Navigating the hedge fund frontier: Insights from Elo Pension Fund

[Music]

Kumar Panja: Welcome to another episode of ‘Market Matters.’ I'm Kumar Panja and today we're going to be talking about the Finnish pension industry and how hedge funds form part of their overall portfolio. Here to take us through his views from a very well-informed lens is Kari Vatanen from Elo Mutual Pension Insurance Company and Kari's formal title is Head of Asset Allocation and Alternatives at Elo. Kari, welcome to the podcast. Nice to see you again and thanks for doing this.

Kari Vatanen: Thank you.

Kumar Panja: Belated congratulations on your appointment at Elo at the end of last year when you left your last role as CIO at Veritas Pension and I was curious to know what Elo stood for. I was wondering whether it was an abbreviation or something else so I did a bit of digging on your website and of course I couldn't find anything other than how to use your black and yellow logo and all the rules around it. Then I did a bit more digging and I found out that Elo means life or harvest and presumably your role is about harvesting returns from the market. But why don't you tell us a bit more about your title and your role and what that encompasses?

Kari Vatanen: Yeah, maybe it's interesting that you have studied what Elo means and I'd like to add something to that because pension it’s close to the word Elo. It refers to pensions as well.

Kumar Panja: I see.

Kari Vatanen: It's life and pensions together in one word.

Kumar Panja: Imagine that.

Kari Vatanen: But then the other question about my role as a head of asset allocation and alternatives. Basically I'm responsible of the asset allocation process, both the strategic asset allocation conduct that. It's typical that in Finland pension insurance companies they are forced to do annual asset allocation process and typically they adjust little by little their strategic asset allocation over time. But then beside that we have tactical asset allocation and solvency risk management, what is typically conducted on daily basis. And because we have a local solvency regulation and it requires that we have to be solvent every day, that means that time to time we have actively managed our risk in the portfolio and basically that's part of our tactical asset allocation process.

Kumar Panja: I see. Okay, thank you. Thank you for that. I know we're going to get into what that means and how you construct the portfolio and the different stripes within that. Why don't we start with the current state of the market? And I don't think there's any argument, maybe in some pockets, but any argument that we're currently in an uncertain market regime of the kind that you've mentioned in some of your previous written articles. How are you thinking about the portfolio in general and in particular what I would love to get from you is your view on asset correlation in this type of environment?

Kari Vatanen: Okay, let's start with my recent academic papers. They focused on the challenges on diversification and asset allocation in the current market environment. On my thinking, I think that during last 10 years there has been important change in the markets. Market dynamics has gone a little bit far away from the fundamentals little by little. It started in 2010s when the central banks were keeping their rates zero, even negative in Europe, and then supporting the markets with massive stimulus packages. That created some kind of environment where the risk takers were focusing only if there's enough central bank liquidity in the markets and fundamentals didn't matter. And then after that we got COVID. There's, once again, one factor affected the whole market and the whole market dynamics was dependent only on factor what happens with COVID and what kind of support packages central banks are providing. And in fact, the recovery started when Fed promised unlimited QE to save the markets, once again. Then we got inflation. Russia starting to invade Ukraine. That once again, one kind of focus to the markets and markets were focused on inflation. And once again, there was no, let's say, fundamental base market dynamics. And maybe the last point, this April, one factor from the Oval Office moved the markets. And once again, there was no diversification left. And I think that we are now in a market regime where there comes some external shocks and whole market moves immediately after that. And fundamentals don't matter in that kind of environment. In the longer run, of course, they will matter if we take our horizon to five to 10 years. But in the short term, market shocks are caused by external factors affecting the market. And there, it's really hard to get any diversification with traditional asset classes.

Kumar Panja: So modern portfolio theory, as you know better than me, well, modern portfolio theory since Markowitz is based on choosing the optimal portfolio when expected returns and covariances between asset classes, asset returns are known. And what you've just described is we're in an environment where none of those can be known. So are investors blindly following theory in the hope for diversification right now?

