Stockholm (HedgeNordic) – Danish pension fund LD Pensions manages two separate pension funds, each with different investment horizons. While the allocation across equities, investment-grade bonds, and credits varies between the two funds, a common feature is that high yield accounts for about half of the credit exposure. According to Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions, this is because high yield is one of the most liquid and transparent ways to achieve the desired credit exposure.

LD Pensions manages two funds, the Holiday Allowance Fund overseeing DKK 21 billion, and the Cost-of-Living Allowance Fund managing DKK 25 billion. “The oldest and most mature pension scheme, which has an estimated investment horizon of around ten years, requires a safer asset allocation,” explains Kjærbye-Thygesen. This fund, the Cost-of-Living Allowance Fund, allocates 78 percent to fixed income, including both high-grade securities and credit, with the remaining 22 percent in equities. In contrast, the younger Holiday Allowance Fund has an investment horizon beyond 20 years, allowing for a higher investment risk in the portfolio. This fund allocates 65 percent to equities, 25 percent to credit and 10 percent to the high-grade fixed-income segment.

The credit allocation “serves as a mediator between the higher risk associated with investing in equities and the safer yields from high-grade fixed-income investments,” explains Kjærbye-Thygesen. This credit universe includes high-yield bonds, loans, leveraged credit, and more illiquid credit such as private debt, and opportunistic credit strategies. Despite the varied and diversified nature of the credit spectrum, the fixed-income team at LD Pensions follows a benchmark approach for constructing its portfolio. Slightly over 50 percent of the benchmark is related to the global high-yield index, with the remaining portion related to loans.

“[The credit allocation] serves as a mediator between the higher risk associated with investing in equities and the safer yields from high-grade fixed-income investments.”Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions

The team can deviate from the benchmark exposure both in the short term and the long term, according to Michael Kjærbye-Thygesen. “Our allocation to more illiquid private debt and leveraged credit indicates a shift from our benchmark, which we expect to persist in the longer term,” he explains. Despite this flexibility, high-yield bonds hold the highest weight in the pension fund’s credit portfolio. “This is because high-yield bonds are much more liquid as an asset class and represent the most transparent way to gain the desired credit exposure,” says Kjærbye-Thygesen.

Benchmark-Weight to High-Yield Bonds

As explained by Kjærbye-Thygesen, high-yield bonds offer one of the most liquid credit exposures available, making them the easiest to allocate in and out of. “If we want or need to make tactical asset allocation changes, high-yield bonds are the most accessible option to implement those changes,” Kjærbye-Thygesen asserts. He emphasizes that tactical decisions cannot be implemented quickly with illiquid assets or loans, highlighting the importance of high yield in both tactical and strategic allocations.

However, determining the allocation to high yield involves assessing the “comparable spread and the issue’s position in the borrower’s capital structure.” High-yield bonds occupy the lower part of the capital structure, “and historically, in the event of a default, the losses have been much higher, and the recovery much lower compared to instruments higher in the pecking order.” For that reason, “it is crucial to consider the spread levels on high yield bonds versus other segments, and more importantly, to evaluate if the compensation is appropriate for the risk being undertaken.” This process entails evaluating recent trends in default rates, forecasting defaults, and estimating recovery rates.

“It is crucial to consider the spread levels on high yield bonds versus other segments, and more importantly, to evaluate if the compensation is appropriate for the risk being undertaken.”Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions

Kjærbye-Thygesen and his team currently maintain a neutral position on high yield compared to the overall benchmark, a stance partly influenced by the tighter spreads across markets. “Our perspective is that if spreads go lower, the compensation is not there to justify the risk,” explains the senior portfolio manager. Remaining neutral and maintaining a below-average exposure, Kjærbye-Thygesen adds that “we can remain below average for an extended period.” In a scenario of weakening macroeconomic developments and widening spreads, “our tactical allocation could change.” However, as things stand, “we maintain a neutral position given the level of spreads that we see.” 

Benchmark-Plus Approach to High-Yield Investing

LD Pensions exclusively invests in high-yield bonds through external managers. “We do not invest directly,” explains Kjærbye-Thygesen, “as we believe that managing a high-yield portfolio requires a much larger organization.” Investing directly in high yield “not only requires portfolio managers but also a large team of analysts,” he continues. Therefore, Kjærbye-Thygesen finds it challenging “to build an internal setup for managing high yield, even in a beta-oriented way.”

