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?” says Erik Valtonen, chief investment officer of AP3, who had a
chance to compare experiences with his Australian counterparts last month as a
speaker at Terrapinn’s Asset Allocation Summit in

Sydney.

“We are an equity-heavy investor; we
paid a price for that last year, we believe that equities are a good longterm 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 ($A8 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 said 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.”

Ideally, AP3 would like to increase its
allocation to alternatives even further; however investment restrictions placed
on the fund by the Swedish government prevent that from happening. Under the
restrictions, the fund’s allocation to unlisted securities is capped at 5 per
cent. At least 30 per cent of the fund’s assets are to be invested in interest-bearing
securities with “low risk”, and a maximum of 40 per cent of assets may be
exposed to currency risk. At least 10 per cent of the fund is to be managed by
external asset managers, and commodities exposure is not allowed.

Valtonen says
the 5 per cent cap on unlisted assets – which means private equity for AP3 at
the moment – restricts what the fund can do in infrastructure, and is a
“suboptimal” constraint. He hopes that the government may consider removing the
limitation to allow the fund to invest more freely across alternatives. 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 (initially through catastrophe bonds); and equity with an
absolute return focus – for example micro caps, an actively managed life
science portfolio and possibly frontier markets.

One of the key themes in
choosing the new long term asset allocation has been diversification. 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.”

All private equity investments are made through funds and fund of funds as
required under the government’s mandate and both infrastructure and timberland
investments are made through external funds. AP3 holds a 25 per cent stake in Vasakronan,
the biggest real estate owner in

Sweden, and also invests in several
real estate funds around the globe. Over recent years, the fund has been
reducing the amount of traditional active stock picking within the portfolio and
last year AP3 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.”

 

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