Constructing a successful portfolio will always require careful planning and a clear set of principles to ensure it develops effortlessly and efficiently. This is an ethos that Sweden's €22.8bn AP3 scheme fully understands. With investment returns falling from 17.7% in 2005 to 9.5% in 2006, the state buffer fund began implementing a radical revision of its portfolio structure and risk budgeting last year.
THE ROOT OF THE PROBLEM
AP3 began redrafting the reconstruction of its portfolio, now an award-winning project, by identifying reasons why this was necessary. "A few years ago we sat down at the fund and started to look at basic rationale of our business. What are the key belief statements on which the business model is built? How should the portfolio be constructed in order to fully comply with these beliefs?" the scheme asked itself.
This led to the scheme setting out three central statements that are designed to drive the make-up of the portfolio going forward:
AP3 adds that these three principles translate in practice into long-term asset allocation, medium-term asset allocation and the generation of alpha from active management. A couple of important factors that will complement these three underpinning objectives were also identified, including flexibility and cost effectiveness.
SEPARATE IDENTITIES
But that was the only the beginning. Aware that traditional portfolio construction mixes the three principles in a way that leaves a suboptimal and inflexible structure, AP3 next sought an innovative means to ensure they did not interconnect so readily and so achieve an optimal portfolio structure.
"Allocation decisions not only affect the playground for active management, but can be very costly to implement. Alpha can only be earned in asset classes that are present in beta allocation. Furthermore, if medium term asset allocation decisions become more frequent and if they are implemented by allocating capital between mandates, the transaction costs might be unnecessarily high and the performance of the active managers might be interrupted," AP3 explained. "To overcome these problems, our solution is to implement a layered decision structure where the different decisions are as independent from each other as possible. To achieve this, part of the alpha and beta decisions have to be portable."
PRACTICE MAKES PERFECT
That's theory. How does AP3 see this working in practice? The answer, it claims, lies in derivatives, alpha risk budgeting and the introduction of a global tactical asset allocation programme as a new source of alpha.
Using derivatives - where these are available - instead of trading in physical assets will be used for the medium-term asset allocation. AP3 says this allows it to separate the long-term allocation that is driven by the scheme's liabilities by placing capital in different asset classes and the medium-term value of the assets. "The result is a flexible strategic portable beta overlay that allows for a cost effective and timely implementation of the medium horizon decisions," the fund claims.
Henceforth, AP3 is introducing portable alpha solutions into its alpha risk budgets, as it recognises that sources of alpha do not have to be exclusively and necessarily tied to the long-only management of asset classes the fund invests in. They can be found from whatever alpha generation policy the fund's rules allow. So though part of its capital will be allocated in line with long-term asset weightings, the risk budgets will contain other sources of alpha. "For example, we have changed the way the internal equity portfolios are managed: we have moved from traditional long-only management to separating the passive index replication from stock-picking. The latter is now done in long/short hedge fund portfolios."
According to AP3, this has introduced greater clarity in its objectives for creating alpha, as previously this was reliant on a portfolio-like benchmark. Further developments in the risk budget depend on stochastic modelling information to protect against dips in performance. "We know that some managers thought to be good will fail," says AP3. "Furthermore, the risk budget calculations try to optimise the ratio of expected active return in relation to the costs of active management."
As part if its foray into global tactical asset allocation, AP3 says it has streamlined the part played by its treasury in financing the different mandates in the GTAA programme.
FRUITS OF LABOUR
AP3 is proud to say that though the changes represent on ongoing project, the advantages of the change are already visible. The fund claims the investment process has become more flexible and perhaps more importantly, transparency in the investment process has increased as different decisions now interact less than previously. In addition, AP3 says there will be savings in the implementation costs of the medium-term allocation.
Even the use of derivatives - with all the legal documents and contracts this involves - has not presented any major headaches, despite teams all the way down from the front to the back office being involved.
HIGHLIGHTS AND ACHIEVEMENTS
Determined to construct the most efficient and profitable portfolio to ensure it remained successful in volatile times, AP3 has gone back to the drawing board and completely stripped its operations back to the core as if starting over.
Adopting a statement of investment principles that supports three central themes, it has managed to come up with a portfolio that is complex and includes a wide set of mandates and asset classes but is imminently manageable and more flexible than the portfolio it replaces.
Such has been its determination to have the right skills and checks in place, that even the use of derivatives - new ground for many schemes - has not fazed the scheme and it has incorporated these techniques with ease.
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