed income instruments. The most prominent path in the Nordics in recent years has been Ilmanen's second option: Increasing exposure to private markets.
According to the Kirstein survey, Danish institutions have the highest average exposure to private assets at 22 percent while Norway’s exposure to the asset class stands at 11 percent. The Nordic average is 20 percent.
To compare, this figure was 13 percent on average in 2006-2008, prior to the financial crisis.
"The most common path for Nordic institutions seems to be adding more private market assets. While such alternatives may well have several strong years ahead, I believe that this path won't be as popular ten years from now."
Overrated illiquidity premium
The shift to alternatives is more of a global than a Nordic phenomenon. It is motivated by an illiquidity premium for investors willing to commit their capital for a longer term.
According to Ilmanen, investors seek this risk premium to boost returns but in reality, the historic illiquidity premium is modest, he says, referring to the fact that the market has seen no positive premium for U.S. direct real estate over more liquid Real Estate Investment Trusts since 1978.
Additionally, the premium from US private equity to listed equities has dropped since 2006 as the valuation gap has narrowed.
"I did expect a bigger illiquidity premium and I think it is common for investors to do so," Ilmanen says. "I suspect this premium is partly offset by investor preference for smooth returns. Another motivation for private assets is that there might be a better chance for managers to generate positive alpha in the dark and dusty corners of less liquid markets," he says, adding:
"However, more recent studies suggest that while there's a big performance gap, it might be difficult to identify the top performers."
Applied Quantitative Research
Studies and academia are the common denominators throughout Ilmanen's career.
In the past, he has managed a macro hedge fund, worked at the Bank of Finland and advised several of the largest global investors on asset allocation, including Norway's Government Pension Fund Global.
Today, he continues to provide investment advisory to large institutions at US-based asset manager AQR. The company was founded in 1998 by the name Applied Quantitative Research and, as the names suggests, it has been known for its deeply academic approach to investing since it was a startup hedge fund to this day as a global asset manager.
"The academic investment approach is part of AQR's DNA," Ilmanen explains. "There is a growing interest in understanding the return sources better and use evidence-based investing. The style factor approach – such as favoring cheap and improving assets – and the equity premium are where we see the most compelling long-term historical evidence," says Ilmanen.
The rise of factor funds
According to AUM Estimates by Morgan Stanley, factor-based investment products surged in demand and grew at an annual rate of 13 percent between 2010 and 2018. This is also part of Ilmanen's presentation.
"We have seen growing investor interest in factor-based strategies at the expense of the traditional active alpha manager," Ilmanen says.
Has this development lowered the attraction of the most common factor investing strategies?
"When more money flows into any space, that can lead to lower expected returns," he explains.
"But whether it leads to no returns at all is much more debatable. Overall, bearing in mind the evidence, factor investing is still likely to be the better long-term answer in the current low interest rate environment," he says, adding:
"You should probably expect a lower equity premium, a lower illiquidity premium on private market investments and lower factor premia on styles, but these are still the best available solutions to improve investor portfolios."
Ilmanen received the CFA Institute's 2017 Leadership in Global Investment Award.
Today, AQR manages USD 194bn and employs 1,000 people globally of which 45 percent hold advanced degrees, including 80 doctorates like their Finnish Principal.
Other AQR Principals of Nordic origins include Danish duo Lasse Heje Pedersen and Lars Nielsen of whom the latter also holds the title of Co-Head of Portfolio Management, Research, Risk and Trading.
The investment manager offers 40 strategies ranging from traditional to alternative products, according to its website.
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