Over the last year, Sweden’s SEK345 billion ($39.1 billion) buffer fund, AP2, has increased its allocation to Chinese A-shares to 2 per cent of assets under management and built an allocation of 1 per cent to Chinese bonds.
The A-shares allocation is run by three external managers – Singapore-based APS, Cephei Capital and UBS – and strategies all focus on Chinese stocks exposed to domestic consumption as China’s households shift from low- to middle-income levels.
The A-shares portfolio returned 36.3 per cent last year, and AP2 chief executive Eva Halvarsson says the allocation could increase depending on parliamentary approval of new investment freedoms for Sweden’s AP funds.
“It is doing extremely well and is the best-performing asset class that we have,” she enthuses in an interview from the fund’s Stockholm headquarters.
AP2 was the first Swedish pension fund to have its A-shares licence increased to today’s 2 per cent, in a decision that finally enabled it to build on a portfolio that dates from 2013, when the initial licence was awarded. The last five years have been a learning curve Halvarsson says, particularly in getting to grips with the impact China’s inefficient and debt-ridden state-owned industries have on the market’s function. She also advises careful selection of external managers and spending time in-country. ESG is also central to the fund’s due diligence and AP2 is an active member of the Asian Corporate Governance Association.
In-house expertise transforms fund
It’s a growing expertise that means AP2 will probably manage the allocation in-house in the future, bringing Chinese equity to join the other 83 per cent of the portfolio that Halvarsson’s investment team already oversees.
“Over time, we will probably be able to manage our Chinese equities in-house but not at this point,” she says. AP2 already manages the allocation to Chinese bonds itself, and in both portfolios, ESG is assessed quarterly; the fund’s Chinese exposure also includes real-estate funds.
AP2’s in-house management ability has grown to span complicated portfolios such as emerging market bonds in local currency. It is competence that has dramatically changed the fund since it was set up in 2001, Halvarsson notes. Apart from Chinese equities, the only other externally managed portfolios comprise alternative risk premia covering convertible arbitrage, merger and acquisitions arbitrage, and an uncorrelated allocation to re-insuring insurance companies – AP2 is the fifth-largest provider globally.
“We like to keep a few of our equity allocations external because it allows us to learn from our managers,” Halvarsson says.
ESG integration via bespoke indices
In another innovation in the equity allocation, Halvarsson’s quant team has recently integrated ESG across the entire foreign quant portfolio via two new bespoke indices. The portfolio accounts for about 29 per cent of assets under management, at about SEK99 billion ($11 billion) The team has replaced six single-factor indices with two multifactor indices, one for developed markets and one for emerging markets. Under the old system, four of the indices tracked about 1600 companies in developed countries and the other two followed about 800 companies in emerging countries, with various factors determining the weighting of the equities in each index.
Now stocks are weighted according to four factors: ESG in a basket of themes around climate, diversity, corporate governance and transparency; value; volatility; and uncorrelated returns. Halvarsson is particularly proud that the indices were developed in-house, in a process that involved the team building its own algorithms from raw data and rigorous back testing. The new indices have better expected absolute and risk-adjusted returns than the former six, and swapping six for two reduces transaction costs.
“They have turned out well and we like what we see, although we are constantly monitoring to see if we can improve them,” Halvarsson says. “We were able to build them in-house because of the abundance of ESG data, AP2’s long history with quant investing and our talented people. ESG integration is very much driven by everyone here and is a bottom-up and top-down approach. It is not easy doing this and we are doing many things for the first time.”
The team is now considering developing a similar index for the bond portfolio, along with developing quant strategies that identify and weight smaller companies that are developing solutions to future ESG challenges.
“It shows that it is possible to do ESG integration in different ways – internally via quant or fundamental management, or with external managers,” Halvarsson says. “In our case, we have learnt by doing it ourselves and this makes us stronger.”
Diversity as part of ESG
She is equally proud of the fund putting diversity centre stage in its ESG criteria, a matter that is particularly close to her heart because of the lack of women in senior roles in the industry.
“I am 55 years old and CEO of one of Northern Europe’s largest pension funds, but I have had meetings where it is assumed that one of the men is the boss. Even though we think we are impartial, we unconsciously judge women and men from a different perspective,” Halvarsson says.
The fund’s diversity strategy focuses on board nomination committees, where reform can reap real results, she says.
“Corporate boards without a formal nomination committee have the fewest women. Nomination committees that include women lead to more women on the boards.”
Back in 2001, AP2’s assets were split between a 20 per cent exposure to Swedish equities, 40 per cent to foreign equities and 40 per cent to Swedish fixed income. Now the fund’s diversified portfolio spans Swedish equities (9.5 per cent and actively managed) developed market equities (22 per cent) emerging market equities (11 per cent) fixed income (27.5 per cent) emerging market fixed income (6 per cent) real estate (11 per cent) private equity (5 per cent) alternative credit (2 per cent) alternative risk premium (3 per cent) China A-shares (2 per cent) and Chinese government bonds (1 per cent)
The asset allocation will change again when the AP funds are able to reduce their bond allocation from 30 per cent to 20 per cent and make additional allocations to illiquid asset classes now capped at 5 per cent (excluding real estate) from January 2019. The relaxation of government rules around investment could also result in the fund investing more in infrastructure and private debt. AP2 is looking at private debt opportunities via fund investment and directly in club deals, Halvarsson says.
