Henrik Gade Jepsen, chief investment officer at the 579 billion Danish krone ($102 billion) ATP, Hill-eroed, Denmark, and his team are bringing the concept of contrarian investing to a whole new level.
In 2011, when many institutions struggled to scrape a positive return out of a difficult economic environment, ATP delivered 26.3%. The bulk of the returns came from its pension liabilities hedging portfolio, and both the beta and alpha portfolios contributed to the stellar performance.
Just as markets were looking up early last year, ATP decided to nearly halve the risk within its investment portfolio in the second quarter of 2011. Though Mr. Jepsen insists that the fund is not in the business of forecasting, the risk reduction exercise turned out to be a prescient move. (ATP's all-weather portfolio also registered an 18.8% return for 2008 following the Chapter 11 bankruptcy reorganization of Lehman Brothers Holdings Inc., which triggered a global financial crisis and left many of its peers deep in the red.)
An economist who had worked at the International Monetary Fund before joining ATP in 1999, Mr. Jepsen was chief investment officer for the beta portfolio until he was promoted to group CIO in January 2011. Back from his summer vacation several months later, the eurozone debt crisis was in full force, resulting in what Mr. Jepsen described as “an environment in which macro forces have completely overwhelmed the micro forces.”
In 2011, ATP recorded the best performance in the fund's history during what were pretty challenging market conditions. How did you do it? Obviously our hedging portfolio meant a lot last year. About 85% of the returns came from fully hedging our pension liabilities. The investment portfolio gained another 17 billion (Danish krone). The main benefit was a balanced approach to risk, which helped us to generate positive returns in our investment portfolio in all four quarters of 2011. For example, in equities, we mainly reduced foreign equities. In times of market stress, equity markets tend to be highly correlated, and it is thus more important how much equities we own rather than which equities we own. You could argue that our equities portfolio became less diversified, but on the other hand, we considered it more important to sell the most liquid equities, in order to de-risk cheaply and efficiently rather than retaining a very diversified equity portfolio itself. In government bonds, we've been gradually excluding various countries, mainly peripheral Europe, but we have also opted out U.S. and U.K. government bonds. For right or wrong reasons, we think these were countries with very large budget deficits, and there's a strong incentive to inflate away the debt. Obviously that hasn't materialized, but that was what we saw as a big risk.
One of the key contributions to 2011's results was a move to reduce risk in the second quarter. Can you explain that decision? I've had this job for a little more than a year now, and it has been an exciting one. The first quarter of 2011 started out in a decent way. We saw markets go up, rates rise, and there was a growing sense of optimism taking hold. But when we got into the second quarter, we started to worry. I'm always hesitant to say that we predicted something was going to happen, because that's not the way it works. However, we saw that (the quantitative easing) program was about to expire, the U.S. economic indicators turned downwards, and most importantly, increasing signs of trouble in the eurozone. We decided to simply take risk off our entire investment portfolio.
Given the large pool of assets at ATP, how did you implement the risk-off strategy? We split our portfolios into five risk groups — interest rates, credit, equity, inflation and commodities. We have internal guidelines to try and maintain a portfolio in which we're able to reduce risk in every risk class by 30% within a two-week period. Of course, it's not an exact science, but you get the point that we try to be liquid enough so that we can reduce risk rather swiftly. In the second quarter (of 2011), we conducted a balanced risk-off program across the board. It wasn't just a call on equities. We reduced risk in all five categories by almost half. That's quite a lot.
How is ATP's decision-making process structured so that such changes can be quickly implemented? We have basically made sure that private equity, real estate and ATP Alpha — all of which are labor-intensive — are spun off into subsidiaries. I sit on the boards of these ventures, but the day-to-day management of these investments is not something I have to deal with. Why is that important? At least from what I've seen, there is a tendency that management spends 90% of the time on 10% of the portfolio. You can easily spend all your time discussing specific private equity deals, real estate projects and so on. That would leave you with very little time to focus on the big portfolio issues. The way we've organized ourselves is to be able to deal with issues at a total portfolio level. We also have a lot of flexibility within our guidelines. For example, we don't have benchmarks. We have risk buckets. That makes us very nimble in the decision-making process.
Going forward, are you more optimistic for 2012? We're again going through a period where, on balance, we are seeing improvements. Some of the tail risks in Europe have been reduced, which is obviously a good thing. We're still careful, though. The debt is still there, and I don't think you can cure a debt problem with monetary policies alone. I think it's fair to say that this debt will be there for a long time, making economies more vulnerable to shocks. It's hard to imagine that we're entering a sustained high-growth environment in which risky assets will perform strongly. Another concern is that having stretched both fiscal and monetary policies to the limit, the ability for governments to deal with any new economic shock is very limited. ... We are still quite significantly below our maximum risk level in all five risk groups. ... We're still driving in unknown territory. We think it's prudent when you're driving into places you don't know that you sort of lift your foot from the accelerator.
How do you view the role of active management in a pension fund? Because 98% of our investment portfolio is called the beta portfolio, people think it must be passive, but it's completely different. If you look at our fixed-income portfolio before we went through the alpha/beta separation concept (in 2005), we had considered ourselves active core-plus managers. What that meant, of course, is that you tilted the portfolio against a benchmark, overweighting certain sectors and underweighting other sectors. If you look at our fixed-income portfolio now, it's much more actively managed. Take the asset class that we call interest rates, consisting of government bonds. What we have done is we've sold anything that's not Danish or German bonds in the last couple of years. We are, from time to time, moving the entire portfolio along the yield curve. I'm really uncertain whether we would have been able to get rid of our exposure to peripheral countries if we had stayed with an active, benchmark-driven approach.
How about the alpha portfolio? ATP Alpha made money last year and they've made money so far this year. One of the problems is being able to get enough risk in the alpha portfolio so that the returns, in an absolute sense, become higher. But obviously, we don't want to take more risk than we think we are rewarded for in the current environment, in which macro forces have completely overwhelm micro factors. ... We are moving in the right direction. When you look at a lot of hedge fund returns, they are very often positively correlated to beta factors. When you look at our strategies (within ATP Alpha), the correlation is close to zero.