As an avowed long-term investor the Second Swedish National Pension Fund (AP2) has taken a 40-year view when looking at its balance sheet, which includes attempting to comprehensively build in sustainability considerations into its investment strategy.
AP2 chief executive officer Eva Halvarsson said the fund had built its own Asset Liability Model (ALM) that looks at 40-year-time horizons.
The ALM aims to put the portfolio into perspective with the overall Swedish pension system.
It looks to build in yearly forecasts for how liabilities and inflows into the pension system will affect AP2’s funding inflows and outflows.
Also plugged into the model are demographic trends, basic macro-economic assumptions and estimated long-term rates of return across a range of assets. The limitations on the fund such as set limits on liquidity and risk that constrain its investment options are also included.
Halvarsson said the ALM was then extensively tested.
“We can test it on approximately 600 different scenarios and then we get, not the one answer, but we see a tendency,” Halvarsson said.
“It (The ALM) is not something coming out of a machine but it is an input to our work.”
AP2 is one of Sweden’s five buffer funds that are tasked with seeking greater returns during favourable economic and demographic conditions. The funds aim to build a buffer to protect the Swedish pension system during times when there are large cohorts of retiring workers.
The buffer funds make up 12 per cent of the Swedish Pension system, with the bulk of the remaining assets held in vehicles that are not connected to financial markets.
AP2 chief strategist Tomas Franzen said because the Swedish Government requires the AP funds to be “generation neutral” and not disadvantage younger people entering into the system.
“We are long-term and we should be able to bear financial risk,” Franzen said.
“If our holdings are severely hit over a few years, which actually happened a few years ago that it is not something that we take lightly. But it should be tolerable if we believe that markets are priced for the reasonable long-term compensation of risk,” he said.
Franzen said AP2’s ALM model uses Monte Carlo simulation techniques to map the basic returns trajectory of the portfolio given a range of variables.
In line with fulfilling its return-seeking role, AP2 had 54 per cent of its assets in equities at the end of 2010. This was made up of 20 per cent Swedish equities, 18 per cent North American equities, 13 per cent European equities and 4 per cent emerging market equities (mostly Asia).
AP2 had 36 per cent invested in fixed income, including 19 per cent in Sweden, 13 per cent in Europe, 4 per cent in North America and 1 per cent in emerging market.
Eleven per cent of its investments are in alternative investments, the majority of which are in Sweden.
The fund aims to achieve a 5 per cent real return on investment annually and, in keeping with its long-term perspective, has started to examine how climate change risk could impact its performance.
Halvarsson said that the fund was looking at ways to build climate change into its investment approach in the same way it would look at other underlying fundamentals when deciding on a particular investment.
“A couple of years ago we tried to calculate the carbon footprint for our portfolio, just to increase our knowledge internally and how this might affect the businesses we invest in,” Halvarsson said.
“We are constantly trying to integrate sustainability issues into the investment process. We believe that increased knowledge of sustainability will help us make better investment decisions.
We have a deep commitment because many funds have one person who is responsible for corporate governance and sustainability. But we don’t believe that is a good way to do it if you really believe that this is something that is important for your investments in the long-term.”
Halvarsson said that fund had looked at a number of ways to build in climate risk into investment strategies and admitted that despite good intentions it was a challenge.
The fund had managed to look at the portfolios carbon footprint and gained several ideas as how the emission issue could be integrated as part of the investment process, Halvarsson said.
“We have been talking about the carbon footprint and talking about an index for us when we are a passive investor globally that would take this into consideration – but we haven’t finished that thought yet,” she said.
“So, we don’t have a structured process but we try to learn and eventually get to where we are setting a price or figure on this (sustainability). That is what the challenge is about, getting this into your excel spread sheet.”
When it comes to sustainability the Swedish funds have been particularly proactive in flexing their combined muscle as investors.
Five years ago four of the AP funds combined to form an Ethical Council which claimed in its last annual report to “systematically monitor’ more than 4200 companies.
AP2 will chair the council next year and has in a particular case acted ahead of the other council members in excluding a company that did not meet its corporate governance principles.
Global retail giant Wal-Mart was excluded from the fund’s list of potential investments, despite the council later engaging in dialogue with the company over its industrial relations policies.
Last year the council engaged in direct dialogue with 10 companies and used consultants to engage with up to another 200 companies.
The Council and AP2 align their investment principals with the conventions that the Swedish government is a signatory to.
Last year some of its more high-profile engagements included with Rio Tinto about its environmental record in Indonesia and Toyota for alleged ant-union activity in the Philippines.
The council has excluded 11 companies, predominately for involvement in the manufacture of cluster munitions or landmines.
“Our aim is not to exclude companies but to seek improvement,” Halvarsson said.
“We are not just selling our shares but trying to make a difference. It is easier to be listened to if you are four times as big. We also try and cooperate with the largest funds in the world.”
AP2 has also applied its sustainability principles when it recently pushed into agriculture as a way to diversify risk across its portfolio.
Halvarsson said the fund had been looking to boost its allocation to real assets to seek more exposure to assets that were not correlated to financial markets.
This year it invested $250 million in a joint venture with a US pension fund and financial services provider TIAA-CREF to buy farmland in the United States, Brazil and Australia.
It was the fund’s second foray into agriculture, which forms part of its 5 per cent “real estate” allocation.
Halvarsson said the funds aims to boost double this allocation to 10 per cent.
AP2 has not put a timeframe on its real estate expansion.
The fund was patient to find investors who shared its long-term outlook and sustainability objectives rather than rush to meet a pre-determined investment deadline, Halvarsson said.
Along with real estate, AP2 has also flagged that it would increase its allocation to emerging markets with a region focus on Asia. It has not revealed any set aims in terms of allocation.
Both TIAA-CREF and AP2 were signatories to the United Nations Principles for Responsible Investment. Halvarsson said AP2 was looking at staying in these agriculture investments for around 20 years.
“We are not interested in buying and selling but in buying and holding good agriculture properties,” she said.
The AP funds are required to keep a minimum of 30 per cent of their assets in low credit, highly liquid holdings and Halvarsson said they were not concerned about a lack of liquidity in their real asset investments.
AP2 reported that at the end of 2010 it had 35 per cent of its portfolio in liquid assets.
The move into real estate has also involved an innovative joint venture arrangement, where AP2 joins with other investors to form a company.
It first used this approach in March when it formed a joint venture with the First Swedish National Pension Fund to launch a $734 million real estate investment company. European finance group Catella manages the project.
The company planned to invest in commercial real estate in major European countries.
Halvarsson explained that it enable the fund to broadening the European portfolio.
“It will enhance the Fund’s overall investment focus and is expected to generate a robust and stable return over the long term,” she said.
The fund already manages more than 75 per cent of its investments in-house, which includes active management of Swedish equities, developed market equities, Swedish bonds, developed market bonds and tactical allocation.
External managers are used for its global equities, Swedish small-cap, emerging market bonds, global credit mandates, TAA mandates, emerging market equities and alternative investments.
In 2010, assets under active management generated a 0.8 per cent return, with externally managed mandates contributing 56 per cent to the positive result and assets under in-house management 44 per cent.