Stockholm (HedgeNordic) – In 2022, the usual negative correlation between equities and bonds, essential for the construction of diversified portfolios, disappeared. This rare anomaly, where both asset classes incurred losses simultaneously, posed a significant challenge for many investors, especially for the Danish pension fund ATP. Known for structuring its investment portfolio around risk factors, with a predominant exposure to equity and interest rate factors, ATP faced a substantial setback in 2022. In response, ATP is implementing two new overlay strategies to enhance the investment team’s ability to manage unexpected changes in correlations between equities and bonds.
“In 2022 the volatility came up and the negative equity and bond correlation which is usually our saviour, disappeared,” Christian Kjær, ATP’s head of liquid markets, tells Top1000Funds. “This negative correlation is important for all investors, but for a risk balanced investor like us, it is more important.” The spike in correlation between bonds and equities in 2022 resulted in ATP’s investment portfolio booking a loss of 40.9 percent for the year, equivalent to DKK 54.5 billion.
“This negative correlation is important for all investors, but for a risk balanced investor like us, it is more important.”
Christian Kjær
“We have been preparing for the equity bond correlation spikes to happen again,” says Kjær in an interview with Top1000Funds. “It’s important to prepare for a war during peacetime, and this is what we have done.” Of the two overlays, ATP’s ‘correlation overlay’ detects market signals indicating shifts in correlations, alerting the ATP investment team to potential losses on both its equity and interest rate investments.
“We have been preparing for the equity bond correlation spikes to happen again.”
Christian Kjær
“It sends us a signal to take risk off,” notes Kjær. “The overlay flags the beginning of losses in the portfolio, particularly the interest rate portfolio, combined with shifting correlations.” The correlations are measured using intra-day data across different markets, allowing the team to detect correlation shifts as quickly as possible. The process integrates two critical components. Firstly, it warns of heightened volatility, which directly increases risk in the investment portfolio. And secondly, it highlights changes in the correlations that also alter risk dynamics.
The second overlay involves a continuous process of monitoring correlation changes and involves constantly maneuvering and positioning to adjust for these changes. Predominantly developed since 2022, these new overlays will be gradually implemented throughout 2024. Neither of the new overlays has a significant risk budget, according to Kjær. While Kjær acknowledges that these additions add to the portfolio’s complexity, he argues that the small risk budget allocated to the latest strategy adjustment does not significantly alter the investment portfolio’s risk profile.
ATP runs an investment portfolio and a hedging portfolio, with the hedging portfolio managing guarantees and the investment portfolio generating returns on top of the guarantees. ATP splits the risk of each individual investment into four risk factors to construct a broader investment portfolio with the desired risk profile. Risk allocation in the investment portfolio at the end of 2022 included 53 percent to the equity factor, 25 percent to the interest rate factor, 13 percent to the inflation factor, and 10 percent to other factors.
