Reducing risk not risky asset classes: AP3

Sweden’s Third National Pension Fund, AP3, has rejigged its long-term strategic asset allocation and increased its exposure to alternatives. Kristen Paech talks to chief investment officer Erik Valtonen about the reasons behind the changes.

Like all other pension funds, Sweden’s AP3 is a long term investor. However, the extraordinary circumstances of the last 18 months has forced the fund to reconsider its short-term risk appetite, and whether there are better ways to allocate its risk budget in this highly volatile environment.

“We, as is every fund in the world, are discussing also our short-term risk preference and the big question is: where are equities going next?” Erik Valtonen, chief investment officer of AP3, says.

“We are an equity-heavy investor; we paid a price for that last year, we believe that equities are a good long-term value proposal but we have to think about what the next 12 months will bring.”

Kerstin Hessius, the fund’s chief executive officer, admits a high level of portfolio diversification was “insufficient to ensure a satisfactory result in 2008”.

AP3 reported a full year loss of SEK44.8 billion ($US4.9 billion) in 2008, corresponding to a return of -19.8 per cent after expenses.

The sharp downturn in global equity markets had a significant impact on the fund’s equity portfolio, which saw its value drop by almost 40 per cent.

“We simply have to acknowledge that the overall level of portfolio risk was too high,” Hessius says in a statement.

But according to Valtonen, reducing the level of risk in the portfolio does not mean shying away from risky asset classes.

“The answer might be that equities are exceptionally cheap right now and we increase the allocation, but we are discussing what to do with all the risky assets,” he says.

In fact, AP3 recently reset its strategic or ‘normal’ portfolio, reducing its weighting to bonds and equities and increasing the weighting to alternative investments to 20 per cent of the total fund.

For a fund that’s aiming to reduce risk, such a move might sound counterintuitive, but as Valtonen explains, it’s all about diversification.

“We increase other types of risk, yes, but we reduce our dependence on equity risk,” he says.

“We will not be allocating more money to private equity, but real assets – for example infrastructure and timberland – are assets that to some extent are independent of what’s happening in the equity markets so that gives a diversification benefit.”

The new normal portfolio redefines asset classes and includes a 5 per cent allocation to ‘new strategies’, which at this stage consists of farmland in the Ukraine and Russia; secured bank loans in the US and UK; reinsurance risk through catastrophe bonds; and equity with an absolute return focus – like micro caps, actively managed life science portfolio and possible frontier markets.

Valtonen stresses that the new portfolio is still in the early construction phase and is not a reaction to what’s happened in the global markets but rather a long-term goal to improve diversification and raise the allocation to alternative assets.

“The main purpose is to create a portfolio structure that’s flexible,” he says.

“The ‘new strategies’ is a container for different kinds of risk premiums; stand alone risk premiums would be too small to warrant individual allocations but the combined risk premiums make sense. We wanted to get rid of the siloed approach.”

Over recent years, AP3 has been reducing the amount of traditional active stock picking within the portfolio and last year implemented an alpha/beta separation strategy for both internal and external management.

While there is no explicit allocation to hedge funds as an asset class, Valtonen says in future, hedge fund-like structures could be an exotic beta play in the new strategies portfolio.

“We have hedge funds in two places in the portfolio – first of all we have reduced our risk allocation to traditional active management and replaced part of that risk allocation with some types of hedge funds,” he says.

“We have a program with global macro CTA managers, which we see as an alpha play for us. Those managers replace some traditional stock pickers, so they are sitting in the alpha portfolio, but we recognise that there are other types of hedge funds that really are picking up different kinds of risk premiums that should do that as a more exotic beta play. If and when we invest in those types of managers, the natural place would be in the beta portfolio, and that would be within the new strategies allocation.”

The old normal portfolio

Nominal bonds – 29 per cent
Inflation-linked bonds – 8 per cent
Real estate – 8.5 per cent
Equities – 54.5 per cent

The new normal portfolio (2009)

New strategies – 5 per cent
Public equity – 47 per cent
Private equity – 5 per cent
Real assets – 10 per cent
Inflation-linked bonds – 7 per cent
High yield – 2.5 per cent
Investment grade bonds – 4 per cent
Mortgage bonds – 2.5 per cent
Government bonds – 17 per cent