Gill Wadsworth speaks to AP3 executive vice president Gustaf Hagerud about the pension buffer fund's risk-weighted approach to portfolio construction
Like many pension funds the world over, the Swedish buffer funds were hit hard by the financial crisis that took hold in 2008.
The AP3 fund lost SEK44.8bn ($6.5bn) and while much of this damage was repaired during the upturn in 2009, the scheme has since adopted a new approach to risk management and implemented a dynamic asset allocation strategy.
AP3 had always switched between asset classes in response to market conditions and an emphasis on diversification has been clear in the AP3 portfolio since 2001, generating SEK5bn in the seven years to 2008. However the losses endured during the global financial meltdown highlighted the failings of AP3’s existing approach to asset allocation, calling for a more structured process.
A change in approach
In 2009 the fund revealed its intention to ditch its fixed benchmark and adopt a more holistic approach to portfolio management by weighting each asset class according to risk and dividing them into categories. The strategy was fully implemented at the start of 2010.
AP3’s head of investments Gustaf Hagerud said: “The financial crisis was a catalyst for adopting the new strategy. We realised that we could not have a fixed benchmark in the way we had before; we had to adapt our portfolio to the changes in volatility.”
Under the new strategy, the fund targets an absolute return of 4%; meaning it must hit that goal irrespective of what is going on in the market. There are seven risk classes into which the fund’s investments are grouped comprising equities; fixed income; credits (corporate and mortgage bonds); inflation-linked; foreign exchange; absolute return strategies; and other (convertible bonds, insurance risks).
Once the asset class has been categorised, the investment team then analyses the various market dynamics which affect the investment and takes an allocation decision accordingly.
Hagerud said: “At any moment of time we want a portfolio that gives us 4% real return at the lowest possible risk. In periods of uncertainty and when volatility is very high we can’t go to a fixed benchmark, we have to look at the markets and the macroeconomic indicators that affect return, and then make a decision on how to allocate the portfolio.”
The AP3 team analyses structural factors including demographics; productivity; debt levels and savings ratios within the context of the overall economic conditions. It uses its own internal research showing the returns from different asset classes at each stage within an economic cycle, allowing AP3 to understand when equity returns are likely to be at their highest, or when they might pose a potential risk of falling.
“Based on these forecasts, and taking into account uncertainty and correlation in returns, we construct the portfolio that we believe will be most likely to generate a 4% real return over a timeframe of one to three years. A large part of the dynamic allocation process will focus on managing negative investment outcomes – and in this context we will constantly review the need for asset protection strategies,” stated AP3 chief executive Kerstin Hessius.
Applying the dynamic asset allocation strategy requires a disciplined and rigorous approach, something Hagerud noted places significant demands on the in-house team at AP3 in comparison to a more traditional asset management model.
“What you need is a very structured investment process; you have to have analytical tools that you can use all the time and you have to refer to the same analytical sources at all times,” he said. “You can develop your process over time, but you should decide on a framework to work within and stay within that. You have to be disciplined.”
In terms of success, AP3 claimed to be happy with how the new strategy is progressing, although short term performance is not on target. The fund’s 2010 interim report shows that market volatility caused the fund to be 2% adrift of its 4% goal and, in spite of delivering SEK2bn between January and June 2010, the annual real return was 2%.
AP3 had taken a positive view of economic trends which was reflected in a high exposure to equities and foreign exchange, and in the first six months of the year the asset classes returned -0.8% and 1.3% respectively.
The fund has since reduced its equity holdings from 58.2% to 54.8% over the year, while actively managing its currency exposure, an approach it has described as “successful”.
At the same time, AP3 increased allocations to Swedish and European government bonds during the first half of 2010 as part of a drive to increase exposure to low risk fixed income instruments. It also pulled out of Japanese bonds, increased the portfolio duration and sold half its holdings in secured bank loans to realise the gains in these investments since 2008.
Hagerud added: “The market has been fairly volatile this year but it hasn’t caused the dramatic losses that you saw in 2008, and we learnt a lot from the financial crisis and that is reflected in our strategy.”
In common with the other Swedish public pension funds, AP3 is obliged to hold set amounts in particular asset classes and not exceed specified limits in others. For example, commodities are banned outright; private equity must not exceed 5% of the total portfolio holdings; and fixed income should represent at least 30%. Consequently, irrespective of positive views on certain asset classes and negative views on others, the AP3 investment team is bound by law to take certain positions; a situation Hagerud said can present challenges.
“We are not allowed to have more than 5% in private equity and that can be a problem, but if you look back to 2008 it was not a period when you wanted a lot of private equity; it would not have saved us. We have to have at least 30% in fixed income – either government or investment grade – and sometimes that is a problem for us but it’s not a major one,” Hagerud said.
AP3 has long embraced alternative asset classes and has allocations not just to private equity but also hedge funds and infrastructure. The fund is able to take advantage of relatively illiquid investments since it has such a long-term time horizon, and is committed to companies including wind farm Arise Windpower.
Hagerud said that although the infrastructure allocation is limited to staying within the 5% private equity allocation the fund is looking for new investment opportunities in this area.
AP3 also favours emerging markets, a position motivated by strong performance in this area ahead of developed markets. According to the 2009 annual report, AP3’s listed portfolio achieved a return of 21.1% in 2009 – its best performance since 2001 – thanks to equity returns of which emerging markets were the strongest performers delivering 60.5%. However, the fund will focus on all options in the emerging markets arena rather than limiting itself to equities.
Hagerud noted: “We have had a fairly large exposure to emerging markets and that is somewhere that we continue to look for investment. That doesn’t have to be through equities, it could be exposure in the developed world through bonds.”
Real estate related investments have also proved a positive holding for AP3 and the fund remains committed to inflation linked opportunities particularly in international timberland fund investments.
AP3 also made additional allocations to insurance related instruments, which come under the ‘other exposure’ risk category, reflecting the fund’s interest in maintaining its diversification strategy.
Looking to the future, AP3 continues to hunt for sources of diversified return while the overall emphasis remains on risk management. Hagerud is philosophical when asked about immediate and ongoing challenges, arguing that AP3 is no different to any other pension scheme in worrying about volatility and what the markets hold.
He said: “Currently we have no major challenges; we are facing the same problems that everyone else is facing. We left the recession and now the question is will we go back there or into a recovery? That is nothing special to us, we are all thinking about the same thing.”
AP3 Facts & Figures
- Total portfolio: SEK208.6bn (€22.4bn)
- Total investment return since 2001: SEK55.2bn (€6bn)
- Long-term target: 4% real return over one to three-year time horizon
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