After years of waiting, AP7, Sweden’s SEK 900 billion ($84 billion) DC state pension plan, has just completed an inaugural investment in real estate, marking a leap forward on the road to building a strategy that is less correlated to the equity market.
New regulations in place since the beginning of the year finally permit AP7 to invest up to 20 per cent (up from 10 per cent) of its assets in alternative, illiquid investments. A new allocation to infrastructure and targets to double private equity are in the offing following the fund dipping a first toe in real estate with a stake in a multi-use development in Stockholm.
“We have asked for this for a long time. If you manage investments with a time horizon of 40 to 60 years and 100 per cent of the fund is required to have daily liquidity, of course it will cost you in returns,” says Johan Florén, chief ESG and communication officer at the fund.
The move is indicative of the gradual evolution of strategy at the fund which has had to adopt a creative approach to diversification because of its regulatory confines. It’s main life cycle product comprises a small allocation to fixed income (primarily Swedish exposure) with all the remainder in equity in a full throttle approach.
The majority of the equity exposure is in a global market cap ACWI allocation where diversification comes via stakes in some 3,000 global companies spread across all sectors and regions. Over the years AP7 has added diversification via paring back on global equity, introducing some factor exposure and increasing the allocation to small cap, emerging markets and a private equity allocation, explains Florén.
“This was our strategy to diversify the portfolio and reduce risk,” he says. “We reduced the global equity portfolio with the aim of lowering volatility a little, but also keeping returns at the same level. We hoped the risk adjusted return would improve.” Between 2010–2022 the equity fund has returned 415 per cent compared to 5.5 per cent returns in the fixed income allocation. The equity fund made a –9.9 per cent loss in 2022
Less leverage
The ability to diversify will also impact AP7’s use of leverage, accelerating a strategy to gradually reduce leverage over the years. At the end of 2022, the net equity market exposure amounted to 115.5 percent of the fund capital, in contrast to earlier periods of much higher leverage. In 2010 AP7 applied 50 per cent leverage to the equity portfolio and Florén says the fund now targets leverage of around 25 per cent over the long term. “We have gradually taken it down,” he says.
The ability to invest more in illiquid assets also supports AP7’s sustainability ambitions. The lifting of restrictions will allow the fund to boost its allocation to green real estate and infrastructure.
AP7 has changed its own internal regulations to allow it to invest more in green bonds, highly rated state-owned companies and supranationals like the world Bank and EIB. Investments in green bonds increased to SEK 9.2 billion ($0.87 billion) in 2022, corresponding to 10 per cent of AP7’s fixed income portfolio with a target to increase this to 50 per cent by 2025. These types of bonds yield slightly higher returns than Swedish government bonds, partly because they are not as liquid.
Under its sustainability strategy, AP7 has also began work on a new transition portfolio, targeting this portfolio account for 10 per cent of the equity fund by 2025. The actively managed allocation seeks to increase holdings in certain companies compared to the index. The idea is that the increased weighting and focus via an active ownership and increased stake will boost corporate transition.
“We are more likely to do good as active owners in a company with high emissions that has a longer transition ahead of them, than in a company that is already best in class,” says Carl Fredrik Pollack, responsible for sustainability integration in asset management.
Illiquid implementation
AP7 still hasn’t finalised processes around implementation and how best to access more illiquid assets, continues Florén. Its first investment involved partnering with AMF in a joint venture.
“This is definitely one way we will do it,” he says. “But there is no final decision and we are looking at different ways.”
AP7 will likely approach infrastructure investment it in the same way as private equity – aka investing small amounts over a long period of time to avoid concentrating risk in a particular life cycle. “It can be hard to have high quality investments if you invest a lot quickly,” he says. “We will do it over a number of years, step by step.”
He also sounds the possibility of AP7 going into the secondary market to get more diversification over time. Although AP7 can invest up to 20 per cent of its assets in illiquid investments Floren says the fund will likely invest between 15-20 per cent over a number of years.
“Everyone is very enthusiastic about it and we don’t see any big risks since we don’t have a strict timetable. We are looking for good opportunities and will take it step by step.”
Costs
AP7’s outsourcing strategy means the internal team design strategy but select managers to deliver. “We look for the best there is when we do our procurement, in particular around asset management.” Although he says the fund might need to slightly boost its headcount to invest more in alternatives, there are no plans to abandon its outsourcing philosophy and hire a new team.
Similarly, Floren says the fund is determined to keep its investment costs low. Management fees for the AP7 equity fund (0.05 per cent) and the fixed income fund (0.04 per cent) remain unchanged in 2023, in line with policy.
“It’s well known that these investments can be more costly, but we are not going to raise fees and 5 basis points in the equity fund will remain. This fee is a clear condition that we must consider – cost efficiency will remain a priority even in new assets.”
