Thursday, February 12, 2009

AP1 Focuses on Strategic Asset Allocation


Sweden's AP1 pension fund said Wednesday, ahead of its full-year results next week, that it will cut its staff by about a third and alter its investment style after the value of its assets fell by almost 50 billion Swedish kronor, or $6 billion, last year.

I quote the following from the press release:

Sweden’s Första AP-fonden is changing its management model and increasing the focus on its core activity - strategic asset allocation. This will lead to the redundancy of some 20 employees. These measures are expected to reduce operating expenses by around 25% annually when fully implemented. Return on the Fund’s assets in 2008 was -21.9%.

“We want to raise the level of ambition in strategic asset allocation, which has the greatest influence on the Fund’s ability to deliver long-term returns, and have therefore decided to make this change. We deeply regret having to lose skilled and competent people, but the Fund has an explicit responsibility to manage the Swedish people’s pension assets as efficiently as possible,” says Johan Magnusson, Managing Director of Första AP-fonden.

The Fund is mobilizing its management around a common goal – to boost its total return through a stronger focus on strategic asset allocation.

In connection with this, the Fund’s previous organization for active management will be decreased in size. This will enable the Fund to simplify its management model, reduce the number of transactions and thus create the conditions for a higher total return in the long term. A number of employees will be given new duties and over 20 of the staff will be made redundant. Contact has been made with the labour unions.

“We must naturally draw our own conclusions from the global financial crisis that has severely impacted our own earnings. A shift in the Fund’s strong research capacity in order to increase the focus on mid and long-term investment decisions is therefore necessary and will also reduce our overall operating expenses,” says Första AP-fonden’s Chairman Anna Hedborg.

For 2008 the Fund posted net investment income of SEK -48 billion after expenses, equal to a total return of -21.9%. Net assets under management at 31 December 2008 amounted to just under SEK 172 billion (219). The complete financial report will be released on February the 19th.
The Second Swedish National Pension Fund, known as AP2, also announced an end of year net loss of SEK55.1bn (US$6.8bn):
The results were equivalent to a 24% fall in the value of the fund, which was blamed largely on declines in global equity values.

AP2 chief executive Eva Halvarsson said the global economic environment was one undergoing one of the “most serious financial crises since the 1930s”.

She added: “In spite of deciding to reduce risk in the equity portfolios under in-house management, to reduce the scale of our positions in fixed-income and exchange-market securities and to cancel a number of investment strategies completely, the decline in market worth was still substantial.”

At the end of 2008, AP2’s assets stood at SEK173.3bn, down from SEK227.5bn in 2007.

In terms of asset classes, the fund said unquoted holdings fell 1.9%, with a 9.1% decline in the values of private equity holdings.

Although the largest declines were attributed to across the board falls in equity values, the fund said the overall importance of AP2’s equity holdings was limited, as the fund accounted for “only 3% of the Swedish pension system’s total capital assets, of which equities comprise a mere 7%”.

AP2 said its part purchase of real estate company Vasakronan alongside AP funds 1-4 in summer last year contributed to positive real estate returns of 0.7%.

The Vasakronan deal was agreed between the Swedish government and AP1-4, and saw AP2 take a 25% stake in the firm (Globalpensions.com ; 3 July 2008).
I think Sweden's AP1 is on the right track, looking to boost its total return through a stronger focus on strategic asset allocation.

Pension funds around the world should pay attention and rethink how they can bolster their total return by rethinking their strategic asset allocation.

But what exactly does this mean? The following article by Ian de Lange of Seeds Investment Consultants on Strategic and Tactical Asset Allocation can help clarify this:

Long run evidence that higher risk assets have produced higher rates of real return

The standard theory myth is that by taking on higher risk, an investor will receive a higher rate of return.

Clearly this is invariably the case over the long run, but definitely does not always hold true over a short or perhaps even medium time frame.

The theory does not hold true because at varying times, asset valuations move far away from their long run equilibrium valuations. Quite simply assets move from cheap to expensive levels over time.

Remember prices and value normally have an inverse correlation. I.e. Price declines that we saw in 2008 improve value, and hence the future return outlook.

Given this fact, one method which many global asset managers, including ourselves, adopt is a strategic and tactical asset allocation of assets.

The strategic allocation is based on the long run evidence that higher risk assets have produced higher rates of real return. The chart below gives one firm's assessment of these long run equilibrium real rates across various asset classes. There is not too much argument about these figures.

Where the return per asset class is plotted against the volatility of that asset class, again it's clear that the reward for subjecting ones investments to higher volatility is higher returns. All assets can be plotted on one chart to achieve a risk return trade off graph.

Where a particular asset is cheap, giving the possibility that its future return is higher than the long run return, then on a tactical allocation, it should be overweighed and vice versa.

Chart 1 : Long run equilibrium real returns

Source : GMO

Seven years ago, GMO, a global investment firm, forecast a return from various asset classes that ranked emerging markets as no 1 with a compound 9,4% real return. The rank was spot on and the actual number came in at 9,9% per annum real return.

At the same time they ranked the return from the US S&P 500 last with a negative 1,1% for 7 years. At the time they were very contrarian, but this proved to be optimistic, because the actual number came in at a negative 3,9% p.a. for 7 years.

They had a reputation as being permanently bearish because of these dismal forecasts for their home base, the US.

Now with the collapse of equity prices, the value has improved. Their forecast real return over the next 7 years is as per chart 2 below. I.e. 13% for high quality US equities and 13,6% for emerging market equities.

Chart 2 : GMO forecasts



Source GMO. These are not guarantees.

These forecasts will not be realized in a linear fashion. I.e. the first 12 months or perhaps even 2 years could be negative, before reverting back again, but this is what the numbers are telling them at the moment.

Tactically investors should be looking to increase weightings to real assets and reduce exposure to fixed income assets - in the red.

Not necessarily tomorrow, but highly likely in 2009.

The key takeaway is that pension funds that get their strategic asset mix right will come out ahead in the future.

One problem is that this is easier said than done. Tomorrow I will examine the recovery plan and offer some more thoughts on strategic asset allocation given the precarious state of the U.S. and global economy.

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