Kjærbye-Thygesen and his team employ a beta-plus approach to building their exposure to high-yield bonds, which revolves around a systematic high-yield strategy. “This is the core part of our exposure to high yield as we wanted to achieve the same return as the benchmark for the overall asset class,” explains Kjærbye-Thygesen. “It’s not pure beta, rather, it aims to deliver returns after costs on par with the benchmark.” This strategy follows the benchmark using a systematic approach but also allows for deviations, and the manager must demonstrate the ability to rebalance the portfolio in a way that costs do not hinder the attainment of benchmark returns.

“[We opted for a more prudent approach of building] a core allocation to a beta-plus systematic strategy and then selectively choosing active managers who have the flexibility to deviate from the benchmark more actively, thereby creating the alpha required on a smaller scale.”Michael Kjærbye-Thygesen, senior portfolio manager within fixed income and credit at LD Pensions

The rationale behind establishing its primary allocation in high yield through a systematic strategy stems from observations made by Kjærbye-Thygesen that “many high yield managers have struggled to consistently outperform their benchmarks over the past five, seven years.” Despite maintaining faith in active management, LD Pensions opted for a more prudent approach of building a “core allocation to a beta-plus systematic strategy and then selectively choosing active managers who have the flexibility to deviate from the benchmark more actively, thereby creating the alpha required on a smaller scale.”

Despite adopting a benchmark- and systematic-based approach to investing in high yield, Kjærbye-Thygesen still recognizes the value of active management. “We also believe in active management and invest with active managers,” says Kjærbye-Thygesen. The team has also explored the possibility of investing in passive instruments such as exchange-traded funds (ETFs). “We have been investing using ETFs in the past, but the problem is that the costs are still too high, and the beta may not necessarily mirror the benchmark,” explains Kjærbye-Thygesen. While ETFs serve well for short-term tactical allocations, they may not be ideal for longer-term investments. “For longer-term allocation, you need to have a manager in place who can execute trades at a very low-cost basis.”

LD Pensions also favors investing through segregated mandates rather than existing fund structures. This approach enables Kjærbye-Thygesen and his team to “have full transparency into existing investments and make our own exclusions.” Given that high-yield bonds are among the most liquid and transparent credit asset classes, Kjærbye-Thygesen’s team applies the same ESG process as for equities. “We evaluate various ESG factors such as CO2 emissions, worker rights, and controversial weapons,” he explains. “With segregated mandates, we can promptly react to any issues that arise.”

Even though credit spreads in many liquid segments do not adequately compensate for the risk, Kjærbye-Thygesen concludes by asserting that high-yield bonds are “an attractive asset class within the credit portfolio” due to their liquidity, transparency, and strong structure.

Emerging market investing has never been a one-size-fits-all approach, and China’s sheer size and role has only added to the complexity. As the world’s second-largest economy and a major part of emerging market (EM) indices, China presents both opportunities and challenges. Geopolitical tensions, regulatory shifts, and market access concerns have led some investors, including Finnish pension insurer Veritas, to rethink their approach. Rather than eliminating China exposure entirely, Veritas has embraced “Ex-China” allocations to gain broad EM exposure while maintaining flexibility to allocate to China separately.

The Case for a Separate China Allocation

As a proponent of active management in emerging market equities, Veritas had traditionally relied on fund managers employing an “all-markets” approach. However, starting last year, the team initiated a comprehensive overhaul of its EM portfolio, shifting half of its allocation to “Ex-China” emerging market managers while appointing dedicated China specialists for the remainder. “We saw the need for greater control over our China exposure,” explains Portfolio Manager Tapio Koivu, citing several factors behind the decision.

One key reason for the shift was the varying perspectives and approaches that “all-market” managers took toward China. “Each manager comes with distinct biases and views on China—some prefer to avoid it entirely, while others maintain more significant exposure,” explains Koivu. By separating emerging market allocations into dedicated China-focused and Ex-China mandates, Koivu and his team seek to achieve greater control and flexibility in managing their China exposure.

“We recognize that emerging markets are not a single, uniform story, but China stands apart in many ways, including its demographics. We saw the need for greater control over our China exposure.”

Another important factor behind the decision to separate China from the broader emerging markets allocation was the fundamental differences between China and other EM economies. “We recognize that emerging markets are not a single, uniform story, but China stands apart in many ways, including its demographics,” says Koivu. In many respects, China resembles a developed market, with a highly sophisticated economy, deep capital markets, and globally dominant industries. However, its political and regulatory environment remains distinct, with state intervention playing a far greater role than in traditional developed markets.

