Sweden’s AP funds might see asset moves, merger

STOCKHOLM — High correlation among four of Sweden's AP funds — accounting for 421.5 billion krona ($56.9 billion) — is leading to speculation of major asset allocation changes, or possibly even a merger of the four.

A report published by the Swedish Ministry of Finance late last month triggered the merger rumors, as the government is now conducting a review of the entire 577 billion krona AP system, said Crispin Lace, a Watson Wyatt LLP consultant based in Stockholm.

But AP fund executives downplayed the merger rumors and said the key issue raised by the report is getting higher alpha. While the funds' boards have set risk targets of 3% to 5% (as measured by tracking error against the benchmarks), the report found all of the funds to be around 1%.

The search for higher alpha could bring greater opportunities for active money managers, as the funds diversify their portfolios into more specialized investments, including alternatives.

But a merger of the four funds would drastically reduce the number of mandates, hitting the pockets of their external managers. Only five of the 28 managers now used by the funds — Barclays Global Investors Ltd., Capital International Ltd., Nomura Asset Management U.K. Ltd., State Street Global Advisors U.K. Ltd. and Pictet Asset Management, all of London — manage assets for more than one of the three funds for which manager names could be obtained.

The report, a routine evaluation of AP-1, AP-2, AP-3 and AP-4, pinpointed two major areas of concern: the low levels of risk and diversification. The Ministry of Finance also flagged high administration costs relative to the low returns. Wassum Nordic AB, a Stockholm consulting firm, conducted the report.

"It's news to everyone that the four funds' asset allocation is so highly correlated," said Lars Gavelin, senior adviser at the Swedish Ministry of Finance. Mr. Gavelin could not comment on what will happen regarding the report's findings, which are preliminary, saying only that the government will re-visit the issues.

Erik Valtonen, head of quantitative research at the 142 billion Swedish krona AP-3, Stockholm, disagreed on the impact of the report. "We are pension funds with the same liabilities," Mr. Valtonen said, adding that while each fund operates independently, if they conducted asset-liability studies, the outcome would be the same asset allocation. Mr. Valtonen added AP-3 is happy with its current asset allocation, and talk of merging the four funds is a question for the politicians.

Anders Backstrom, partner at KPMG in Stockholm and auditor of the AP Funds, doesn't think the funds will merge. For that to happen, "there must be agreement among all of five political parties in Sweden," he said. "Diversification is a key element, as there's an obvious need to move away from the same investment styles for all four funds."

The AP system was reformed in 2000 to generate long-term returns on capital to back up the pay-as-you-go financed state scheme. The four funds were set up to offer risk diversification, and each was given the freedom to set its own asset allocation. (There are two other AP funds: AP-6 invests in private equity and AP-7 is the default option for the government's premium pension system).

In 2003, the four AP funds posted a total return of 16.4%, but the average annual return over five years was 1.7%, which is 0.1 percentage points per year below the average rate of inflation, which is the funds' benchmark.

Jan Waage, managing director at Wassum, said the four funds aren't taking enough risk, compared with the targets the boards set. The tracking error ranges from 0.3% to 1%, which is fairly low, he said. The strategies of all four are strikingly similar, as well, with about 60% of their asset allocations devoted to equities, primarily outside of the Swedish market, Mr. Waage added. This doesn't fulfill the needs of Swedish investors who were hoping for different investment routes, he said.

"The easy way out is to say: ‘OK, it didn't work. The differences between the four funds are so small, so we might as well merge them into one fund,'" said Fredrik Palm, actuarial and financial consultant at PMR Consulting in Stockholm. But this doesn't solve the problem, he said. Merging the funds decreases the probability of a high total return per unit of risk, even though administration costs would probably be lowered. Mr. Palm suggested increasing risk to obtain the sought-after diversification.

Managers interviewed for the story — not surprisingly — agree.

Patrik Silfverling, head of sales for the Nordic region at Gartmore Investment Ltd., Stockholm, sees a growing demand in the Swedish marketplace for actively managed products. This demand is not just for traditional equities and bonds but also for alternatives, like private equity and hedge funds. And Gartmore plans to capitalize on these new opportunities, he added.

Anthony Biddulph, head of institutional accounts in the Nordic region for Merrill Lynch Investment Managers, Stockholm, said the AP funds now "have the manpower and have reached critical mass" to begin diversifying their portfolios. They will add alpha through outsourcing, Mr. Biddulph added. He sees opportunities in alternatives and fixed income.

The 139 billion krona AP-1, Stockholm, is taking measures to increase active management, in an effort to increase risk and return, said Goran Styrman, head of the performance team. This year, AP-1 added external managers to handle its U.S. small-cap portfolio: UBS Global Asset Management and Morgan Stanley Investment Management Ltd., both of London; Martingale Asset Management, Boston; and IronBridge Capital Management LLC, Chicago, were allotted $50 million each; Dimensional Fund Advisors Ltd., London, is managing $100 million, said Nadine Viel Lamare, spokeswoman.

AP-1 is examining other areas that can be outsourced, she added, but she was unable to provide further details.

Mr. Styrman said AP-1 is not outsourcing in response to the government's report, as plans were well under way last year. He doesn't see a change in the overall asset allocation in the foreseeable future, but does think there will be changes within the various asset classes and new managers will be added.

As of Dec. 31, AP-1's asset allocation was 57% equities (40% global, 12% domestic, 5% emerging markets); 40% fixed income; and 3% alternative investments, dominated by property.

AP-1 returned 17.1% last year, compared with -13.8% in 2002, according to its 2003 annual report.

For Peter Odhnoff, chief investment officer at AP-2, Gothenburg, the issues in the report are more a question of diversifying assets. "It's more important to identify positive sources of alpha, vs. big sources of alpha," he said.

Mr. Odhnoff said the 140.4 billion krona fund, which is about 90% actively managed, wants to generate positive alpha. "If we can do it without high tracking error, no one will complain, but it would be difficult," said Mr. Odhnoff. Risk is not the target, outperformance is, and risk is the source of that, he added. "We do want diversified risk."

AP-2 will conduct its yearly review and asset-liability study in the second half of the year and then decide on a course of action. AP-2's asset allocation is 60% equities, 35% fixed income, 1% hedge funds, 3% real estate and 1% private equity. Its total return for 2003 was 17.7%, compared with -15.3% for 2002.

AP-3 is gradually moving to active management from passive, said Mr. Valtonen. The fund now has 42% of assets managed passively versus 100% three years ago. The fund needs to find areas where there are active managers that have a chance of outperforming. "But, there are areas you don't want to be active in — like U.S. large cap," said Mr. Valtonen.

As of Dec. 31, AP-3 had 54.5% of its assets in equities — 16% Swedish, 17.5% European, 14.7% U.S. and 6.3% Asian. Its fixed-income allocation was 37% — 12.6% Swedish, 8.4% European, 6.5% global ex-Europe, and 9.5% index-linked. The fund also had 8.5% of assets in real estate. AP-3's total return for 2003 was 17.2%.

AP-4, Stockholm, which has 135 billion krona in total assets, had a total return of 17% in 2003. Its asset allocation is: 42% global equities, 19% Swedish equities, 37% bonds and 2% real estate. No further information on that fund could be obtained.