It has been 20 months since Björn Kvarnskog moved from Stockholm, Sweden, to Melbourne to become head of equities at the Future Fund.
Since then, the former head of global equities for $55 billion Swedish pension fund AP4 has been busy conducting a complete review of the Future Fund’s $30 billion equities portfolio.
When Future Fund chief investment officer Raphael Arndt hired Kvarnskog, he gave the international recruit an open mandate to look at the equities portfolio’s strengths and weaknesses and propose what needed to be done to improve its value proposition.
The result is a new objective and a recalibrated portfolio that separates mandates along active and passive lines and requires managers with more active risk to generate its alpha.
Ready to talk publicly for the first time since taking on the role – and with much to say – Kvarnskog agreed to be interviewed live on stage at the 2017 Investment Magazine Equities Summit, in Melbourne, on September 12.
“The listed equities program had been performing well, but we thought it could do better,” he said. “It was not something that was broken and needed to be fixed.”
Kvarnskog said that as the team embarked on the review of the equities portfolio it found “a lot of factor risk”.
Sometimes that was deliberate, with targeting of certain factors, but other times it wasn’t. As multiple long-only managers had been added over time, the tracking error, or risk, in general had been diluted. While this is one of the benefits of diversification, it also added much factor risk, particularly around the momentum theme in the long-short portfolio.
“I’ve seen this in trading as well and I think it applies to hedge funds,” Kvarnskog told the summit. “You have traders or funds taking deliberate risks but when you put everything together there are certain risks that pile up and sometimes you don’t get rewarded for that.”
This was the case for the Future Fund’s equities portfolio, so plenty of work was undertaken to address its structure.
Taking back control
Once it was clear what was under the bonnet, the Future Fund set about recalibrating to address the unwanted factor risk. Then Kvarnskog’s team, in consultation with the board and investment committee, found a new objective.
“We focused on how we could take control of the portfolio; that was probably the most important task,” he explained. “The listed equities program had been serving several masters in the past. We had been involved in completion trades, thematic investments, stockpicking mandates and factor mandates. We needed to take a step back and define what we were targeting.”
It was agreed that the most important objectives for the portfolio were to take as much desired risk as possible, and to play a role in portfolio completion. A new strategy was designed to accomplish those aims.
“This meant bringing in the factor exposures we had in other areas,” Kvarnskog said.
The equities team is now more particular in where it targets its factor exposures, and is cognisant of the many factor risks the Future Fund is exposed to at a total portfolio level; for example, in fixed income or private equity. The equities portfolio now has a reduced exposure to the momentum factor and has refocused the way it targets what Kvarnskog calls the “more solid” factors, such as value and quality.
The new streamlined structure is simpler. The portfolio is divided into a number of sub-categories, each having a unique objective and role to play.
Kvarnskog described it as “almost a barbell approach”, and said that while he is reluctant to label the process an alpha/beta separation, the vast majority of the assets are now in beta and alternative-beta mandates.
“The objective for these portfolios is super simple – to tap into market risk premia or alternative risk premia and get properly compensated for taking risk,” he said. “That said, we are not benchmark huggers. We think there are benefits to moving away from the [market-cap weighted index], but using a benchmark approach to structure the portfolios.”
High-risk, alpha mandates complement the beta mandates, with a preference for hedge funds – mostly market-neutral ones.
“Instead of having long-only managers in between carrying a lot of deadweight in terms of holding stocks where they don’t have high conviction, we put more risk into the alpha space and use replication strategies in the beta and alternative-beta book,” Kvarnskog said. “It’s important to stress the model doesn’t trump the way we implement. Even if we use many passive replication strategies, we have components of long-only mandates as well, but more in areas where we think [it’s more difficult to] replicate the strategies.”
Young, hungry managers
Previously, the Future Fund had a number of large mandates with some of the “fancy big hedge fund names”, including an equity long-short mandate of $2.5 billion.
“We also had a number of managers operating with a lot of net exposure. This is not an optimal way to use the balance sheet in the hedge fund space.”
The fund has shifted focus to smaller, more nimble, stockpicking mandates, where the objective is to maximise idiosyncratic risk. The fund now also targets managers at an earlier stage in their lifecycle.
“There are heaps of benefits to this. These managers tend to be hungrier, easier to negotiate with, and we get better terms and conditions and better transparency, which is extremely useful,” Kvarnskog explained.
But it wasn’t just the type of manager that changed in the portfolio clean-up; the fund also addressed the systems used for information and communication with managers.
“We can’t just have a quarterly call with managers; we need to integrate the data, see what is going on, and view it through a factor lens,” Kvarnskog said. “For the big guys, this is very sensitive information, I get that. We are trying to engage with smaller, more nimble managers operating with market-neutral mandates. They are not that active in the crowded names, so it’s good for us because we won’t end up with bad hedge fund risk or bad momentum risk.”
A better deal on fees
Not only is the new setup a more efficient way of allocating capital, it’s a better way of spending fees.
The Future Fund can replicate a strategy that a long-only manager charges 30-60 basis points for and end up paying a fraction of one basis point.
“We are happy to pay fees for skill and for managers that can handle idiosyncratic risk or harvest complexity,” Kvarnskog said. “But for a large chunk of the beta book, especially, for long-only managers riding factors for many years, we don’t want to pay for that.
“This is a business of scale. We can create our own indices and hand them over to State Street or Vanguard and players like that, and in a low-returning world, that is an efficient way to make money by not paying fees.”
Essentially, the portfolio has adopted a different way of addressing risk, with fewer big mandates, but is also more efficient.
“We pay less [in] fees in the alpha and beta book so, in general, we have saved a lot of money by doing this,” Kvarnskog said. “Fees are an important governance tool, especially in the hedge fund space. You can give managers a rule book but nothing works as well as a fee structure.”