Alecta, Sweden’s largest occupational pension provider, will celebrate its centenary next year. Through the years the SEK730 billion ($89 billion) fund has witnessed every type of investment idea and decades of bull and bear markets. It’s a perspective that has come to inform a strategy centred on the old-fashioned idea of buying carefully selected, quality investments.

The Stockholm-based fund, which manages pension assets for 2.3 million individuals and 33,000 corporate clients from across Sweden, abandoned index-heavy investment management a decade ago.

It doesn’t really invest in funds or alternatives and doesn’t use any managers in equity or fixed income; and only a handful in real estate, but that is changing.

It opts instead for a Sweden-centric, active, in-house strategy where just under half the assets are in interest bearing investments – half of which are in Sweden – with the remainder split between a 42 per cent allocation to shares and a 9 per cent allocation to real estate. Keeping it simple, and costs low, are central themes.

“We believe that market prices are not always efficient and that an active, or selective, investment approach pays off over time,” explains Per Frennberg, deputy chief executive officer and head of investment management at the fund. He holds a PhD in finance from Lund University and began his journey at Alecta 21 years ago.

“It also reduces risk if you have scrutinised each investment before you enter [into] it. It’s about consistency, accountability and, of course, cost efficiency. We want to be accountable for every individual investment; and we also have high ambitions when it comes to ethics and sustainability; and want that integrated in our investment process. With our size, the economies of scale are tremendous.”

The fund has internal costs of less than 3 basis points of assets under management.

At the end of 2015, Alecta had just over 100 listed companies in the portfolio, in often substantial holdings, in a concentration that allows the deep analysis and effective monitoring Frennberg seeks.

“As a very large investor we have almost a duty to be capable of valuing every investment we consider. If we can’t, who can? When it comes to the depth of our analysis, it’s not so much about digging very deep into the accounting, or doing extensive industry analysis. It’s more about having a consistent approach with a standardised checklist ultimately combined with personal judgement,” he says.

High level of scrutiny

The fund recently increased its exposure to US equities, with American companies now amounting to 24 per cent of the total share portfolio; with 40 per cent in Swedish companies. Alecta’s level of scrutiny does limit the fund’s investment universe, simply because of the depth of research required.

“It is not so much a limit as to where we can invest, but rather how many potential new investments we can consider over a year,” he says.

“We have no predetermined huge allocation to Swedish assets. If we couldn’t find interesting opportunities in Sweden we wouldn’t invest here. As we grow it’s quite likely that the share of domestic assets will go down gradually. The benefits are that we usually get better informed on Swedish assets which improves the results over time, but also to some extent that we invest in the future of the society where our clients operate and live.”

It’s a sense of duty as a responsible owner that drives Alecta’s increasingly prominent environmental, corporate and social governance strategy. All investments are confined to companies that follow international conventions which Sweden has joined.

“Our focus is not so much on excluding but rather on what to avoid – bad management, outdated business models and so on – and constructive dialogue with companies in the case of environmental, corporate and social governance-related issues,” Frennberg says.

A key aim of 2016 is to vote at the annual general meetings of all of the companies in the portfolio.

Airports boost Alecta’s domestic real estate

The thread to streamline and create economies of scale that runs through the fund is behind Alecta’s recent decision to sell its entire UK and US direct real estate allocations.

The real estate portfolio had been divided between a 50 per cent allocation to Swedish real estate with the remainder in the US and UK.

“We want to reduce our operational risks and to further trim our cost efficiency,” Frennberg says. “These allocations were a small part of Alecta, despite being successful. We reached a critical point whether to keep it, or not, and real estate markets are strong at the moment.”

He says “lots of people” are interested in the 42 assets split between both countries. The indirect real estate allocations Alecta is holding on to comprise joint ventures and fund and company structures. The reason they are not being sold is easy to guess: “They are more cost efficient,” Frennberg says.

Alecta’s domestic real estate was boosted last year with the acquisition of some 20 airport properties via a company jointly-owned by Alecta and Swedavia, a state-owned airport operator. All Alecta’s directly-owned Swedish properties, including Alecta’s head office, are powered from renewables.

