Market and return
The stable performance of the world’s stock markets in 2017 has given way to higher volatility and flatter performance during the start of 2018. Granted, the economy continues to be strong across a broad base both in Sweden and internationally, however, during the spring we have seen a higher risk premium in the financial markets.
There are several explanations for the relatively tentative sentiment in the markets. In part, we have a long period of high and stable returns behind us. We are also in a later stage in the economic cycle with a waning growth rate and expectations for a less expansive monetary policy in many countries. The latter has already become apparent, mainly in the USA, where the Federal Funds Rate has been raised and bond rates have risen during the first half of the year.
Internationally there have also seen signs of political concern, such as the USA’s increasingly protectionist stance. We have also seen financial problems in a number of emerging markets, with Argentina and Turkey perhaps as the most prominent examples. These types of fears have fuelled periodic volatility in the markets. In addition, at the start of 2018 the Swedish krona weakened, owing in part to the Central Bank of Sweden’s continued expansive monetary policy paired with concerns over the Swedish housing market.
AP4 posted a return of 3.8 % for the first half of 2018, which I am satisfied with given the prevailing macro and market environments. As I noted in by CEO’s letter in the 2017 Annual Report, we also see considerable challenge for the AP Funds during the coming ten-year period to deliver returns at the levels we experienced during the past ten years. In this context it is very gratifying that our active management continues to deliver an excess return in relation to the reference index that guides our long-term asset allocation. This excess return was 1.4 percentage points during the first half of 2018 and thereby accounts for a considerable share of AP4’s total return. Significant contributors during this period were Swedish and global equities, and unlisted assets. Of course, a half year is a short period of time on which to base an assessment, but the fact is that AP4’s asset management has now generated a positive active return for ten years running. This is an impressive achievement that I thank my competent and committed colleagues for.
Continued development in sustainable investments
The work on developing and adopting a comprehensive approach to AP4’s sustainability work that was begun in 2017 continued with full force during the spring. Naturally, the new framework encompasses sustainability in general. However, Climate & Environment and Corporate Governance continue to be our special areas of focus.
Our development work in sustainability is conducted as a prioritised project that encompasses a broad spectrum of initiatives and activities. A concrete example of a sustainability initiative that was carried out during the first half of 2018 is the investment we made in the Amundi Planet fund, which aims to develop and invest long-term in the market for green bonds in emerging markets and developing countries. An interest aspect of the fund is that International Finance Corporation (IFC), which is a part of the World Bank, has provided equity capital and with its long experience in working in developing countries will also help educate and develop these markets.
We have also taken further steps to reduce the carbon footprint of our portfolio. To begin with, we have now incorporated low carbon strategies into our internal asset management. This gives us greater control to develop and streamline methods, and enable us to further reduce our carbon footprint. In addition, it also gives us an opportunity over time to add other sustainability factors, such as resource efficiency. Second, we have divested our shares in companies in which thermal coal accounts for more than 20% of sales, which has lowered our carbon footprint while also reducing climate risk in our portfolio.
Corporate governance – An integral part of asset management
Corporate governance is a central feature in AP4’s asset management. As a long-term active owner of listed companies in Sweden and internationally we have a responsibility to contribute to development and improvements in the companies’ operations and to ensure that our ownership role is performed responsibly and transparently. Consequently, AP4 was very active in corporate governance during the first half of 2018. For example, during this year’s AGM season we participated on 32 nomination committees and voted at the Annual General Meetings of 81 Swedish and 821 foreign companies.
AP4 advocates for greater diversity and a more even gender balance on company boards, since we believe that this creates value for the companies in which we own shares. Toward this end, AP4 demands that at least one person of each gender should be on the short list of nominations for new board members.
Importance of new investment rules for the AP Funds
I am very happy to note that the Pensions Group’s and Ministry of Finance’s work on updating the AP Funds’ investment rules is beginning to reach concrete results, as evidenced by a proposal on the matter submitted by the government in June to Swedish parliament. Nearly 20 years have passed since the current investment rules were established, and the capital markets have changed fundamentally since then. I therefore have a very positive view of the modernisation of the investment rules. This modernisation is necessary to give the AP Funds the conditions for modern asset management that can generate the best possible returns at the lowest possible cost. All in all, the proposed changes will give the AP Funds greater flexibility to fulfil their mandate, which will ultimately benefit today’s and tomorrow’s pensioners.
The changes in the investment rules are intended to be implemented in two steps. The bill I mentioned above pertains to the first step, which according to plans will go into effect on 1 January 2019. This change lowers the requirement that the AP Funds hold low yield liquid interest-bearing securities with high credit ratings from today’s level of at least 30 % of the portfolio to 20 %. The change in the first step also opens up greater opportunities to allocate capital to illiquid investments. This is an investment category that is very well-suited for the AP Funds’ very long-term asset portfolios and has the potential to make a significant contribution both to higher returns and better diversification of risk.
However, the first step in the changes does not include a modernisation of how and in which forms the AP Funds may invest in unlisted assets. This is a prerequisite in order for the AP Funds, in a suitable and cost effective way, to be able to use the greater degree of freedom that the initial change entails. It is therefore very positive that the Pensions Group has clearly communicated that it also intends to proceed with a second step and look into opportunities for direct investment in unlisted holdings, such as infrastructure companies, illiquid credits, and co-investments in unlisted companies. I cannot stress enough the importance of this second step in the modernisation of our investment rules being carried out. This would give the AP Funds greater opportunities and the necessary tools to make long-term, sustainable and cost-effective investments in unlisted assets.
With these welcome and valuable indications from the Pensions Group and government concerning changes in the rules for the AP Funds, we at AP4 are already full speed ahead in our preparations to be fully ready to take advantage of the oppor-tunities that the new investment directives will entail.
However, one should not expect an immediate restructuring of the portfolio, but rather a gradual process over several years. In this context one must also have great respect for the fact that we have a market situation with strained values in many respects. Changes will be made prudently and in stages. We will put great emphasis on ensuring that every individual investment can be made on solid grounds.
I also welcome the fact that sustainability is now being added to the wording of the investment rules with the clarification that asset management must be conducted in an exemplary manner through responsible investments and responsible ownership. In this regard as well, the change represents a modernisation and adaptation to the requirements that are put today on long-term institutional asset managers with high sustainability ambitions. In addition to this, of course the new wording in the investment rules will also spur us to continue development in the area of sustainability, with the ambition to steadily – over time – stay at the international vanguard in this area.
In conclusion, I would like to offer warm thanks to my colleagues at AP4 who through their professionalism, innovative thinking and ability to implement are helping manage the buffer assets and continuously develop our operations so that we can best execute our mission in Sweden’s national pension system.
Stockholm July 12, 2018