Kari Vatanen: Let's refer a little bit about the traditional portfolio theory. And let's say 60-40 allocation, which has been quite common for institutional investors. It relies strongly to the assumption that there's low or even negative correlation between equities and bonds. And bonds are able to diversify equity investments. And in addition to that, there's low correlation between single assets and you get diversified portfolios. But what is the real problem there is that we don't know if the correlations are still negative between equities and bonds. And it seems that when any kind of market shocks comes, the correlations with all the asset classes are very high. And maybe we are a little bit biased to believe that equities and bonds have negative correlations within each other, because basically that has been the case since early 18s until the COVID crisis. 40 years of declining rates, 40 years of rising equity markets and 40 years of negative correlation between bonds and equities. If we go a little bit beyond that, and take, for example, data from 19th century, most of the time equities and bonds were positively correlated during that period. And there are long periods where bonds were providing even better returns than equities. It was totally different compared to the reality after the beginning of 80s that we have observed. And I even think that a lot of academic papers are written from the data from declining rates, negative correlation between equities and bonds. And they are biased to that one period in the markets, which might not be the normal time.

Kumar Panja: Okay, well, very interesting. And I'd like to turn you to another area where you'd like to challenge kind of thinking is around illiquid assets. And as you and I were talking about this before, the valuation of private equity and real estate assets, often based on smooth and delayed reporting, which presents a diversification benefit, but also a risk. How should investors balance the benefits of these smooth valuations with those risks of potential mispricing?

Kari Vatanen: I call that artificial diversification because it's not real, but we see it's a diversifying effect. Maybe I think that there are two different parts. One part is smooth valuations, which means that over the time, the drawdowns are smaller for private assets compared to the listed assets. That gives some kind of, it's not exactly diversification, but it helps in quick drawdowns in the market. But maybe even more important effect is delayed reporting. That really creates diversification and even hedging properties in a short and quick market drawdowns. Let's take an example, the COVID crisis in March, 2020, listed equity market went down during one month. It happened within first quarter of 2020, 35% down. At the same time, the private equity marks were from the last quarter of 2019, which means they went up. And there was clearly negative correlation between listed assets and private assets.

Kumar Panja: I see. So you're saying, yes, while there is this artificial nature, artificial diversification, it has a place in a portfolio.

Kari Vatanen: Yeah.

Kumar Panja: Let's now look at how these things that we talked about then play into the specific portfolio you have at Elo. So let's talk about the evolution of the asset allocation at Elo and how it's balanced between traditional long only type assets and alternatives. And within alternatives, we just spoke about how you see this more, how the split is between liquid and less liquid alternatives.

Kari Vatanen: Yeah, I'll start with the overall asset allocation of Elo. It's quite similar to other pension insurance companies in Finland. Let's say overall risk level is defined basically due to regulation. And that's why the differences at risk level are quite small. But there are a lot of differences in implementation, how we manage our assets and how much we have allocated to the private assets and alternatives. And overall, I could say that we have approximately 60-40 portfolio, but that 60 means liquid assets and 40 alternative assets. It's not exactly the endowment model, but let's say it's quite close to the endowment model, having a lot of different alternatives. In listed side, let's say that we have around 50% of equity risk, 35 in listed, over 15 in private side, 20-25 in fixed income, and then around 15 in real assets, around 10 in hedge funds, which means that we are using quite widely alternative asset classes in our portfolio. What we are thinking at the moment is that even if we have endowment type of model, it seems on paper to be well diversified. But if we go to the macro factors that are moving our portfolio, the most of the risk is tilted to the equity type of investments. And if we take into account that credit tends to behave like equities during the drawdowns, then basically the first principal component describes the most of our risk budget in the total portfolio. And then of course, we can use artificial diversification. We know that there are equity type of risk in private equities, private credit, and we know that they react a little bit with delay smoothly, and that gives some time to adjust portfolio. But then when going beyond those, then the diversifiers. Real assets help in the longer term, especially in the environment of higher inflation, they will give some extra type of diversification and returns in the inflationary environment. But then when focusing certain market moves, then it's quite hard to find places that work properly. In hedge funds, we are hoping that, but it highly depends how you have structured your hedge fund portfolio. If it's return seeking or if it's more like a bond type of portfolio for diversification.

Kumar Panja: Just going to the asset allocation kind of view, we've talked in the past about that strategic asset allocation versus a total portfolio approach. Can you talk about that? And also any plans to change that at Elo over the coming time period?