About 90 per cent of the fund’s assets are in a defined benefit plan, with the remainder in a smaller, but growing, defined contribution scheme.

The portfolio returned 5.9 per cent last year with an average annual return for the past five years of 7.4 per cent. With a solvency level of 171 per cent at the end of 2015, Frennberg is in a comfortable position ahead of next year’s celebrations in March.

“It will be a modest celebration; low cost. It won’t be like a bank would celebrate a centenary – although we have more capital.”

 

In 2015 the second Swedish National Pension Fund (AP2), with about SEK300 billion ($37 billion) in assets, completed an internalisation of $6 billion in external mandates, introduced new risk systems, formalised its environmental, corporate and social governance strategy, and implemented a change of custodian, moving $31 billion in assets.

“I am really proud of the organisation,” Eva Halvarsson, chief executive of AP2, says.

“We felt we were evolved enough to do that. When the fund was set up in 2001 we wouldn’t have been. But we now have competence and knowledge and built up new systems, so we felt ready.”

With total costs now at 17 basis points, the plan is to reduce that further to 14 basis points.

The main vehicle for achieving that is in-house asset management, and in the past three years more than $6 billion has been shifted from external mandates to the internal investment team, including in emerging market fixed income and global credit. The fund now manages around 83 per cent of assets in-house.

The team is lean, with 65 staff in total, around 35 of who are in investments.

Internally the team manages: Swedish equities, credit, emerging markets bonds, Swedish bonds, and developed market bonds. There is a large quant division, so more assets managed in-house does not necessarily translate to needing more staff.

The fund still has a number of external mandates with development market equities specialists such as Generation and AQR.

“We have four values and one of them is constant improvement, so we look at costs but it’s not a purpose on its own. We have chosen the portfolio we think is the best,” Halvarsson says.

AP2 has government restrictions around where it is allowed to invest. With the main investment requirement that the fund invests 30 per cent in bonds, and not more than 5 per cent in unlisted assets, with the exception of real estate and real assets such as timber and agriculture.

The fund’s asset allocation is 44 per cent equities, 31 per cent fixed income and 25 per cent alternatives. The equities allocation is split between Swedish equities (10 per cent), global equities (24 per cent), and emerging markets (10 per cent). Within fixed income there is a 6 per cent allocation to emerging markets. The alternatives allocation is split between real estate (12 per cent), private equity (5 per cent), alternative credit (2 per cent), alternative risk premium (3 per cent), and Chinese Series A equities (2 per cent).

Halvarsson admits that the mandated 30 per cent in bonds, which naturally means lower returns, creates a bipolar portfolio, with the fund needing to take risk in other parts of the portfolio.

“I look back and see three trends in the way we work with the portfolio. There’s been a move from developed markets to emerging markets; a move from listed to unlisted (real assets); and fund investments to direct investments and joint ventures,” she says.

AP2 is keen on real assets, and under different rules Halvarsson says the fund would invest in infrastructure. “It suits us,” she says.

“We continue to increase investments in real assets, it suits our objectives. In a globalised world it is so hard to find uncorrelated but real assets.”

The fund takes a 30-year time horizon and believes in active management, and in 2015 produced about 1 per cent of active return.

 

Knowledge-sharing and common values

Halvarsson says it was a positive and necessary challenge to develop the organisation further – and bringing the assets in-house helped with that.

In addition to the internalisation process, in 2015 the fund also introduced new risk systems, formalised its environmental, corporate and social governance strategy, and implemented a change of custodian moving $31 billion in assets.

The new risk system is a combination of Risk Metrics and Barra One, which not only allows a portfolio view of risk but also enables environmental, corporate and social governance analyses of the portfolio.

The fund is also tendering for a new performance system, and is developing its own business system which includes knowledge sharing.

“This has been a magnificent way to increase cooperation in the organisation – we have common values and we work with our values as part of [our] daily work. With competence, systems and a willingness to cooperate and improve, all this has tightened the team,” she says.

Halvarsson has been chief executive of AP2 for 10 years, and she says this is “one of the greatest things I’ve done.”

“I’m privileged to be working with very talented people, everyone is better at what they do than me,” she says of her staff.

