AP3 drives further portfolio diversification

Investment staff at Sweden’s Third National Pension Fund, AP3, have discretion to make tactical decisions as part of a dynamic asset allocation strategy that along with a drive to diversify investments aims to achieve an ambitious 4 per cent real return target.

Since inception in 2001, the state-owned pension fund is yet to achieve this long-term performance target. But, while streamlining short-term decision-making and risk management has been a focus, the fund’s head of asset management Gustaf Hagerud explains that longer-term strategic asset allocation still has the most impact.

After the financial crisis, during which the fund lost 19.8 per cent, it was decided to instigate a dynamic asset allocation model that looks to improve the way the AP3 manages risk across the portfolio.

Assets were split into seven risk classes: equities, fixed income, credits, inflation, currency, other exposure and absolute return strategies.

The fund’s investment team aims to adjust risk levels and return targets to market conditions over the medium term, which is defined as a period of one-to-three years.

Hagerud, who is also deputy chief executive officer, explains that the decision-making framework that AP3’s dynamic asset allocation model is based on involves macroeconomic analysis, valuation of risk classes and evaluation of the overall market sentiment or risk appetite.

The board of directors sets the guidelines for fund management and overall portfolio allocations, and also decides the deviation mandates within which the CEO can change allocations. According to Hagerud, the investment team has a fair degree of autonomy to make tactical decisions.

“Overall asset allocation is decided by the board and the organisation itself has quite a lot of room to change that between board meetings,” Hagerud says.


Focus on equities

The fund typically has around half of its assets in equities as it needs to have exposure to risk assets to reach it return targets, Hagerud explains.

“The reason is that we stick with so much equity is our 4 per cent real return target. If we want to reach that in these markets – when the real Swedish long bond is negative or very close to zero – we have to have a lot of equities in our portfolio,” he explains.

As one of Sweden’s five buffer funds, AP3 has to maintain a delicate balance between trying to seek long-term returns for future generations while avoiding large drawdowns such as those experienced over the financial crisis that led to cuts to pension payments.

In 2011, the fund returned a 2.4 per cent loss before expenses, with its equities portfolio contributing -5.3 per cent to the overall total return.

However, AP3 has managed to continue contributing to the Swedish pension system by returning an annual nominal return of 3.4 per cent. This exceeds the income index of 3.1 per cent, which is used as the basis of pension indexation.

The fund has also contributed Swedish Krona 9.2 billion ($1.4 billion) to cover pension deficits, which occur when pension commitments exceed contributions. It is forecast that AP3 funds will continue to cover these deficits for at least the next 30 years.


Long-term portfolio construction

The fund has used a range of strategies to try to cushion the volatility of its equity holdings.

This has included a variety of option strategies of different sizes as well as hedge fund strategies that, with 30 external managers, aim to provide returns when markets decline.

While the dynamic asset allocation regime is designed to better manage risk and exposure over time, Hagerud says it is still too early to say if the strategy allowed the fund to avoid heavier losses on the portfolio last year.

“It is a very short time frame to analyse this. I don’t think 2011 was a very good year for evaluating this as we had a lot of financial turmoil,” he says.

“But in the end, if you look at the performance of markets so far this year, the right decision would have been to stay in equities.”

While dynamic asset allocation has been useful for the fund in order to better understand and manage its risk exposures, Hagerud says that the long-term returns are still driven by strategic asset allocation.

“It is portfolio construction for the long-term. The main part of that is diversification and the second part dynamic asset allocation,” he says.

“So it is wrong to say that we are primarily working with dynamic asset allocation, we spend much more resources in diversifying our portfolio. Portfolio construction is much more important than dynamic asset allocation.”

Another limitation to the fund’s drive for diversity has been the pressure to keep costs low.

AP3 has a focus on cost effectiveness in asset management: its total expenses, as a percentage of average fund capital, have come down from 17 basis points in 2009 to 11 basis points in 2011, considerably lower than comparable sovereign wealth funds.

Total expenses comprise operating expenses, staff, premises and administrative costs as well as external management costs.


The other classes

This has, however, limited the fund’s ability to seek active management or diversify to a greater extent into higher fee-paying asset classes such as hedge funds.

The fund currently seeks index managers for almost all of its overseas equity holdings, with only emerging markets being actively managed.

Domestic and most of the European equities are managed internally, as are European and Swedish fixed income portfolios, while US high yield fixed income is managed externally.

In recent years the investment team has sought diversification through expanding its holdings of corporate credit and real estate.

The credit risk category comprises Swedish mortgage bonds and investment grade corporate bonds in Sweden and the US.

In 2011, AP3 sold a large part of its European credit bonds holdings, increased its exposure to Swedish credits and invested in US high yield bonds. The credit portfolio generated a 7.5 per cent return for the year, which corresponds to a 1 per cent contribution to overall returns.

“Government bond markets have a problem in that you cannot diversify anymore, you have Germany with extremely low yields and then you can go into Spain and Italy with high yields, but you will get an extremely concentrated portfolio in government bonds,” he says.

“The event risk you get in that kind of portfolio is not very nice. If you want to take on risk in fixed income markets you are far better in the credit markets where you have many companies to diversify your portfolio into.”

Real Estate now makes up 7 per cent of the overall portfolio with both domestic and foreign investments.

Sitting in the inflation risk class, along with index-linked bonds from Sweden, Germany and the US and timberland and agriculture land, real estate generated a 15 per cent return last year.

The ratio of index-linked bonds to these other real assets in the portfolio is 55:45, with the inflation risk class returning 13.5 per cent, corresponding to a contribution of 1.9 per cent to the fund’s overall returns.


Regulatory limitations

The fund is limited in diversification opportunities open to its investment team by regulations. These include a requirement that at least 30 per cent of the fund be invested in interest-bearing securities with low risk. A maximum of 5 per cent of the fund assets may also be invested in unlisted assets (not including real estate).

These regulations are under review, with findings due to be released in August and possible legislation changes likely to come into effect sometime next year or early in 2014.

The current regulations governing the fund have limited AP3’s capacity to explore opportunities in private equity and infrastructure, with the investment team having already filled the 5 per cent quota in private equity.

“It does limit the possibilities to making major changes to our long-term asset allocation,” Hagerud says. “So, what we are trying to do is to find new kind of investments that we can invest in to diversify our portfolio. It replaces listed equities since we have to have 30 per cent fixed. We spend a lot of time trying to find other investments, both in the listed and unlisted space, that can diversify us away from listed equities.”

In the 11 years since its inception the fund has achieved a real annual return of 1.7 per cent, while experiencing three major downturns on global equity markets.

Last year the export-led Swedish stock market lost 17 per cent, while emerging markets lost 21 per cent.

The funds equity portfolio returned -10.3 per cent, contributing -5.3 per cent to the total return, and underperformed the market-weighted MSCI All Countries World Index (MSCI), which recorded -6 per cent.