By Hamlin Lovell, NordicInvestor 

AP3’s annual report shows emerging market allocations of between about 4% and 5% of the fund, at year end 2019, 2020 and 2021 – but zero for year end 2022 and year end 2023, when AP3 managed SEK 499.8 billon (EUR 43 billion). That will soon change as AP3 once again invests in the asset class.

Strategic and tactical asset allocation, and evolving ESG data guide investments

AP3’s mandate and purpose, as a buffer fund of the Swedish pension system, are long-term. This enables the fund to work across different time horizons. AP3’s process is a mix of systematic and discretionary. The top down macro view is all driven by systematic and quantitative analysis. The new AP3 Chief Investment Officer, Jonas Thulin, personally selects funds and strategies on a top down basis, while other portfolio managers use bottom up fundamentals,  following a more traditional discretionary approach.

Strategic Asset Allocation is the core, based on ALM (asset liability management) studies on efficient frontier portfolio optimization theory, but Thulin is ramping up the role of tactical asset allocation. which is working alongside the strategic asset allocation and bottom-up fundamental stock/bond/strategy picking. “It is vital that the tactical work is complement, not substitute,” says Thulin and continues “The past seven years have challenged the traditional view that asset allocation accounts for 90% of returns. SAA is like Mike Tyson’s saying, carry on playing until you get punched in the face. Market timing has been very important over the past few years. With an active tactical overlay, investors needed to care about the Ukraine war, and the broad rally since the lows in October 2022. We expect to make good returns in emerging markets from being tactical.”

Emerging market equity targets

Unlike some other allocators in the region, AP3 is not investing in private debt, nor microfinance, in emerging markets. AP3 already has some extremely small exposure to emerging markets government debt: about SEK 0.5 billion, which is about 0.1% or one thousandth of assets, in the annual report.

The long term target is more than 100 times greater, or 11% in emerging markets equities, but the fund will start cautiously with a smaller initial allocation. Additions will party depend on macroeconomic and market stress testing. “Any investment has to compete for its place in the portfolio. We are not locked into a long term commitment. If the macro picture deteriorates, we might not even get to the full 11% target weighting,” admits Thulin.

ESG criteria

The country selection criteria are partly based on three ESG pillars: democratic development, human rights and corruption, which are all assessed using third party data.

For instance, in Asia, AP3 will not currently invest in mainland China equities, but can invest in Hong Kong and Taiwan. “The allocation to Taiwan, South Korea and India is heavier than in the normal MSCI index,” points out Thulin. In the Middle East and North Africa region, AP3 will not currently invest in Saudi Arabia.

The allocations above, as of April 2024, are not set in stone. Just as central banks are data dependent in their decisions on interest rates, so too AP3 is keeping a constant eye on evolving ESG data. “It is always a moving target and the data points develop almost on a daily basis. They can move in a positive or negative direction. We look at the country scores on human rights and see how they change over time. Whatever is bad or good today may change in future,” confirms Thulin.

The published AP funds exclusion list is clearly not an accurate or up to date guide to emerging markets exclusions or indeed their overall exclusions policies. Avoiding mainland China implies avoiding thousands of companies, but the published AP exclusion list only contains 15 companies, much shorter than say the Norges Bank list of several hundred,  and does not mention country exclusions. “In any case, the published list is only a minimum base level from collaboration between the AP funds, and each one tmay develop their own policies for exclusions, apart from any emerging market country exclusions,” points out Thulin.

Of course, ESG is not just about negative screening, as positive impact is also sought. “We work actively with the industry to get more data on sustainability,” says Thulin.

Interaction between ESG and TAA

There is an interesting potential conflict between the tactical asset allocation and ESG policies. Some “value investors” have recently been adding to mainland Chinese equities, but this option is not currently open to AP3. If an emerging market sells off for reasons related to AP3’s ESG criteria, AP3 may not be able to use tactical asset allocation to take advantage of the lower valuations.

Insourcing

Most of AP3’s asset management – some 99% of fixed income, and 87% of equities, is in house. “We are still insourcing rather than outsourcing, for reasons including costs and operational risk.We have great portfolio managers, who are seeking around 100-150 basis points of alpha above benchmarks. We apply our investment philosophy and positioning, and have full transparency of risk,” says Thulin.

In corporate debt, it is steady – and there are different teams on the equity and bond sides, all with a bottom up focus, rather than looking at broad indices. AP3 is very selective and is exposed to less than 200 corporates. “The portfolio is set up for alpha generation, and we are not worried about benchmark tracking error,” points out Thulin. Incidentally, AP3 would not necessarily choose a commercial ESG index for benchmarking, because this might not fit its own sustainability framework.

Alpha targets

“We aim to generate single stock alpha with no bias to styles of factors,” he says. The outperformance target at AP3 is  however very modest compared with Thulin’s personal career history, which he claims has generated 650 basis points a year of outperformance. “We have a constant discussion every year about outperformance but have not increased the target from 150 basis points per year”.

This is separate from any value added from currency exposures. The emerging markets currency allocation varies by asset class. “In currencies, our EM exposure is fairly stable, and is also integrated with overall currency hedging decisions,” says Thulin

External investment vehicles

External managers could be global players or local funds, and no names have yet been disclosed. As well as single stockpicking, vehicles could include active or passive UCITS mutual funds, and ETFs.  “We screen tens of thousands of products every day to gauge trends in equity markets. Machine learning and AI make it very easy to look at 150,000 products. If the US and emerging markets are both booming, we want to work out which part is growing fastest. This all comes from our fundamental approach, trying to find alpha all the time”.

Outlook

The allocations will depend on economic and ESG data, but Thulin’s personal outlook for emerging markets was somewhat positive in April 2024. “We think emerging markets are undervalued and also see good macro momentum. We will start small and increase if we get it right. India is an example of a real eye opener. It has been great on the equity side. Once a market gets going, we can allocate a lot to it”.

Thulin can even envisage scenarios under which emerging markets are up when developed markets are down: “divergences are opening up globally as the world becomes less and less synchronised. We may decrease the US weight and increase other regions”.

The definition of an emerging market is of course open  to debate, and some of the more mature emerging markets are arguably no longer emerging. MSCI still classifies wealthy South Korea as an emerging market whereas FTSE Russell and S&P Dow Jones classify it as a developed market that has  already emerged. This is another reason to maintain a flexible and evolving data-driven approach to the allocation.