 

Sustainability a key driver

“The integration of sustainability is part of our daily life, so I forget to mention it,” she says.

“Ten to 15 years ago, a financial analyst would say if it isn’t in our spreadsheets it can’t exist. But now we look at things you can’t put numbers on. What is the best possible information that you have before making a decision – and we use all types of information before investing in the future.

“Sustainability turned into a hygiene factor, everyone is talking about it but not knowing what they’re doing. Asset owners, governments, consumers and companies, who does what and what are the expectations, it’s a mess,” she says.

But Halvarsson is clear on the role of her fund, and other asset owners.

“Every time I talk about it, I want to mention it is not up to AP2 to put a price on carbon,” she says. “We have a very important role as a catalyst, but the expectations are that asset owners are sitting on money and should transform the economy.”

“The financial industry has a very important part to play, and we have to learn more or else we can’t make the right decisions. But we are looking at it from financial risk perspective, and we are not a political instrument.”

Halvarsson sat on a panel on sustainable investments at the 2015 World Climate Summit in Paris, which added further weight to her belief that the finance industry needs greater knowledge and competency around sustainability issues to achieve better financial outcomes.

The framework for AP2’s sustainability program is anchored in the international conventions that Sweden has signed, such as labour conventions.

In 2015 it reduced its risk to climate by limiting investments in power companies whose profits derive primarily from coal-powered generation of electricity, and has consequently divested from 28 power companies.

When the fund divests it is done from a financial risk perspective, a view that assets are not priced correctly, and is not a moral decision, Halvarsson says.

The vision is to make environmental, corporate and social governance an integral part of all analytical and investment processes. And the fund connects actions to the United Nations sustainability development goals, and in this way can visualise that what they are doing is connected to a bigger perspective.

AP2 has been investing in green bonds since 2008, and was one of the first in the world to do that. Now it has decided to make it part of the strategic asset allocation, of 1 per cent, for benchmark purposes, which Halvarsson also says signals it is an important part of the portfolio.

“I hope it will increase over time, green bonds have performed in line with other bonds,” she says.

 

Diversity as a competitive advantage

In 2003, AP2 developed a female index, measuring the percentage of female employees at companies listed on the Swedish stock exchange.

“We want to ensure the companies we invest in have the best talents and use all the possible recruitment. It puts the facts on the table,” she says.

“Gender diversity drives better governance and better company returns, we are totally convinced of that.”

The index focuses on female board representation and leadership roles.

“The number of women in management is showing steady but slow growth, it’s now about 20 per cent. But women on boards is more volatile.”

Halvarsson says quotas are being talked about more seriously than ever before. After the annual general meetings this year, if there is not 40 per cent of women on boards then there is a discussion about enforcing quotas.

While last year 50 per cent of all new board appointments were women, it will still take 44 years before management is 50:50 because of the slow pace of change.

“My view is if we reach 30 per cent, then it will become easier, because it starts reinforcing itself. We need some self-recognition here, it will be stupid not to avoid a law on this, it’s about competency. We need more understanding around this competency driver and that it can be seen more as a competitive advantage.”

“In our Myers Briggs testing, the chief investment officer and I don’t have one figure in common. That’s good for us, we need to work together.”

“It is about the same thing – values. We recruit and retain and develop people and have to work with the whole spectrum. Younger employees see it differently, and I don’t want an organisation that’s conservative, with old values. We cooperate with other asset owners on sustainability, so how can we do it on gender and diversity?”

 

“We view ourselves as a pension delivery organisation, while a lot of other funds see themselves as asset managers. Asset managers generally measure risk in terms of market volatility or drawdown in capital, but our mantra is to deliver on a pension promise,” says Jim Keohane, president and chief executive of Healthcare of Ontario Pension Plan, HOOPP.

“We define risk as based on factors that may impede our ability to write that cheque 25 years from now, which would include additional factors such as changes in the purchasing power of our assets, caused by changes in interest rates and inflation. We don’t benchmark ourselves against returns, we aren’t this type of organisation. Measuring against returns does not give a full picture of whether or not you have succeeded.”