Kari Vatanen: Yes, I think that we are moving towards total portfolio approach little by little. And one of the reasons is that we have a currently pension reform coming to Finland. And that would mean that equity allocations will increase for the whole industry. If we are talking about a 50 plus percent allocation nowadays, it will be 60 to 65, including listed and private equities, which means that there are other asset classes less than 40 percent to get diversification. And then when looking our fixed income allocation nowadays, it's mainly credit. There's a really small allocation in high quality bonds. And that's typically what the institutional investors have done during 2010s when rates were zero or negative. They tilted, they fixed income portfolios towards credit, towards higher yielding fixed income investments. And that means that there's diversification benefits have diminished. They are equity like during the crisis. And that means that we can trust that we get diversification enough from our fixed income. Then there are real assets, hedge funds. I think that we need to consider in our asset allocation model also off balance sheet type of strategies for duration management, FX management we already do in-house in our FX overlay portfolio, but also a little bit more emphasis of the equity risk management and maybe additional diversifying strategies on off balance sheet format, either done in-house within our own team or then by using bank strategies or managers.

Kumar Panja: Right. And actually on that, given that there will be an increase to the overall equity weighting, you know, it might be worth talking about Elo's approach to some of that can be done in-house and you will be expanding that capability. Is that a negative or a positive for external managers?

Kari Vatanen: Let's start first with the fact that equity allocation will increase. We manage most of our listed equities in-house. All the developed listed equities are basically in our own balance sheet within our equity management team. And that will increase, which means that our internal management will increase in that side. And then on the other side, I think that we will decrease other asset classes in a private side. Maybe there might be some pressures also in hedge fund sites. At least we cannot increase that, in that kind of situation. And then it's a question of what we can do in-house, what kind of derivative strategies or balance sheet strategies we can implement in-house. And I see them as a complement to the hedge fund portfolios or other alternatives. I'd like to see the organization that is able to do things, some things themselves directly with either cash assets or derivatives, something where we can use bank strategies. And there's clearly some place for asset managers as well in an alternative space and a hedge fund space that we noticed that we cannot do ourselves or that banks cannot provide such kind of capabilities.

Kumar Panja: Okay. Just sticking with hedge funds for a moment then, when you are looking at going back to alternative risk premia and you are trying to look at, let's say, pick on a factor, let's say credit volatility factor. How do you look at a credit manager that will have the credit volatility factor embedded in its profile? Would you sort of ask them to become factor neutral on that one factor because you might be hedging using a risk premia separately? Or do you just adjust your overall risk premia? How does that work? Do you sort of manage your overlays in accordance and measure how much of the factor you've already exposed to in your diversifiers book?

Kari Vatanen: That's a good question and hard to answer because basically, of course, when we have in-house assets managed in-house, then we know exactly what are the factors…

Kumar Panja: Yeah

Kari Vatanen: And what kind of tilts we have. And we can adjust the overlays according to them. When there are managers, we don't have full transparency for all factors. We have to guess about their risk profile and what is the expected behavioral profile of different asset managers. And same applies to the private assets. We don't exactly know how private equities behave or even how they should behave if they are priced in the right manner.

Kumar Panja: So, Kari, we were talking about optimal asset allocation, and you were saying that as regards hedge funds, it depends on sometimes whether it's return driven or diversification driven or sometimes elements of both. And groups like yourself, which have got regulatory solvency requirements, you might need a higher weight in things like tail hedges when compared to endowment type investors. But just thinking about hedge fund strategies, which strategies then work well for your portfolio?

Kari Vatanen: Let's say when investing in hedge funds or allocating to hedge funds, I think the first important thing is to define what is the role of whole hedge fund portfolio in your total asset allocation. And basically, it can be that you want equity type of returns with high carry like a profile. Then it typically means that you don't get any hedge. They are highly correlated in tails. Or then if you want to tilt your hedge fund portfolio more like a bond type of diversifying portfolio, then you need to have different strategies compared to the carry type. For example, if you are targeting to have a higher return, higher carry type of portfolio, you typically could have equity strategies, equity long short, even equity long only type of strategies, event driven or distressed debt strategies that typically have a higher expected return. But as we know, they don't hedge during the crisis. Instead, if you want to tilt your hedge fund portfolio to the bond like diversifying part, then you typically should select relative value strategy, macro, CTAs or quant strategies that typically are hedging a little bit more, but typically the expected returns are a little bit lower than in carry type of portfolios. And then I think it's a question, what is the right balance between those? It highly depends on the role that you have defined to your hedge fund portfolio. And then if we are talking about tail risk hedging for your solvency purposes, maybe then it's some other solutions needed than hedge funds, meaning that direct hedging strategies that you can either implement yourself with a plain vanilla options and have a different kind of option structures directly on your balance sheet, or then have a solutions which are more efficient or even a little bit cheaper type of hedges, have long volatility strategies or rule-based hedging strategies or something between them. And I think like a diversifying basket in your hedging basket, it's important to diversify your hedges because basically you don't know beforehand what kind of crisis you are hedging against. And we humans, we are typically biased to hedge the past crisis, like financial crisis, COVID crisis, Trump tariff crisis, but basically the next crisis is always something else and we have to be prepared to that.

