Stockholm (HedgeNordic) – Ilmarinen, in a tight race with Varma as Finland’s largest earnings-related pension insurance company, has emerged as a noteworthy investor in hedge funds in recent years. Partly influenced by the low-interest-rate environment, Ilmarinen has significantly ramped up its allocation to hedge funds, climbing from under two percent in late 2017 to 8.6 percent by the end of 2023. The benefits of this increased allocation were on full display in 2022, as both stock and bond investments experienced significant downturns at the same time.
“We’ve been in a growth mode since 2018. The hedge fund portfolio has grown almost fourfold since the start of this initiative,” states Juha Niemelä, Ilmarinen’s Head of Allocation. Indeed, Ilmarinen’s hedge fund portfolio has expanded from just over one billion Euros in early 2018 to over €5 billion by the end of 2023. Niemelä highlights that the primary motivation behind the increased allocation to hedge funds “is the traditional aim to achieve diversification benefits for Ilmarinen’s investment portfolio.” However, he also points out that “on a broader industry level, a regime shift in the rates market has been a major driver of hedge fund investing.”
“We’ve been in a growth mode since 2018. The hedge fund portfolio has grown almost fourfold since the start of this initiative.”
Juha Niemelä, Ilmarinen’s Head of Allocation
As a large institutional investor with nearly €59 billion in assets under management, Ilmarinen prioritizes maintaining a well-diversified portfolio spanning various asset classes. According to Niemelä, the diversification offered by the hedge fund portfolio arises from “uncorrelated risks with rest of the balance sheet and a positively skewed return profile.” Ilmarinen’s objective with the hedge fund portfolio “has always been to achieve absolute returns while being very mindful of capital preservation,” further elaborates the Head of Allocation. Ilmarinen’s pursuit of absolute returns “leads us to hunt for true alpha sources that cannot be explained by usual risk factors.”
‘True’ and ‘Manufactured’ Alpha
On an annual basis, Ilmarinen’s board of directors approves an investment plan that sets targets for risk-taking, investment allocation, and the distribution of investments across various asset classes. “Our benchmark somewhat dictates the types of strategies we should be looking at any given point in time,” explains Niemelä. The ultimate aim, however, is to construct a portfolio of predominantly alpha-seeking or alpha-driven strategies, with a focus on capital preservation. As the Ilmarinen team seeks true alpha managers to fortify their broader investment portfolio, Niemelä cautions that different strategies may be suited to varying market environments.
“Of course, those true alpha managers are always welcome, but we also welcome more manufactured alpha.”
Marko Mikama, Senior Portfolio Manager within Absolute Return Investments at Ilmarinen
“We believe that rare true alpha managers are good all-weather investments that one should stick to over the business cycles,” emphasizes Marko Mikama, Senior Portfolio Manager within Absolute Return Investments at Ilmarinen. While Mikama underscores the value of such managers, he also acknowledges the importance of maintaining a tactical mindset to strategy exposure. “There is always a tactical element to the attractiveness of the majority of the funds,” he explains. “Of course, those true alpha managers are always welcome, but we also welcome more manufactured alpha.”
“We try to be active all the time and keep the capability to adjust exposures as opportunities arise,” says Mikama, who is responsible for hedge fund manager selection at Ilmarinen. Mikama highlights their commitment to remaining proactive and adaptable to seize opportunities, including “those more transitional alpha strategies that could emerge from regulatory changes or some other inefficiencies.”
Return Characteristics and Fees
In line with Ilmarinen’s focus on alpha-driven strategies with a capital preservation feature, its manager selection team seeks strategies characterized by “high-quality return distribution with a slim left-hand tail,” according to Mikama. “Realized return levels should be well above the risk-free rate and returns per unit of risk measured by metrics like Sharpe ratio or similar should be top of the class,” further elaborates the senior portfolio manager.
“In carefully selected cases, Ilmarinen might be willing to accept higher cost structures, but we expect those managers and funds to be exceptional and the net profit to meet high levels.”
