Finland money

Fast and Slow: Finland’s Veritas Makes New Additions to Portfolio Building Toolkit | Interviews

Market manipulation by central banks has reduced the dimensions of markets where all risky assets move in sync and the only way out is to be in cash, with negative interest rates in the Eurozone creating a nightmare of asset allocation and portfolio construction for institutional investors.

That’s the sentiment of Kari Vatanen, CIO of Finnish pension insurer Veritas with assets of 4 billion euros ($3.3 billion), which he expressed at the recent IPE Nordic Forum. Vatanen believes that while there are few diversified asset classes in the traditional asset space, there are opportunities in illiquid assets through delayed pricing and valuation. There are also systematic strategies that can be used on both the carry side as well as the diversification and tail hedging side.

Another way to look at diversification and portfolio construction is fast and slow investing, says Vatanen, referring to Daniel Kahneman’s book “Thinking Fast & Slow.”

He explains: “There are two investment systems. The first is fast, instinctive, emotional and sentiment-driven and the second relies on rational decision-making based on carefully prepared financial analysis.

Kari Vatanen

  • 2020 to present: DSI, Veritas
  • 2006-20: Head of cross assets and allocation, previously various functions, Varma
  • 2004-06: Senior Portfolio Analyst, Carnegie Asset Management
  • 2000-04: Researcher/quantitative analyst, Evli Investment Management
  • 2000: Project assistant trainee, Nokia Siemens Networks
  • 1993-99: Chief Music Director, Savonlinna Opera Festival

Most liquid asset classes operate in a fast-paced, trader-oriented market based on emotional thinking. Here, it is not fundamentals that drive market movements, but rather central banks that provide liquidity. The main risk for those participating in the fast market is whether or not central banks are providing enough liquidity and where liquidity injections are also boosting riskier assets. If they fear that liquidity is about to dry up, they trade risky assets and vice versa.

As a long-term institutional investor, Vatanen seeks a slower and more rational decision-making process where fundamental financial analysis will help select investments. “In illiquid markets, there are opportunities to find more rational ways of making investments where the fundamentals still matter and where you can make rational decisions. The traditional way, as long as market valuations and changes in valuations prices don’t affect those markets too much, tends to be more rational in the current environment. Marking the market would create unnecessary noise that we don’t want,” he adds.

Vatanen says an example of slow investments includes private equity, even though the asset class tends to behave like listed stocks and offers little correlation. “There is a phenomenon where private equity reports typically lag three months behind quoted returns reports. When there are rapid movements in the market, this three-month time frame shows an artificial negative correlation which can be beneficial for long-term investors if they have solvency requirements to take risks,” he explains. he.

The same applies to direct real estate which is not valued at market price in Finland. “In Finland, direct real estate is usually valued once a year when held directly on the balance sheet. Since we collect direct cash flows and don’t have to price them in the market because they are not available for sale, we get a smoothing effect over time,” says Vatanen.

Vatanen used “artificial” diversification of illiquid assets to construct Veritas’ post-COVID 19 asset allocation framework, as well as some alternative risk premia (a hedge fund-like strategy that aims to reap returns from certain risk factors).

“We have defined three types of asset classes based on their behavior, in particular their tail behavior. We have asset classes looking for carry that tend to have positive expected future returns. The more asset classes we have looking for carry, the higher the expected returns from our asset allocation. Then we need diversifiers for risk management purposes and even extreme hedging in the current environment,” Vatanen explains.

Listed asset classes looking for carry include equities, emerging market credit and debt, and currencies. “Even though we can measure a fairly weak correlation over longer time periods, they tend to be highly correlated with each other. If there is a crisis, there are diversification benefits in these asset classes,” he says.

Within asset classes looking for carry, there are also private asset classes. “Even though they are fundamentally correlated to listed assets, we can gain diversification benefits in sudden market moves like during the pandemic,” he points out.

“If market valuation comes with a lag, we can use the benefit of illiquidity in pricing or valuing these assets. We know that if there is a recession in the economy real, all of these carry-seeking asset classes tend to suffer at the same time, but in sudden volatility spikes in listed assets, these private assets still provide some diversification benefits,” Vatanen said.

When it comes to traditional diversifiers such as duration, macro-hedge funds and CTAs (another hedge fund-like strategy focused on futures trading), Vatanen doubts that you can achieve a diversification effect using duration. in a rising interest rate environment. “I am also skeptical of CTA’s strategies. In our studies they tend to be correlated to rates and if we have high volatility in rates it could be a tough time for CTAs or any type of trend following model,” he adds.

Traditional diversifiers may therefore not be as reliable as they have been in the past, leading Vatanen to consider tail hedges to secure Veritas’ solvency ratio during very rapid declines in listed markets. “The easiest way is to use direct option hedges, but we also know that is a very expensive way to hedge. They have negative carry, which means they have negative expected returns” , he notes.

In addition to the three asset classes (carry-seeking, diversifiers, tail hedges), Vatanen has added systematic strategies into the framework in order to gain new tools for portfolio construction.

“First of all, we can find other sources of carry, such as selling volatility, which is another source of positive returns…but we know it’s highly correlated to other risky assets, so means it doesn’t provide diversification but might offer some additional returns over time,” he says.

He urges investors to question their investment beliefs in a changing market environment where fundamentals are no longer the driver and central bank actions are creating volatility as they begin to reduce liquidity .

“There are no all-weather portfolios in a rising rate environment. Defensive strategies will not work and risky assets are volatile due to central bank manipulation. It is the strongest power in the current market environment and, in the words of Adam Smith, the invisible hand of markets has become the visible hand of central banks,” he says.

Screenshot 2022-04-01 at 11.47.56

Screenshot 2022-04-01 at 11.48.06

Screenshot 2022-04-01 at 11.48.15

Vatanen says his biggest worry at the moment is the interest rate sensitivity of Veritas’ equity and alternatives portfolios and the effect any rapid rate hikes could have on valuations. On the fixed income side, he is less concerned as Veritas has reduced sensitivity by moving towards illiquid and complex structures that offer yield without being sensitive to interest rates in developed markets, such as US Treasuries.

Rising inflation is not in itself a market variable for Veritas, but the reactions of central banks would be. Vatanen doubts central banks are getting too hawkish and sees it as positive if inflation hits 2% or the ECB’s target rate. “But there is a high risk that central bank actions will be too fast and risky assets won’t be able to sustain it, which could cause the next recession in the next 2-3 years,” he concludes.

For the full year 2021, Veritas returned 12.6%, making it the best year of the 21st century, with the stock returning 25.2%.