Success, for Keohane who has been at HOOPP since 1999, is better measured by the glowing funded status at HOOPP, up to 122 per cent from 114 per cent in 2014, despite all of last year’s economic uncertainty.

HOOPP is a C$63.9 billion ($50 billion) Canadian fund is a multi-employer defined benefit plan, serving 309,000 working and retired healthcare workers.

Its liability driven investment, LDI, comprises two investment portfolios: a liability hedge portfolio, designed to hedge the major risks that would impact HOOPP’s pension obligations – namely inflation and interest rates – and holding assets which perform in a manner similar to its liabilities, and a return seeking portfolio designed to earn incremental returns and bring diversification benefits.

Real estate over infrastructure

Within this structure, strategies at the fund are as noteworthy for what they include, as what they don’t – like the absence of any allocation to infrastructure in the liability hedging portfolio.

“Sure, infrastructure has long-dated and inflation hedging characteristics similar to real estate, but infrastructure also has sovereign risk and regulatory risk. We have invested in infrastructure in the past,” Keohane says.

He prefers real estate, with its high correlation to inflation. The 12.5 per cent allocation returned 8 per cent last year, despite a currency hedge.

The absence of infrastructure is not only informed by the risk of governments acting against stakeholders, but also by Keohane’s belief in the value of liquidity and always having enough on hand to be in a position to buy at points of distressed selling.

“Liquidity can be valuable at various points in time. For example, in January if you had liquidity you could take advantage of this,” he says referring to the sharp fall and subsequent rise in asset prices six months ago. “Liquidity is a trade-off. If you are going to consider tying it up in illiquid assets you have got to be sure you are getting a premium for this. The pricing of infrastructure today doesn’t hold sufficient risk premia: private equity can if you are in the right deals.”

Other current themes at the fund include absolute return strategies in the foreign exchange forward market where HOOPP is exploiting odd pricing anomalies. Keohane also plans to increase the fund’s allocation to real-return bonds relative to nominal bonds. He also sees opportunities in credit, structured credit and credit derivatives, where uncertainty around new financial regulation within the Dodd-Frank Act has left opportunities.

“The spreads here are wide, relative to what we’d expect and are not relative to the credit fundamentals. There is an absence of ownership, a sense of being in no-man’s-land. Some of these things are priced favourably against the risk.”

Opportunities as well as challenges

Confused credit markets, and banks exiting traditional business because of capital charges, are some of the areas where new regulation brings opportunities. But it is also raising challenges, particularly for HOOPP’s heavy derivative use and dependency on banks’ ability to act as a counterparty.

The trend among banks to exit high balance sheet usage, low margin businesses is starting to reduce liquidity in the repo market, with banks “shedding repos off their balance sheets.”

Although HOOPP can address this through central clearing, it involves the fund changing its model and sets it on a challenging road.

“Dodd Frank creates problems for us as a derivative user in terms of how we do deals and exit them. Central banks understand the challenges but the regulators are marching on.”

HOOPP’s strategy relies on in-house management and cutting edge technology in an organization where of the 600 staff, 250 reside in the IT department, with Keohane having a 60-strong investment team.

HOOPP’s investment costs are about 20 basis points, while total costs at the fund are 30 basis points.

“There is no way we could keep this low if we were outsourcing. Many of our strategies involve the efficient management of our balance sheet, but the outsourcing model doesn’t allow this. With an in-house model, we can also dial risk up, and down, and we can move money across asset classes; and if you’re outsourced this is more difficult and expensive to do.”

“If you outsource to another party they won’t tailor what they do to you. They tell you what the service is and you can either give them money, or take it away.”

 

Investors should not rely on investment theory because the complex and connected risks in the real world cannot fully be accounted for, says Tim Unger, head of advisory portfolio group at Willis Towers Watson in Australia.

For example modern portfolio theory, for which Eugene Fama won a Nobel Prize, factors in the exogenous risk of changes to underlying fundamentals, but only explains about 20 per cent of the realised market volatility, Unger says.

The theory does not account for endogenous risk, such as the random behaviour of investors who are acting on incomplete information.