Addressing Geopolitical Risks and Opportunities

“Initially, the discussion focused on China’s sheer size – its weight alone justified a dedicated allocation,” Koivu explains. However, the unique political landscape and the broader implications of China’s relationship with the United States ultimately became the deciding factor in Veritas’ decision to separate its China and Ex-China emerging market exposures. “China holds a substantial weight in EM indices and remains a key driver of overall performance. If you simply follow the index, you’re inherently taking on substantial exposure,” Koivu notes.

The team at Veritas evaluated multiple scenarios, including more adverse outcomes where escalating geopolitical tensions could lead to China’s isolation. “In such a case, the impact on the emerging market allocation could be devastating,” argues Koivu. Rising tensions between China and the West – particularly with the U.S. – have already resulted in trade restrictions and fears of forced divestments. “For that specific downside scenario, it’s important to have the flexibility to manage and reduce exposure quickly,” Koivu emphasizes. “It’s not our base case, but it’s a risk we need to account for.”

“Having this flexibility is an advantage – it gives us an additional lever in our toolkit to fine-tune our exposure as market conditions evolve.”

The potential for a positive scenario also reinforced the decision to separate China from the broader EM exposure. “The opposite case is equally valid,” Koivu explains. “China is currently trading at very low valuations and, on a broader scale, appears somewhat out of favor. If conditions improve, it could present significant opportunities,” he continues. “In such a scenario, we would want the flexibility to quickly overweight China – even substantially.” Ultimately, multiple factors pointed to the same conclusion: having greater control over China’s allocation and treating it separately within the portfolio was the right approach.

This adjustment, however, comes with its own challenges. “It’s not an easy shift because it requires us to take a more active role in determining our stance on China versus the rest of emerging markets,” Koivu admits. “Previously, we could rely on managers to make those calls, without needing to worry too much.” However, he sees this increased involvement as a net positive. “Having this flexibility is an advantage – it gives us an additional lever in our toolkit to fine-tune our exposure as market conditions evolve.”

The Benefits of Active Management in Emerging Markets

Over the years, Veritas has developed a diverse and region-specific strategy for investing in global equities. The firm employs a direct, fundamental approach for Finnish equities, a quantitative strategy for European equities, a predominantly passive approach for U.S. markets, and primarily relying on external managers for emerging market equities. “This is where active management can truly add value, in our opinion, which is not the case all across the globe,” he emphasizes.

“In U.S. large-cap equities, a passive approach makes a lot of sense,” Koivu argues. “However, in emerging markets, the environment is still quite inefficient. Active managers can add significant value here, helping to avoid pitfalls related to companies with poor governance or weak ESG profiles.” For more tactical allocations in emerging markets, Veritas may also turn to passive ETFs. “While the active funds we rely on are mostly daily liquid and not illiquid in that sense, our philosophy is to avoid interfering with active managers through inflows and outflows,” Koivu notes. “For more tactical trades, we prefer instruments like ETFs that are better suited for that purpose.”

“However, in emerging markets, the environment is still quite inefficient. Active managers can add significant value here, helping to avoid pitfalls related to companies with poor governance or weak ESG profiles.”

When selecting managers for emerging market investments, Veritas primarily favors discretionary stock pickers who adopt a “boots on the ground” approach. “I wouldn’t say there’s only one right way to approach EM investments – there are multiple successful approaches,” Koivu notes. However, the majority of Veritas’ managers tend to have strong analytical skills and a hands-on mentality, actively meeting with companies to gain a deeper understanding of the drivers and risks. Ultimately, Veritas prioritizes managers who follow a well-defined process and have the resources to execute it consistently, ensuring that their success is repeatable and not just the result of luck.

Emerging Markets as an Element of Portfolio Diversification

Veritas maintains a broad and diversified portfolio, with emerging markets being a natural component due to their place in the global economy. Koivu highlights that the allocation to emerging market equities is valuable for diversification, as many of the drivers in these markets differ from those in developed markets. While the past decade has been challenging for emerging markets in aggregate, Koivu remains optimistic. “In the long term, the underlying drivers are still there, and the region offers a diverse mix of countries and companies,” he notes. With a more active approach, he believes there are significant opportunities, even during periods of market uncertainty. “Before this prolonged downturn, emerging markets experienced a significant boom, and there’s no reason why that couldn’t happen again in the future.”