AP4, the SEK 459.1 billion ($41.4 billion) Swedish buffer fund, links the success of its hedge fund portfolio to a few key characteristics. Like other investors, AP4’s allocation is rooted in a belief that hedge funds are primarily a source of alpha and diversification, used to provide uncorrelated returns distinct from beta risk. Like others, AP4 also outsources the allocation, pouring its efforts into a rigorous selection process to hunt out managers (it currently has around 15) with the best processes to harvest the diversification and alpha it seeks.
However, in contrast to other investors, AP4 invests the vast majority of its SEK18 billion ($1.6 billion) hedge fund allocation with emerging managers in a strategy it believes taps both outperformance and lower fees.
“We invest most with early stage emerging managers because there is empirical evidence that when and if these managers reach scale, they tend to outperform. It’s also a way for us to access future capacity at a reasonable cost,” says Magdalena Högberg, head of strategic allocation and quantitative analysis at AP4.
Talent spotting is complicated by emerging managers lacking a track record or historical results like more established funds. Due diligence requires putting the hours in to understand and gain confidence in the strategy and the people behind it – as a long-term investor, AP4 wants to see past short periods of under-performance.
“A typical red flag is not understanding how the manager is making money,” says Högberg who also insists new managers have previous experience of building a strong team and business, despite striking out on their own. “We don’t’ want to be investing into an emerging fund run by an analyst that has gone into a portfolio manager role without having the experience of training people and creating a business. We want to invest alongside a supported team.”
AP4 typically adds one or two new lines a year and splits strategies between regions. Högberg doesn’t have a specific limit on how much she is prepared to invest, but ensures the allocation is never too concentrated. A key focus is on how a particular allocation will fit into AP4’s wider portfolio. Another risk she seeks to avoid in portfolio construction is a synchronised sell off whereby all allocations plummet.
“Many of the strategies we invest in, and the way we invest, make us vulnerable to deleveraging events – a sell off where everything is affected, and the uncorrelated portfolios also sell. This is when you must hold your nerve, and when understanding the manager and the process really kicks in and allows us to be long term.”
Högberg expects all prospective managers to have an ESG policy and framework, although she notes ESG integration is easier in particular strategies. For example, it is difficult to integrate ESG in a rates, relative value strategy. In contrast, equity managers are increasingly integrating ESG. She also notes the emergence of long short hedge funds that short companies that have bad ESG characteristics. However, she believes the impact of these strategies remains a grey area. “It’s still not clear what this means from an ESG perspective. If a manager is shorting a company that is violating our ESG standards, is that a good thing? Sure, they are taking an active stance on not owning that company but is it better to not touch it at all?”
She also notes that investing in the climate transition can be complicated by hedge funds’ short-term horizon.
“Investing in the transition can take a long time and hedge funds are sometimes on a different time horizon. Are you allowing yourself enough time for the theme to play out?”
Högberg’s focus remains on equity market neutral managers that seek idiosyncratic risk and avoid exposure to market factors.
“Market exposure is something we can source cheaper from other sources in our asset allocation – in places like market weighted equity indices or by buying interest rate risk,” she reiterates.
It leaves the portfolio’s 10–15-line items divided between a core strategy to equity market neutral funds alongside other allocations to relative value focused on the quant space and more event driven, long short and directional trading strategies.
She is pondering adding new lines, particularly macro-orientated strategies which appear well placed to capitalize from current and prospective macro dynamics.
However, any addition to CTA-like structures will be challenging given AP4 is prohibited from investing in commodities under an enduring law designed to ensure the portfolio doesn’t benefit from higher commodity prices that could also hurt beneficiaries.
“Trend exposure in macro funds tends to include exposure to commodities as well as financial futures. It’s not impossible to ask a manager to take it out, but we would have to be careful it doesn’t constrain or adversely affect the strategy in general.”
In another approach, the team is also looking at adding sector specialists focused on big secular trends to add alpha and diversification. Areas of particular interest include the energy transition and defence, two of the sectors most affected by trends in the world today.
“The energy transition, and its second order effects, has the potential to be a big alpha driver in the long- short space as different companies react to what lies ahead,” she predicts.
AP4 already has exposure to the energy transition in its infrastructure and in-house equity allocation.
The equity long-short allocation has performed best in recent months off the back of increased volatility and dispersion. “It has been the standout allocation,” she says.
In contrast, volatility has hit the events-based allocation that aims to profit from takeovers and mergers.
“Events-driven strategies are struggling because the convergence to fair value is not as quick in this market environment.”
Elsewhere, a strategy oriented towards climate change- that also has some underlying exposure to economic growth – has struggled given the switch to fossil fuels in Europe in response to Russia’s invasion of Ukraine.
Fees are kept low by focusing on market neutral funds and ensuring the most alpha per fee spend. “Our focus is on finding and paying for a manager that consistently generates out-performance,” she says.
Typically, fees fall the longer AP4 stays with a particular manager given the fund can leverage its long-term capital. Lastly, investing with new managers also slashes the cost. “We can negotiate founder fee terms,” she concludes.