Sweden's AP3: Adding value through active management

Pablo Bernengo, CIO of Tredje AP-fonden (AP3), the Swedish buffer fund, uses a football-based metaphor to illustrate how he approached the job when he joined the institution in 2019.

“If a new coach comes into a team and insists that the team should play in a 4-3-3 formation, but the players are much more suited to 5-3-2, the results will probably be quite bad,” he says.

“That is to say that I think one has to work with the resources available, be that talent, skill, systems or data.”

The CEO and board of AP3 gave Bernengo a clear goal, he says, to review and implement changes in the organisation’s investment team and portfolio. “It was clear that the institution was ripe for change in several areas, in terms of organisational structure, the portfolio and the sustainability strategy,” says Bernengo. 

The CIO’s career in asset management started nearly 25 years ago. He first worked in global equities but quickly moved to asset allocation, which has been his main focus.

“After I joined, I spoke to the senior management, including the CEO, my predecessor and the head of human resources, to find out what they thought we should do, and then I sat down with every member of the investment management team to find out about the institution’s portfolios,” he says.

“My conclusion was that we had an experienced investment management team and that we were in a good position to work with active management across different asset classes.”

Bernengo then oversaw a significant strategic shift, whereby AP3 internalised the management of a large share of the assets that were managed externally and passively at the time. 

“We had to do it to add value and reach our long-term return and sustainability objectives. The way we are structured today allows us to be active investors as well as actively engaged with investee companies from a sustainability perspective,” says the CIO. 

The institution performs asset-liability management (ALM) studies every three years to determine an optimal portfolio. 

The most recent ALM study was conducted in 2022. Bernengo says: “Many things had happened in the previous three years. The efficient frontier basically turned into a flat line, which means that we have to increase our risk exposure if we want to achieve higher returns.”

Currently, AP3 has to earn a net real return of 3.5% per year, based on the level of risk that the board is comfortable with. That is a long-term objective that Bernengo considers achievable but challenging in the current environment. 

“The way we are structured today allows us to be active investors as well as actively engaged with investee companies from a sustainability perspective”

The CIO says that adding value through active management, within the limits of the risk budget and investment regulation, is therefore a must.

Provided that the portfolio is more-or-less in line with strategic asset allocation targets, the investment team tries to beat its benchmark.

Last year’s overall net return (-5.8%) suggests that the focus on active management is working. The fund performed better than many of its peers, and ended the year as the largest of the AP funds in terms of asset volume after AP4 (Fjärde AP-fonden) recorded a 11.9% loss on its investments. 

The focus on internal resources also helps contain asset management costs. AP3 reported costs of 8bps for 2022, of which operating expenses were 5bps. 

AP3’s investment management team is made up of five smaller teams – equities, fixed income, currency, alternatives and a team known as the CIO office – plus a sustainability and governance team, which has been operational for about a year.  

The equity and fixed income teams have clear risk and performance targets but have plenty of freedom in terms of security selection. 

Most of the equity assets are managed directly. “We have external investment mandates for areas that we have no natural expertise in, like global small caps, for instance,” says Bernengo. The whole fixed income portfolio is managed internally. 

The institution has no exposure to emerging markets at the moment, but the CIO says the way AP3 invests in the asset class is being reviewed. 

“We used to have external mandates for emerging market equities, but our intention is to resume investment in emerging markets but with a different setup,” says Bernengo.

“With an external mandate that invests based on a broad emerging market benchmark, we feel we would not have enough control over what the manager invests in.”

One example of this relates to Russia’s invasion of Ukraine, says the CIO. Before the invasion, many emerging markets portfolios were invested in Russian assets, which were sold off after the invasion. But from a governance perspective investing in Russia had become problematic well before 2022.

“The world is much more complicated than even a decade ago, and we need a much more holistic approach to investing in general, and to emerging markets in particular. There are many factors affecting how financial markets perform other than growth, inflation and monetary policy,” Bernengo says.

“Essentially, we are working out what should be the process to minimise the risks related to governance, such as rule of law, corruption or democracy. We may not face another problem as significant as Russia’s invasion of Ukraine, but we may face problems that are similar in nature.”

In that task, the CIO will be assisted by the newly-established team dedicated to sustainability and corporate governance.

“That is an area in which we needed to expand, so that we could work with more engagement and not just exclusions,” says Bernengo.

AP3’s sustainability efforts focus on four key areas – climate, biodiversity, human rights and stewardship – where the institution has seen the most development, according to the CIO.

Climate, in particular, is the area where Bernengo feels the institution has made the most progress. “It is an area where investors are clear about the objectives and how to reach them,” Bernengo says. 

AP3 recently released its climate plan, which has a “clear focus on engagement and change on the ground”, he says. “We are not in the camp of making our portfolio net zero by selling the assets that are not green enough. We want to make real change in the real world, which means that engagement should be our priority.” 

The institution has therefore identified the 75 companies that emit 70% of the greenhouse gases in the equity portfolio and is engaging specifically with them.

“For investors like us, identifying the cyclical peaks and troughs does matter, because it can give us a sense of where we may be in the cycle. Headline inflation may have turned, but core inflation is stickier. Markets are still pricing in a decline in interest rates”

The next plans to be released, after the summer, will be those dedicated to stewardship and human rights. Biodiversity will follow later on. 

“That is a very important area, but the one where investors have the least knowledge. But now there is momentum. We have to learn fast and develop the same ambition we have in relation to cutting greenhouse gas emissions,” says Bernengo.

The institution’s currency team manages overlays and the team dedicated to alternative investments oversees AP3’s real assets portfolios. The allocation to alternatives was increased after the ALM study performed in 2019. 

Over the years, the pension fund has also radically changed the way it invests in alternatives. It first started building a portfolio of alternative investment funds two decades ago, part of which still exists. “But we wanted to gradually become owners of the companies and projects we invest in, so today we own real estate companies, timberland and infrastructure,” Bernengo says.  

“We have chosen four strategic areas: private equity, real estate, infrastructure and timberland. We have looked at private debt, and have come across some interesting opportunities, but it is not part of our core allocation.”

Overall, 78% of the alternative portfolio consists of directly-owned assets. He adds: “Investors have been allocating to alternatives for many years, for good reasons, and mostly enjoyed good performances. As a result of that, are certain markets becoming overcrowded or overpriced now? Absolutely. That is a general assessment, but as investors we focus on our own alternative assets and their performance and we are committed to our allocation.”

Last year, AP3’s alternative investments returned 8.9%, mainly thanks to investments in infrastructure and timberland.

The CIO office team manages a hedge fund portfolio and cross-asset overlays, investing in equities, currencies or fixed income. 

Like many CIOs, Bernengo is reluctant to express clear-cut views about the path of inflation, rates and growth. However, he says: “You have to look at the question both through a structural lens and a cyclical lens. Structurally, there are many signs to suggest that the era of low inflation that we had over the past three decades or so is over. There will be a floor to inflation and rates, due to factors such as nearshoring and the green transition.”

“But for investors like us, identifying the cyclical peaks and troughs does matter, because it can give us a sense of where we may be in the cycle. Headline inflation may have turned, but core inflation is stickier, as expected. Markets are still pricing in a decline in interest rates quite soon. 

“However, unless we have a large financial accident, such as the episodes that we saw in the UK or in the US, I do not see any reason why central banks should start to cut rates soon. This probably means we will see more volatility in the medium term, as markets realise that central banks are not about to cut rates,” he adds. 

Views of this kind are used to implement tactical positions or deviations from the strategic benchmark. “This is another way in which we add value,” says Bernengo.