When Kari Vatanen stepped into the role of CIO at Finnish pension insurer Veritas in March 2020, he didn’t mince words with hedge fund managers. “I fear they don’t work, but I hope to be proven wrong,” he warned, demanding hard data to justify the pension insurer’s 7 percent hedge fund allocation after a period of underperformance for the broader industry.

Four years later, Vatanen has moved on to a new role as Head of Asset Allocation and Alternatives at Elo, one of Finland’s largest pension funds. There, he found himself impressed by the hedge fund selection overseen by portfolio managers Mika Jaatinen and Antti Vartiainen. Elo’s hedge fund portfolio enjoyed the strongest return – 13.1 percent – in 2024 among the country’s major institutional investors.

“We have to thank Mika and his team for their work over the years, the hedge fund allocation has been effective. It has played a key role in asset allocation and provided a well-diversified return stream.”

“Looking at Elo’s hedge fund portfolio and its performance over the past ten years, it has delivered a strong and stable return stream,” says Vatanen, now several months into his new role at Elo. “We have to thank Mika and his team for their work over the years, the hedge fund allocation has been effective. It has played a key role in asset allocation and provided a well-diversified return stream,” he emphasizes. “I see no reason why this performance wouldn’t continue, especially with the same team, now even stronger.”

A Stronger Case for Liquid Alternatives

Vatanen sees a much more favorable environment for liquid alternatives compared to the 2010s. “Back then, macro volatility was exceptionally low because central banks were actively suppressing it with highly supportive stimulus policies. This dampened volatility across macro variables outside equities, such as interest rates, currencies, and commodities,” he explains. The environment has shifted with the return of inflation and significantly higher interest rate volatility compared to the past decade.

“This creates a better environment for active risk-taking and generating active returns,” says Vatanen. As a result, he sees a much fertile environment for macro hedge funds, relative value strategies, and systematic funds that are not purely directional to equity or credit markets. “My view is that macro, relative value, and quant hedge funds could deliver significantly better returns than they did in the previous decade.”

“The key role of hedge funds and other liquid alternatives is to provide bond-like diversification while delivering a higher, more stable return stream. If they can do that, they deserve a strong place in asset allocation.”

Beyond performance, hedge funds have played an essential role in diversification within Elo’s portfolio, often offering a return profile superior to fixed income. “Hedge funds have historically provided better returns than our fixed income portfolio,” Vatanen notes. “The key role of hedge funds and other liquid alternatives is to provide bond-like diversification while delivering a higher, more stable return stream. If they can do that, they deserve a strong place in asset allocation.” By the end of 2024, Elo’s hedge fund allocation had grown to €3.2 billion, representing 9.7 percent of its €32.4 billion investment portfolio, up from 8.7 percent at the end of 2023.

Peer Comparisons and Regulatory Constraints

Determining the optimal hedge fund allocation is shaped not only by Finland’s pension system and its regulations but also by how peer pension insurers allocate their assets. “One of the unique aspects of the Finnish pension system is that we compete against other pension insurance companies. We report asset allocations and returns quarterly, which means we have a clear view of what our peers are doing and can measure our active risks relative to them,” says Vatanen. This transparency creates a baseline for asset allocation across the industry. “From there, we decide where we want to be overweight or underweight relative to our competitors,” he explains.

While hedge fund investments performed well for Elo, other Finnish pension insurers also saw strong results. “Hedge funds have been a solid asset class and a valuable diversifier,” Vatanen acknowledges. “That makes it an area where we might consider maintaining an overweight position relative to our peers, though, of course, there are limitations.”

“We know that over the next two years, we will be increasing our equity allocation, and that capital has to come from somewhere. That creates some constraints on our liquid alternatives allocation going forward.”

One key limitation comes from recent reforms in Finland’s earnings-related pension system, which will significantly impact equity allocations across pension insurers. The changes aim to enhance investment returns by increasing the permissible equity exposure within pension portfolios. “We know that over the next two years, we will be increasing our equity allocation, and that capital has to come from somewhere,” Vatanen explains. “Fixed income allocations are already relatively low compared to global peers, so while we can make reductions there, it won’t be enough. That creates some constraints on our liquid alternatives allocation going forward.”

Impact of Pension System Reforms

Finland’s private pension insurers are set to increase their equity allocations as part of four key changes to the system. One major shift involves raising the equity-linked component of liabilities from 20 percent to 30 percent, which will likely lead pension insurers to increase their equity weightings accordingly. Additionally, the solvency framework – calibrated using a value-at-risk model – will see its confidence level adjusted from 97 percent to 95 percent. “This recalibration will slightly ease risk constraints, creating some additional room for non-equity risk-taking,” Vatanen elaborates.

The final parameters are still being determined by a working group tasked with refining the regulatory framework, one in which Vatanen himself is involved. The reforms are expected to increase equity allocations by approximately 10 percentage points, enhancing potential returns but also introducing greater market exposure.

“The increase in equity allocations will reduce overall portfolio diversification, making it even more crucial to identify new sources of diversification and hedging.”

“The increase in equity allocations will reduce overall portfolio diversification, making it even more crucial to identify new sources of diversification and hedging,” says Vatanen. “Currently, equity exposure in the private sector pension system stands at just over 50 percent. If the upper limit increases by about 10 percentage points, we could see allocations rise to 60-65 percent,” he continues. The exact figure is uncertain, “but a higher equity weighting would mean that other asset classes would account for less than 40 percent of the portfolio,” according to Vatanen. This underscores the need for more effective diversification strategies to complement and balance the increased equity exposure.

Adjusting to a New Regulatory Landscape

For Vatanen, navigating these pension system changes within Finland’s regulatory framework presents both a challenge and an opportunity. “It’s an interesting exercise to prepare for the new pension strategy under the evolving regulations,” he says.

As Head of Allocation and Alternatives at Elo, Vatanen will work closely with his colleagues to adapt to the new system. “I’ve felt really welcomed at Elo, and one positive surprise for me has been the strong technical expertise within the portfolio management team,” he remarks. “There’s a high level of quantitative skills and many opportunities to model and explore new approaches. I’m eager to see what we can accomplish in the coming years.”

“We are still refining our strategy as the pension reforms take shape, but we will certainly be looking at ways to enhance diversification in this new environment.”

The regulatory reform could also open the door for new systematic strategies focused on defensive positioning and hedging. “Beyond hedge funds, we can find diversification in liquid markets through other systematic strategies,” says Vatanen. “We are still refining our strategy as the pension reforms take shape, but we will certainly be looking at ways to enhance diversification in this new environment.”

This article is part of HedgeNordic’s “Nordic Hedge Fund Industry Report.”