Marko Mikama, Senior Portfolio Manager within Absolute Return Investments at Ilmarinen
Fees can erode the investment returns of any investment product, prompting the team at Ilmarinen to meticulously evaluate hedge fund fees and the associated value of the underlying investments. “In carefully selected cases, Ilmarinen might be willing to accept higher cost structures, but we expect those managers and funds to be exceptional and the net profit to meet high levels,” notes Mikama. He further explains that his team monitors profit retention annually to assess how much of the gross returns they retain. While there are no limitations on profit sharing, Mikama notes that “it’s somewhat worrisome that in some cases investors get to keep below 50 percent of returns.”
Redemption Process and Investing in Nordic Managers
While Ilmarinen aims to maintain long-term investments in the hedge funds they select, the team consistently evaluates performance and takes action if returns fall short of expectations. Mikama explains that redemption decisions are usually driven by returns or key personnel issues. “We usually give managers early warning, allowing managers a certain timeframe to do corrective measures before initiating the redemption process,” he elaborates. “If we feel that the manager’s attempts are not enough to turn the ship, we eventually end up signing redemption forms.”
“We have to admit that Nordic funds have not been our core focus. Investing in startups exposes us not only to investment risks but also potential business and regulatory risks, which are not really within our core expertise.”
Marko Mikama, Senior Portfolio Manager within Absolute Return Investments at Ilmarinen
In comparison to its peer institutional investors in Finland, Ilmarinen has at times allocated significant funds to local hedge funds even though this has not been a primary objective. “We have to admit that Nordic funds have not been our core focus,” acknowledges Mikama. While Ilmarinen has done a few incubations in the Nordics over the years, the team’s focus has been on well-established and well-resourced institutional-scale hedge fund managers. “Investing in startups exposes us not only to investment risks but also potential business and regulatory risks, which are not really within our core expertise,” explains Mikama. “Moreover, startup investing requires different resources and target setting from our side.”
Market Environment for Hedge Funds
The team at Ilmarinen focusing on hedge funds has demonstrated skill in hedge fund allocation in recent years. With returns of 5.3 percent in 2019, 3.7 percent in 2020, and 7.3 percent in 2021, the diversification benefits of Ilmarinen’s hedge fund portfolio were particularly evident in 2022. The year presented significant challenges for most investors, as stock and bond returns were both meaningfully negative for the calendar year. However, Ilmarinen’s hedge fund portfolio returned 8.2 percent for the year, partly reflecting strong performance from trend-following strategies and limited exposure to traditional long/short equity investing.
Given Ilmarinen’s substantial exposure to equity beta elsewhere in the portfolio, the team maintains limited exposure to long/short equity strategies. “We have to take into account our internal benchmark, which explains why traditional long/short equity investing has a tiny presence in the portfolio,” says Mikama. Other strategies with slim left-hand tails such as trend-following strategies have proven more useful for the portfolio.
“The opportunities for creating alpha appear reasonably attractive going forward.”
Juha Niemelä, Ilmarinen’s Head of Allocation
“Trend following strategies had a long period of muted returns but were very well-positioned to capture price trends in rates markets,” recalls Mikama. “Inflation and the rise of commodity prices were very conducive for the majority of trend-following programs,” he elaborates. Moreover, volatility in rates has created a more favorable environment for various relative value strategies, notes Mikama. “From a total return perspective, investors have hoarded credit strategies over the last two years, as defaults have been low and distressed situations have remained rare.”
After years of consistent performance from Ilmarinen’s hedge fund portfolio, both Juha Niemelä and Marko Mikama observes an environment conducive to hedge fund strategies going forward as well. “The latter part of the 2010s can be characterized by relatively stable global growth, low inflation, and a low-yield environment. The transition towards higher yield curves and more active central banks can potentially point towards a more volatile macro and financial environment,” concludes Niemelä, Ilmarinen’s Head of Allocation. “In that sense, the opportunities for creating alpha appear reasonably attractive going forward.” Even so, Mikama and his team “still believe true alpha to be rare and only handful managers have the expertise and processes to capture alpha.”