Kumar Panja: But it's impossible to hedge everything because otherwise you'd be spending premiums.

Kari Vatanen: No, it's too expensive. It's too expensive all the time. And that's why what is also important, I think, in our approach is the tactical approach that we are able to change the risk exposure in our portfolios with futures when it's needed. Like what we saw now in April, really tough days, three days, minus 5% in equity markets. We were prepared to decrease risk dramatically if that was needed, but it went quite quick away. Let's say in COVID crisis, there were four weeks of equity market drawdowns. Now we saw only four days of equity market drawdowns. Maybe next time it's only four hours.

Kumar Panja: Let's see. So Kari, are there any tools that you, Elo, use that can help achieve the return and diversification objectives? And here I'm thinking about things like customized solutions or separately managed accounts or even portable alpha.

Kari Vatanen: Yeah basically, we are studying the possibilities to use such kind of tools. And let's say little by little, we are doing some portable alpha solutions in-house already, meaning systematic strategies. But I really think that this is the area where we want to widen our approach little by little over time.

Kumar Panja: You mentioned on your hedge fund strategies, thankfully, actually, you mentioned pretty much all of the strategies. So I think our client base or clients that are listening will be quite pleased with that. But just in terms of managers that haven't engaged with Elo before, what would you suggest as do's and don'ts for those managers when they approach either Elo or actually if you can represent the Finnish pension industry as well, that would be quite helpful.

Kari Vatanen: I think when thinking about Nordic investors and Finnish, especially Finnish investors, is that I think that pushing and selling doesn't work in the Nordics.

Kumar Panja: I don't think hedge funds do that.

Kari Vatanen: No, no, nobody. Even investment banks, they are.

Kumar Panja: We don't do that. We don't do that.

Kari Vatanen: But I think what pension investors, professional investors in Finland, in the Nordics, what they need, they need real arguments, facts, and really deep analysis of the products to understand them and then get reasons why they should look in them. And what is interesting them, what kind of profile there is and how those products can help in their total portfolio and what those products can add to the portfolio level. And I think it's more like changing information and discussing of the client's needs and trying to find the right way to do cooperation. And that works best in the Nordics and especially in Finland.

Kumar Panja: Great. Well, that's been fascinating. We've covered a lot of ground. And it seems like even though we're in uncertain market regime, you have a framework for Elo and your partners to navigate through that. We could have gone on for a lot longer. So thank you, Kari, for being here

Kari Vatanen: And thank you for having me today here. And thank you for the cooperation in recent years.

Kumar Panja: Thank you. And to our listeners, thank you for listening. Stay tuned for the next episode. Stay well.

[Music]

Voiceover: Thanks for listening to ‘Market Matters.’ If you’ve enjoyed this conversation, we hope you’ll review, rate, and subscribe to J.P. Morgan’s Making Sense to stay on top of the latest industry news and trends, available on Apple Podcasts, Spotify, and YouTube.

The views expressed in this podcast may not necessarily reflect the views of J.P. Morgan Chase & Co and its affiliates (together “J.P. Morgan”), they are not the product of J.P. Morgan’s Research Department and do not constitute a recommendation, advice, or an offer or a solicitation to buy or sell any security or financial instrument.  This podcast is intended for institutional and professional investors only and is not intended for retail investor use, it is provided for information purposes only. Referenced products and services in this podcast may not be suitable for you and may not be available in all jurisdictions.  J.P. Morgan may make markets and trade as principal in securities and other asset classes and financial products that may have been discussed.  For additional disclaimers and regulatory disclosures, please visit: www.jpmorgan.com/disclosures/salesandtradingdisclaimer. For the avoidance of doubt, opinions expressed by any external speakers are the personal views of those speakers and do not represent the views of J.P. Morgan.

© 2025 JPMorgan Chase & Company. All rights reserved. 

[End of episode]