How We Run Our Money: Första AP-fonden (AP1)
Mikael Angberg (pictured), CIO of Första AP-fonden (AP1), one of Sweden’s buffer funds, outlines the fund’s investment philosophy to Carlo Svaluto Moreolo
‘We are long-term investors’ may be the mantra of the pension industry. However, defining what ‘long-term’ means is challenging, even for an institutional investor such as Första AP-fonden (AP1).
The fund has searched carefully for a definition. This is essential, since being a long-term investor is the core principle of the AP1’s investment philosophy, according to Mikael Angberg, its chief investment officer (CIO). “It is the first and foremost of our investment beliefs,” he says. “It means we can bear short-term volatility, invest in long-term illiquid assets and be an attractive long-term partner.”
AP1 can do those things simultaneously because it does not face regular calls for liquidity. Although it is crucial for the Swedish pension system that the AP funds keeps growing, they have no concern about matching pension liabilities.
The real challenge is defining what long-term means in practical terms. Here is where it gets complicated.
The CIO starts with an important caveat. “The fact we are a long-term investor does not mean we forgo opportunities to make short-term gains,” he says.
But according to him, AP1’s board has embraced a long-term perspective. “As a buffer fund for the pension system, in theory we have an infinite life, or at least we will be around as long as the pension system does. This means we take our asset-liability management (ALM) modelling as a measure. Therefore, for us long-term means looking as far as 50 years into the future, or even longer”, he says.
Clearly not all investments are buy-and-hold, but many are. “We have unlisted investments on our balance sheet such as ownership stakes in Swedish-focused real estate and infrastructure companies. We will be the owners of those real estate companies for a very long time, reflecting that long-term perspective.”
AP1 has 12.5% and 4.5% of assets invested in real estate and infrastructure. Not all of that is buy-and-hold but they play a key role in driving returns.
A multi-decade time horizon is unhelpful when it comes to assessing the individual work of investment staff and board members. Angberg says: “Most of us will not be around that long. We needed a pragmatic measure to assess our investment decision-making and we felt that 10 years would be correct. It’s long-term, but it’s manageable and at the same time it should capture a full business cycle.” This is how AP1 has set a precise long-term time horizon for its strategic asset allocation.
In these days of frequent exchanges between pension funds, stakeholders and regulators, a time horizon of a decade represents true long-termism. However, boards are understandably preoccupied with achieving consistent returns during their much shorter tenures. So what happens at AP1 if returns do not show up one year? Angberg says: “We have established a clear governance framework stipulating the fact that we are a long-term investor, and therefore in case of underperformance we should be able to stay the course if we believe it is the right one.
“It comes down to trust and communication, and I think on both aspects we have done a lot of work with the board to prepare ourselves for such situations”, he says.
AP1’s support for long-term investment generates a series of deeply-held convictions. AP1 endorses active management, although Angberg says: “We believe it works in markets that are inefficient.” Hence, the fund’s significant emerging market allocations.
“We believe in diversification, but, also that we should carry a relatively high level of risk in order to reap returns over time”, he says. This leads the fund to look at both traditional and alternative risk premia.
These are just some of the aspects reviewed after Angberg was appointed as CIO in late 2013. He has also sought to improve the fund’s investment process, sarting from the framework used to elaborate its 10-year strategic asset allocation.
“Being from a quant background, I felt a strong need to build a robust analytical model. We now have a systematic way of forecasting 10-year return expectations of asset classes, as well as their volatility and correlation with other asset classes”, says Angberg.
The framework is now more robust because it takes into account factors beyond those involved in the classic forecasting and optimisation techniques. One of these is valuations. The CIO explains: “We happen to believe that over a 10-year time horizon valuation has a big impact on return outcomes.”
“We have also improved on the classical mean variance optimisation technique by incorporating the impact of estimation errors, which can have a big impact on returns. Furthermore, we added other types of filters such as how our portfolio will behave under different market regimes”, he says.
The model is under continuous improvement and yet remains the starting point of AP1’s investment process. Angberg clarifies that it serves as support to the investment committee, it does not constitute the ultimate blueprint. There are other elements to consider that the model does not take into account. First, the committee has to decide how to implement exposures, whether through indices, funds or direct investment. AP1, like many of its peers, makes use of indices to invest in efficient markets.
Importantly, says Angberg, the 10-year strategic asset allocation is balanced against the ‘equilibrium portfolio’. This is a theoretical portfolio, representing the whole financial markets, that would be optimal for an investor to hold in the abscence of any views about asset classes.
