“We have been discussing the fact that fixed interest rates and fixed income markets are not providing any kind of returns for a long time,” the CIO said.Even though Varma achieved a strong fixed income return last year of 3.7%, Rytsölä predicted still tougher times for the asset class in the rest of 2018. Finnish pension insurer Varma is increasing the proportion of risk-factor-based, multi-asset strategies in its portfolio in response to the current “challenging” investment environment. Risk-factor strategies now make up just under 5% of the company’s €45.4bn portfolio, according to CIO Reima Rytsölä.Speaking to IPE, Rytsölä said: “Last year we already increased our factor-based cross asset strategies a little bit, and that’s something we will carry on doing, probably increasing the proportion a bit more.”As a euro-denominated investor, Helsinki-based Varma was still struggling with the very low euro interest rate environment. Reima Rytsölä, CIO, Varma“It seems that this year will finally be the year when fixed income as an asset class is really struggling a lot, and if equities are not fully valued, they are at least fairly expensive,” he said.“The fundamental economic environment is really strong at the moment, so there’s widespread, balanced global growth, but its hard to say at the moment how much of that growth is already in the price – so the environment is challenging for sure.”Varma’s risk-factor strategies have similar features to smart beta investment, but Rytsölä explained that the pension fund used a “cross-asset” approach.“Also, we have tended to set up these risk-factor strategies so that they play more of a defensive role against the equity market, so we don’t include strategies that have highest equity correlation such as short volatility or FX carry,” he added.A diversification conundrumBesides a reduction in the portfolio’s correlation to equities, Varma has also tailored its risk-factor investments so that they increase the overall diversification of the portfolio.“Classic diversification would come from bonds going up and yields coming down, but that doesn’t seem necessarily to provide any diversification at the moment,” Rytsölä said.While buying volatility would be a good way to diversify or hedge under these market conditions, he said, the drawback of this is the cost.“Timing needs to be precise, otherwise it cuts your returns so much because long-term volatility is expensive,” Rytsölä explained.Asked whether Varma would consider using a risk-factor approach for a more significant portion or even the whole of its overall portfolio, Rytsölä said this would not be easy for several reasons.“One is that we have a unique feature in our solvency system for pension insurance companies in Finland, which makes us dependent on how our peers’ solvency is developing,” he said. “That’s why it doesn’t make sense for us to deviate too much from them, and if we changed our whole portfolio management approach, that would open up the gap between them and us and there’s a risk then that we wouldn’t be compensated for carrying that standard deviation risk.”The Finnish pension insurance sector’s solvency system is unique in this way and not comparable to other pensions solvency regulatory systems elsewhere in Europe. In Finland, if any of the pension insurance companies became insolvent, the remaining companies would have to pick up its liabilities.In keeping with this principle, the return requirement for technical provision is dependent on the solvency of other companies.