SWEDEN - Tredje AP-fonden (AP3), the third Swedish National Pension Fund, is looking at diversifying into newer asset classes including reinsurance and liquidity, its chief investment officer has revealed.

Discussing the separation of alpha and beta in a pension portfolio, Erik Valtonen said some asset classes, such as private equity and commodities, have "huge alpha components" as the "more exotic the beta the more dependency there is on alpha".

As a result, he said 'newer' alternatives were now gaining interest from the market, such as timberland and reinsurance.

Speaking at the Pension Fund Investment World Nordic 2008 conference in Stockholm, Valtonen told delegates AP3 already has "a few investments" in timberland, but revealed the scheme is looking at the possibility of investing in reinsurance risk.

Although he confirmed the fund is "not a big investor in alternatives", because legal constraints currently limit its allocation to 5%, Valtonen said within its alternatives portfolio the fund "is looking at re-insurance risks". (See earlier IPE article: Sweden to relax alternatives regulation])

Following the conference, he told IPE AP3 "have been evaluating insurance-linked securities (ILS), and think that they could be an interesting asset class for a long-term investor like AP3, given its very low correlation to other asset classes and its long-term return expectation".

He said the issue of investing in this area had raised some legal concerns such as whether investments in catastrophe bonds, for example, "could be interpreted as AP3 conducting insurance business which in Sweden is subject to license requirements".

However, he told delegates the question had "just been settled" as after researching the issue "our understanding is that these kind of investments do not constitute insurance business".

But Valtonen added AP3 still needs to discuss the asset class with its board before the decision gets the "final go ahead", although as with any new possible investments the fund declined to comment on the potential size of the investment or the timetable for making a decision.
In his presentation at the conference, however, Valtonen also highlighted the potential for using liquidity premiums as a source of "alpha" returns, because "liquidity comes with a price" which means long-term investors, such as pension funds, can earn money as a "liquidity provider" to the market.

He said: It's a way of earning money as a long-term investor, and it is also something we are looking into."

Valtonen explained to IPE long-term investors "should be natural buyers of liquidity risk if the risk is compensated for. We believe this is the case in many alternative assets".

"Given AP3 is both a long-term investor and has a governmental status we also have advantages compared to many other types of investors during market turmoil. There are cases when investors like us could act as liquidity providers to the market and get paid for that," he added. 

Valtonen also suggested the value of "deviating from the market benchmark" through alternatively weighted portfolios, as opposed to the normal market cap weighted indices which "give a picture of the investment opportunities in every market but are not necessarily optimal".

Instead, he suggested funds could use enhanced indexing - which AP3 has already adopted - or he claimed funds could add "up to 200 basis points per annum" to returns in the long-term by adopting equally weighted, fundamental or wealth indices - in a similar approach to AP2, which uses a portfolio based on GDP weighting in the global equities sector, (See earlier IPE article: 'Pure alpha" is worth paying for - AP2)

As part of its alpha-beta separation strategy, AP3 currently has six managers responsible for Global Tactical Asset Allocation (GTAA), and two in-house equity long/short managers within its alpha stream, as well as investments in FX trading and a small allocation to hedge funds.

In addition, Valtonen said AP3 has adopted a "couple of pure alpha mandates", while the fund's overall portfolio also includes the use of fundamental and equal-weighted indexing and "some exposure" to total return swaps (TRS) although he admitted "this will probably increase" in the future.

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