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Supplements » Nordics Report 2011

AP FUNDS: Running to stand still

RunningThe AP funds, Sweden's most influential institutional investors, are struggling against the constraints of regulation and hold out hope for changes that will make their jobs less complicated. Angele Spiteri Paris finds out more.

The Swedish buffer funds, that is, the four state pension funds, have a tough mandate. Regulation dictates they have to provide a guaranteed minimum return, but then goes on to restrict their investment capabilities – it’s like they’re being asked to travel at 100 miles per hour and are then handed a bicycle as their mode of transport.

As things stand, the AP funds in Sweden know what they can do to help themselves but not only are they prevented from actually doing it by current regulation, they are also not ultimately responsible in driving any change to the status quo.

The funds which in aggregate form one of the largest asset pools in Europe, have long struggled with the investment constraints outlined in the Swedish regulation coupled with the minimum guaranteed real return of 4%.

In 2007 AP3, the Third Swedish National Pension Fund, which had SEK220.8bn (€25.3bn) in assets under management (AuM) as at December 2010, spoke out against the investment restrictions and now the fund is taking up arms again as the world of investment moves ahead and they do their best to keep up.

Changes in regulation
Currently, the law gives prescriptive restrictions around what the funds can and cannot invest in and what percentage of assets they can assign to each asset class.

This is the major bugbear of the AP funds and the reason they are trying to battle the current regulation.

Andrejs Landsmanis, head of strategic asset allocation at Första AP-fonden, the First Swedish National Pension Fund (AP1), says: “We are interested in having a better specification from our regulators of their risk-preference regarding the assets we manage.”

Gustaf Hagerud, head of asset management and deputy CEO, AP3, says: “We want to see changes in the regulation. We don’t want to have restrictive rules around asset classes; a prudent investor rule is preferable. That is the most common framework for public pension funds globally.

“We currently have percentage restrictions around how much we can invest in some asset classes. Also, we’re not allowed to invest in commodities, which has not worked in our favour.” 

 He adds that the fund’s job is to consider what assets will help them reach the required return. 

 The issue is that some asset classes are completely closed off to them. Most Nordic managers who spoke to Funds Europe agree that the AP funds are restricted in what they can do by percentage allocations and this is holding them back from achieving a more efficient return.

One such constraint is the prohibition of commodities investments. This ban may seem random from an outsider’s point of view, but industry commentators explain there is a historical reason behind it.

“Commodities were disallowed to prevent the possibility of a physical delivery of the commodity in question,” one expert says.  

 But in reality, the likelihood of tonnes of sugar or barrels of oil showing up on the pension funds’ doorstep is remote at best. Therefore, it probably makes sense for this constraint, and potentially other investment restrictions, to be up for review.

Although regulatory change can be difficult, Hagerud holds out hope. “We are hopeful that changes will be made soon to the regulation,” he says.

Prudent process
The Swedish Parliament’s Pensions Group has promised to review the rules sometime this year.

Landsmanis says: “We are engaged in a dialogue with our regulators and might be able to reach an understanding to change some of the present restrictions.”

But if any potential change were to be agreed on, then the implementation of it would be way in the future.

Hagerud says: “We would like changes to be made to the law governing the AP funds but the likelihood is that this will take some time.” 

The AP fund regulation is a five-party agreement and the process has to be carried out with prudence.

The pensions group has not yet proposed any changes and, therefore, one could claim it shows they have not yet realised the problems the funds are having.

Hagerud explains why immediate change is not in the offing. “There is a proposal to do an investigation during this year. This will lead to a decision as to whether this investigation will take place,” he says.

If it is agreed that the investigation is to be carried out, it will not start until after that decision is made, which makes the time delay quite significant.

Landmanis agrees: “We do not think any changes in regulation are imminent. These things take rather a long time to process.” He goes on to explain that the main catalyst for change would probably be the realisation that the funds’ efficiency could increase by instituting changes.

And efficiency, especially in terms of cost, has been deemed very important, as is discussed later.

A change in regulation could mean that the funds will allocate a larger portion of their assets to alternative asset classes, since at the moment the restriction for exposure to assets such as private equity stands at 5%.

Experts in the market believe that were the regulation to change, the AP funds would look more to alternatives.

And the funds themselves agree.

Landsmanis says: “If the regulation might change it is possible that we would have more unlisted assets, presently capped at 5%, and perhaps also more commodity-related exposure, which is presently not allowed.”

Therefore, this could lead to more business for asset managers focused on these areas.

Tomas Scherp, country manager, CEO of the Swedish asset management company Alfred Berg, says: “A change in the regulation in the way the AP funds invest would affect our business. Alfred Berg is the partner for BNP Paribas IP in the Nordics and we have a strong alternatives offering. Therefore, if a large part of the focus is placed on alternatives, this will be a positive development for us.”

But not everyone thinks this way. Gunnar Dahlfors, head of institutional clients at EFG Bank, says: “I’m not sure a change in regulation would mean more investments in alternatives.”

He also warns about changing the regulation to focus on risk budgeting. “I understand the idea of considering risk and risk-budgets but many alternatives are not liquid or transparent and, therefore, you need to question how you would follow up on those investments from a regulatory point of view.”

Landsmanis says: “A risk-budget, if seen in a VaR and market risk context, is not adequate. To understand risk we need more knowledge than just risk-measures derived from markets, as markets, now and then, are unable to price and value assets correctly. In that sense the present set-up with percentage-per-asset class works better, though the system is somewhat crude.”

As in almost any industry, the importance of driving down cost is as important for pension funds as it is for any other actor in the investment world. And in Sweden it has been playing the starring role, with the pressure on the AP funds to continue lowering their cost base.

In 2010, the Expert Group for Studies in Public Economics, a standing committee of the Swedish ministry of finance, was commissioned to draw up a report on the possibility of restructuring the AP funds for scale and global impact. The report made the case that significant efficiency gains would be possible through improving the management of the buffer capital in the Swedish public pension system.

One of the proposals for restructuring the Swedish buffer funds was to combine the four defined benefit funds into one.

Although the report did not come to the conclusion that the AP funds should be united for the sake of cost efficiency, the funds were put under more pressure to cut costs.

Hagerud says: “Our costs were already lower that our European peers and now they’re even lower than that. To reduce our costs, in 2009 we decided to close some externally managed mandates. Some of the management of those assets was brought in-house.

Could the dismissal of external managers mean that AP3 missed out on precious potential investment returns? It seems so.

Hagerud says: “We probably missed some good investments. We saw the opportunity to do many interesting things in financial markets but did not have the freedom to take full advantage of them. One example is convertible bonds – we allocated some assets to this asset class but wanted to do more and couldn’t.”

AP1 also carried out a similar exercise. Landsmanis says: “In 2009 the fund changed its investment model to be able to channel its resources towards the common goal of creating a higher total return by increasing the focus on strategic asset allocation. This has also reduced complexity and thereby given us the possibility to cut costs. We have cut our costs by well over SEK100m per year through staff reductions, simplified management and lower transaction costs.”

One would be right in questioning what the funds are sacrificing for the sake of saving costs but, ultimately, the funds’ fate lies in the hands of the Swedish government and no amount of foot-stamping will do anything to change that.

©2011 funds europe