According to the theory of rational beliefs by Stanford’s Mordecai Kurz, investors make judgement calls about what will happen to the price of securities based on past and present data, but because not every investor will have access to the same information, and this will cause some to overestimate the price and others to underestimate. Based on these rational beliefs investors will take actions, and this in turn causes things to be more volatile than they otherwise should be. Kurz’s research shows once you take this into account, 95 per cent of market volatility can be explained.

“Turns out that we need more than just one theory,” Unger says.

“The world is complex and there is no single overriding theory that does a good job of describing the real world that we live in. It’s just much more complex and changes more quickly than we expect. We can however use and draw on a number of theories to help us get a better understanding of the world, rational belief being one, but there are others.”

Because no one investment theory is sufficient, Unger said institutional investors should be taking actions to account for this, including developing stronger and deeper investment beliefs; allocating more to alternatives as equity markets will always have bad periods; and either being truly long-term or truly short-term, as a portfolio cannot simultaneously capture the benefits of both.

“In all of this, good beliefs are critical … And by having a better mental map of how those [investment theories] can impact security prices and asset classes, you can actually reflect those in your portfolios and generate better outcomes.”

Stronger and deeper investment beliefs

According to Unger, in an ideal world there is a hierarchy of beliefs, starting at the board and running down to those implementing the portfolio.

The board sets the high-level views and beliefs that frame the organisation and the investment portfolio. However, as there is no settled theory on the more detailed aspects of financial markets, the closer you get to those implementing the actual portfolio, the deeper and richer those beliefs need to become to help in the navigation of decisions.

“Embedded in every single investment decision you make is a set of beliefs. And so what we are arguing for, is that judgement and beliefs need to become a bigger part of the investment process, and those beliefs need to be richer and deeper.”

Another suggestion on how to achieve a better performing portfolio was for asset owners to use those fund managers who had sophisticated mental maps and were already capitalising on a deeper understanding.

“Those managers that can do that are clearly worth paying fees for because they generate excess returns. But other ways you can exploit better understanding is either through thematic investing or through dynamic asset allocation (DAA).”

What thematic and dynamic asset allocation require from an investor is the ability to identify where markets have mispriced and then the patience to wait for those to be realised.

“I’m not going to suggest that any of these are easy – none of them are – but they are all doable, that’s the important part.”

Allocate to alternatives, even if it is difficult

Recently Willis Towers Watson has increased its emphasis for investors not to rely on risk premia that are macro sensitive, as most portfolios are too reliant on credit and equity market risk.

“While Australia has led that charge in terms of increasing allocation to alternative assets, more recently they’ve slowed down and the rest of the world has actually overtaken them.

“The question is, why is that? Have they reached the point where they have the right allocation to alternative assets? Or are there factors that are limiting greater uptake of diversity?”

A straw poll of the delegates at the consultants Ideas Exchange in Sydney revealed that headline fees were not the constraint; rather it was a desire not to increase complexities in portfolios.

“But the fact that there isn’t greater conviction in the equity risk premia is also interesting. I think what it says is there is still appetite to take on greater diversity, it’s just that there are things that are making it harder to do; [that] there are higher hurdles to get new assets in your portfolio and that marries with our experience.”

Exploiting endogenous risk

Unger added asset owners need to have a truly long-term view.

“It’s too difficult and it’s too unrealistic to expect that we can build portfolios to do well in the short-term and the long-term,” Unger said.

“We have to adopt a portfolio that will do better over the long-term, partially because while we may well have a belief in mean reversion, we just don’t know when that is going to apply.

“Most of the changes in markets in the short-term are not due to changes in the fundamentals, it’s due to noise, so the best way to outperform with stock selection or asset allocation is to have a truly long-term view.”

However, it was possible to outperform by being truly short-term by exploiting endogenous risk that dominates the financial system, but which is largely noise when looked at from the longer term perspective.

Unger suggested some strategies that exploit endogenous risk were non-price weighing schemes and smart beta.

“There are also some very short-term oriented strategies that seem to do that, but I would argue they are probably not as easy to do as the longer term fundamental stuff, but still doable.”

