Risk levels at discretion of AP7 as more ‘alpha centres’ added

AP7, the default fund within Sweden’s PPM system, is in for a shake-up with a raft of changes set to take effect in May next year. Kristen Paech talks to chief investment officer Richard Grottheim about the fund’s new remit and how its portfolio is tracking.

As the global crisis hits home, many pension funds are looking to de-leverage and reduce the amount of risk within their portfolios.

In this respect, Swedish pension fund Sjunde AP-Fonden might be in the minority.

From May next year, the default fund within Sweden’s Premium Pension system (PPM) will be looking to add more risk to its portfolio, and will also introduce lifecycle funds which take into account the age of savers.

To date, AP7 has operated under a remit from the Swedish government which requires it to deliver performance “in line with or better than the average of the private funds within the PPM system” (of which there are about 800), with lower risk than the average fund.

However as part of a review of the fund, the government has removed the restriction around risk and instructed AP7 to set up lifecycle funds which decrease the level of risk in the portfolio as savers get older.

“That’s a focus right now at AP7,” says Richard Grottheim, chief investment officer of the fund.

“Today we have 90 per cent in equities and we can increase that from May next year for younger people up to 100 per cent if we want to.”

That might sound high, but as Grottheim explains, the government pension must be considered as a whole. The PPM defined contribution system is just one part of the government pension, making up 20 per cent of a person’s pension.

The income pension – the pay-as-you-go part, financed by employer contributions – makes up about 80 per cent of the pension and is basically an index-linked bond.

“So it makes sense to have a lot of equities in [the PPM system],” Grottheim says.

Like most pension funds around the world, AP7 has suffered the wrath of the global market meltdown, returning -35 per cent in 2008, down from 5 per cent in 2007 and 10.5 per cent in 2006. The fund’s net asset value has fallen to SEK 65 billion ($US7.3 billion).

However Grottheim says the fund’s strategic asset allocation, which was altered in May 2007 – shortly before the crisis hit – stands it in good stead to participate in any market recovery.

“We felt we had too low risk in the portfolio compared to the average PPM fund, so we increased the emerging market exposure and we also increased the private equity allocation,” he says.

“In hindsight of course that was too early, but you have to look at investments on a horizon of 25 to 30 years.”

Despite the severely negative return in 2008, Grottheim says AP7’s performance since the inception of the PPM system in 2000 remains ahead of the average PPM fund.

Three years ago the fund introduced alpha/beta separation within the in-house managed Swedish equities portfolio, and AP7 now has six ‘alpha sources’ across Swedish equities, currency and European equity.

Grottheim says AP7 is planning to introduce more ‘alpha centres’ this year and is focusing on Japan, Asia and the emerging markets.

While some commentators argue that alpha will be hard to generate going forward, he does not agree.

“My observation is that during last year, which was a challenging year for everyone, if you looked at our active return for the portfolio, the long-only managers struggled as an aggregate and underperformed their benchmark but the six alpha centres delivered a positive return all in all,” he says.

Under the remit provided by AP7, the managers use their skill in picking stocks and in the case of equity managers, widen the universe by shorting.

“We talk about the three zeros – the cash zero: we don’t deliver any cash to the alpha centre; it is beta neutral, so it’s beta zero; and we look at the benchmark as starting from zero, so it’s an absolute return construction,” Grottheim explains.

“What we deliver is a risk budget, so if they potentially lose money we deliver that deficit on the account to a certain limit.”

For some time now, the fund has been disinvesting from its fund of hedge fund exposure and transitioning its 2 per cent allocation into hedge fund replication.

So far, the investment in hedge fund replication is with Goldman Sachs’ ART (Absolute Return Tracker) fund, however Grottheim says the fund will expand to one or two other replication products, with the hedge fund of fund exposure replaced completely by replication by mid-this year.

AP7 also plans to invest 3 per cent of its 8 per cent private equity allocation in clean technology, and appoint one manager for the Swedish and Nordic market, and one for the global market.

“We think that [clean technology] will be good return-wise for the savers,” Grottheim says.

“Going forward, these companies that are within that sector will be very profitable as this is a large problem for the global environment and the production of clean energy will be favourable.”