NORDIC/EUROPE - Pension funds should be willing to pay more for "pure alpha" but should stay away from private equity unless they have the necessary expertise on due diligence, AP2 officials have warned.

Tomas Franzen, head of asset allocation at the Second Swedish National Pension Fund, emphasised diversification is "very important" when managing pension funds but warned in the current environment there are "lots of global drivers which does not make equities from different parts of the world and different sectors a very good diversifier".

Speaking at the Pension Fund Investment World Nordic 2008 conference in Stockholm, Franzen told delegates "as long as we are in a low inflationary environment, broad asset classes such as equities and bonds are good hedges for each other".

He also claimed "pure alpha" - highlighted by Richard Grottheim, chief executive of AP7, in a previous presentation - is "an excellent diversifier". (See earlier IPE story: AP7 switches to hedge fund replication)

That said, he argued because it is "in short supply, it should be very expensive", as "on average only about half could be prospering from 'pure alpha'".

Franzen claimed: "As fiduciaries, we should be concerned about what we're paying for returns. We should be willing to pay for pure alpha and make sure all alpha sources are reasonably uncorrelated. We should not be paying for taking systematic risks."

In addition, he said that alternatives are used as good diversifiers, "one should remember that there are a lot of alpha components in alternatives", for example Franzen suggested "private equity is more of an alpha play than a beta play".

He also highlighted research which showed "the broadest possible portfolio of private equity does not necessarily give better returns than the S&P500".

As a result, Franzen claimed, if a fund has "superior due diligence skills" then private equity is a good diversifier, otherwise it "just might be better to leave private equity to others".

Instead, Franzen suggested an overlooked investment area at present is diversification of market cap-weighted portfolios, which tend to be "overweight in overvalued stocks and underweight in undervalued stocks".

However he pointed out stocks can be weighted in different ways to provide exposure to a certain "growth tilt" as, for example, he revealed AP2 has been using a "GDP weighted portfolio on the global equities side".

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