Angberg explains: “Whatever we decide in terms of asset allocation is a deviation from the equilibrium portfolio. The trickiest decision is to what extent we should trust our strategic asset allocation model. If, we had complete confidence in our forecasting ability, we would implement our strategic asset allocation fully, but that would be unwise, as there is no such thing as complete confidence. Therefore, it makes sense to have a balance between the 10-year portfolio and the equilibrium portfolio.”
Accepting that forecasts can be wrong is wise. Angberg says that inflation is the economic indicator that worries him. It is a “forgotten risk” that could pose a danger to the investment industry. He says: “To achieve our return objectives, our portfolio needs to be exposed to economic growth. This leaves us very exposed to rising inflation. That is why I am very concerned about our inflation modelling.”
How confident can we be in our inflation models, after so many years of stimulus?”, asks Angberg. As he points out, it is true that while inflation is returning to Europe, it is nowhere near historical levels. This makes it difficult to rely on past patterns. The risk is that investors have discounted inflation, and if it does come back, they will be caught off guard. “People who are relatively senior in the investment industry haven’t even experienced historically normal inflation levels”, Angberg comments.
AP1, of course, can react to changing scenarios fast. The 10-year strategic asset allocation is fixed for the period, but reviewed each year. The fund also employs a dynamic asset allocation framework to adapt the portfolio to changing conditions along the business cycle. This adds another dimension, meaning certain portfolio decisions will be made with a two to three-year timeframe in mind.
Angberg leads a 35-strong investment team. The fund manages about 70% of the assets internally, including Swedish and developed market equities, domestic and international fixed income, real estate and infrastructure. Overlay strategies are also managed internally. “We need many people because we are an active investor”, says Angberg.
Currently external managers are entrusted with AP1’s emerging market investments, which are almost exclusively equities. The fund is also building the capacity to invest in emerging market debt.
The difficulty of managing assets internally is not just that it requires resources and talent. “The structure of the investment team is quite traditional, with individual teams working on the various asset classes,” says Angberg. “The real management challenge is creating collaboration instead of working in silos. I am attracted to the idea of having teams look across the whole capital structure of investee companies collaboratively, and deciding whether to invest in bonds or equity according to what is most attractive. We have decided to keep it simple and separate teams by asset class, but we try to collaborate to take advantage of opportunities in that way.”
This is not to say that AP1 focuses only on optimising exposure to asset classes. It is more advanced than the average pension fund when it comes to allocating to risk premia. Angberg is currently overseeing the roll-out of a programme using derivatives and leverage to build exposure to trend and momentum factors, in order to replace and internalise the fund’s CTA-focused hedge fund portfolio. The strategy applies to 5% of total assets, but it could be expanded to replace the fund’s hedge fund portfolio. There are risks with using derivatives and leverage, but AP1 has experience in the area and tested before implementing the strategy.
On the sustainable investment front, AP1 has taken a pragmatic approach. It begins with the classic premise that its primary objective is to generate appropriate returns. Angberg acknowledges that sustainability is of primary importance to many of AP1’s stakeholders. However, he clarifies: “In order to achieve our objectives, we must undertand and take into account sustainability as a driver of risk and return. If we invest in something that will eventually go out of business, then we are not achieving our objectives. It is as simple and as difficult as that.”
That is why the organisation has focused on defining what sustainability means, which meant determining the universal risk and return drivers. “We cannot deal with every facet of sustainability. On the other hand, we do not want to focus on only one aspect, as that would be too narrow”, says Angberg.
“We define the sustainabilty universe according to what in our view are the most important factors. These are essentially summarised by the concept of resource efficiency. This includes climate, the efficient use of water and waste but also financial and human resources, in order to create a long-term sustainable business or environment. It also includes the idea of a circular economy”, he says.
AP1 is among a number of funds that has integrated chosen sustainability factors in the investment decision and engagement with investee companies over exclusion of stocks.
Angberg explains: “We integrate our resource efficiency framework in every decision we make. It will manifest itself in a slightly different way depending on whether we are making direct investment with an active approach or dealing with an external manager. But, the point is that we want investment decisions to be underpinned by resource efficiency.”
The fund has also a small portfolio of investments that seeks more direct sustainability results It has yet to make an outright commitment to impact investment.
“In general, I don’t think our approach to sustainability is very different from what you hear from others. But, I think the key thing for us was to understand that we have to prioritise. And the focus around resource efficiency was the real breakthtough, because we do really believe that it captures a lot of the important aspects”, he says.