Barry Kenneth joined the UK’s Pension Protection Fund, PPF, as chief investment officer three years ago from Morgan Stanley, where he headed up the bank’s fixed income and pension coverage. It was a role which involved navigating new banking regulation introduced in the wake of the financial crisis, in an experience that leaves the PPF in competent hands today.

The £22.6 billion ($33 billion) lifeboat fund is positioning itself ahead of costly regulation coming pension funds’ way, around the use of derivatives on which the PPF relies upon in its liability driven investment (LDI) strategy.

European pension funds have been exempt from the mandatory central clearing of derivatives until 2017. Next year new rules to bolster markets against systemic risk, mean over-the-counter derivatives will be processed through centralised clearing houses, requiring banks to hold increased capital against these instruments, reducing their availability and increasing costs.

“We are assessing potentially changing our portfolio in advance of central clearing obligations,” says Kenneth.

The PPF takes on defined benefit schemes left stranded if their corporate sponsor collapses. Funded by a levy on eligible schemes, its strategy is one of caution and focus, balanced between generating enough of a return to pay its 200,000 members, yet not place too big a risk on its levy payers.

Kenneth’s plan for reducing the reliance on inflation and interest rate swaps, and better proof the portfolio from the looming cost of derivative strategies, is a hybrid portfolio that will ultimately account for 12.5 per cent of the fund’s assets and “does two jobs.” Hybrid assets will have the hedging and inflation-proof characteristics of the LDI portfolio but also income-generating qualities.

So far investments include renewable energy, index-linked private placements and rental properties. Kenneth’s “proactive” approach to finding assets favours co-investment, allowing the PPF to bid on bigger projects where the competition is less fierce. A flagship deal in 2014 saw the PPF team up with M&G Real Estate to buy Manchester office blocks valued at £300 million-plus ($439 million) bringing both stable cash flows and an interest rate hedge.

The PPF previously targeted a 70 per cent allocation to cash and bonds to match liabilities, with the remainder in risk assets aiming for a LIBOR-plus 1.8 per cent outperformance target. By 2017 the fund will have a strategic 58 per cent allocation to cash and bonds, comprising UK gilts and annuity contracts, global government bonds and global aggregate bonds; including emerging market debt, a 22.5 per cent allocation to alternatives comprising private equity, infrastructure, timber and absolute return strategies, a 7 per cent allocation to public equity, with the remainder in the hybrid portfolio.

The fund’s small 7 per cent equity allocation is designed to counter the large equity allocations held by many of the schemes, some significantly underfunded, that it protects.

The flexible risk budget ranges from 3.5 to 5 per cent but with the current “headwinds” in the global economy Kenneth’s risk appetite currently hovers around the bottom end of the range. “We are looking for pockets that will deliver value in a challenging environment. We have been allocating more of the portfolio to idiosyncratic risk that is not aligned to the broader market.”

Internal and external ‘added value’

The fund is continuing to move more management in-house. The liability side of the balance sheet, namely derivatives and government bonds, will be the first portfolio to be brought in-house.

“If anybody knows what our liabilities look like and how to hedge them, we should,” he says.

Other assets will be brought in-house gradually over time, although this will never amount to the entire portfolio – only the parts of it where he sees real value.

“We are not being driven by a time scale and we are not going to build up massive teams,” he says.

Kenneth believes that both external managers and his 14-strong internal team can add alpha through their decisions.

The external managers add value against their benchmark and the internal team add value through manager selection and benchmarking.

“In portfolio construction we think about our true investment benchmark – our liabilities – not the asset based indices. Since we hedge our liabilities, this is equivalent to looking at the total return. The manager may deliver alpha, but if the index falls by more than the alpha, that is not going to add value to the fund.

“We also think in risk factors, and we have given out risk factor mandates especially in our hybrid portfolio, where we are focussed on obtaining credit, duration, inflation and illiquidity characteristics in physical assets, as opposed to constraining the managers based on asset class name,” Kenneth says.

The PPF has evolved and thrived from small beginnings in 2005. In its latest phase, it is acquiring assets that provide long-term cash flows and have less reliance on financial instruments, showing its continued ability to adapt to changing market conditions and financial regulation.