Former head of Sweden's AP3: Liquidity risk needs attention

Kerstin Hessius is one of the best-known names in European institutional investing, with 18 years at the helm of one of Sweden's largest pension funds.

As CEO of Swedish national pension fund AP3, Stockholm — a role she relinquished on Oct. 31 — Ms. Hessius was at the helm of 464.9 billion Swedish kronor ($45.6 billion) in assets as of June 30 and kept the ship steady amid reform proposals and turbulent markets.

Speaking in a fireside chat at the Pensions & Investments WorldPensionSummit in The Hague on Nov. 3, Ms. Hessius — who will take some time off before embarking upon a portfolio career — said two concerns weighing on her mind right now have been spotlighted by liability-driven investment news coming out of the U.K.

As a result of the LDI-induced meltdown in the U.K. government bond market in September, pension fund executives have to focus more on two risks: "One is the risk of building very complex products, and the other risk is liquidity risk," she said.

Long-term investors are "not focused enough on liquidity risks" — which Ms. Hessius believes will be one of the "biggest risks we have in front of us" due to the challenging environment of an end to unconventional monetary policy, geopolitical risks and inflation risk.

Liquidity risk already reared its head in 2020 at the onset of the COVID-19 crisis — a point at which AP3 executives "started to focus quite a lot in our crisis management on liquidity risk. The risk is that we underestimate risk that is not priced during normal circumstances — especially if you are a long-only fund," Ms. Hessius said.

Another risk is around asset allocation and the issue of the denominator effect: With public market returns pulling down exposures, many pension funds have found their private markets allocations to be at all-time highs.

"What we have seen this year is that our alternative portfolio has increased substantially because (of) what's happening in the liquid markets and it's quite unique that both fixed income and the equity portfolio fall at the same time so much," she said.

In the first half of the year, AP3's alternatives exposure rose to 34.1% as of June 30 from 28.8% as of Dec. 31.

That increase has come "with almost no investments," Ms. Hessius said. "And I think most of the pension funds that are quite big in alternatives have seen something in the same (vein) — and the question is, 'How much you are prepared to invest in alternatives when … you have to think about liquidity in your portfolio?'"

AP3 has about 40% of its portfolio invested in listed equities and the remainder in fixed-income assets. The fund is one of six Swedish state pension funds that, during Ms. Hessius' tenure, have been the subject of reform proposals by the government, including a merger — a suggestion that was ultimately dropped. Four of the funds — including AP3 — are tasked with achieving high returns over the long term. Each has different asset allocations to reach their aim.

Among its alternatives exposure, real estate is AP3's biggest asset class, accounting for about 55% of the alternatives allocation and almost 20% of the overall portfolio.

And AP3 invests in real estate in a different way than other pension funds, Ms. Hessius explained. The fund's real estate strategy is to focus on domestic companies and to take large equity stakes in each one. The real estate portfolio is composed of five firms: Vasakronan AB — which Ms. Hessius said is the largest of its exposures; Hemso Fastighets AB; Trophi Fastighets AB; Fastighets AB Regio; and Trenum AB.

Taking a large equity interest means AP3 executives can really get involved with the companies and help to direct them.

"You can really get them much more professional, and … we can handle the risk within the company," Ms. Hessius said.

Its method of real estate investing means AP3 can direct the companies to new housing or building opportunities and can advise on when they think prices in the market are high.

It is also an example of AP3's sustainability focus — in particular on governance. As such, AP3 focuses on building sustainability into a company's whole business chain. Vasakronan is a good example of that, she said.

"They are one of Europe's most sustainable real estate companies and (they have put) sustainability into the whole business chain, from construction to finance," she said, adding that the company has been "a role model for the whole sector."

However, Ms. Hessius does have concerns over pension funds being forced to put too much focus on key performance indicators in sustainability.

She also thinks investors "should be very picky" when it comes to the primary green-bond market. AP3 began investing in green bonds in 2006 and had increased its holdings to 23 billion kronor as of Dec. 31.

The fund aims to have at least 30 billion kronor, or about $2.9 billion, invested in green bonds by 2025, according to its 2021 stewardship report.

"We are very picky in green bonds," she said, adding that it's important for the investment industry "to be very tough on criteria" related to greenwashing.

Ms. Hessius is now in the process of handing over the reins at AP3 to Staffan Hansen, who was CEO of SPP Pension & Forsakring, Stockholm.

She's leaving the pension fund is good shape, despite a challenging start to the year.

AP3 returned -7% in the first half of 2022 — generating 5.6 percentage points in outperformance vs. its long-term static portfolio benchmark, which comprises listed equities and fixed-income securities — and has achieved an average annualized return of 8.5% over the five years ended June 30 and 9.9% over the past 10 years.

That followed a 20.7% return for the calendar year 2021.

Under its mandate, which is to manage assets that will be drawn upon in the event of deficits in Sweden's national pension system, AP3 also paid 2 billion kronor in capital to the Swedish Pensions Agency in the first half of the year. That capital was used to help cover the difference between contributions and benefits paid out in the country's retirement system.

Asked about the advice she would leave for Mr. Hansen, Ms. Hessius highlighted the power and responsibility — as well as the prestige — that comes with running billions of assets on behalf of Sweden's citizens.

"You will become a distinct and credible leader if you can show long-run perspective, in word and deed. You will attract both competence and business. And … that is so unique and you can avoid opportunism. You can be a contrarian investor. However, the long-term perspective sometimes makes you controversial in your views in ESG," she said.

Mr. Hansen also has a "platform where you can sometimes get into debate and really get the debate a little bit more … nuanced and balanced. And I think this position is so unique," Ms. Hessius added.