IntroductionStrong performance despite turbulent markets
Despite financial turmoil in the second half of the year, Första AP-fonden delivered a strong result for 2007 with a return on net assets of 4.6% after expenses. Active return was 0.4 percentage points, equal to investment income of SEK 870 millio. Over the past five years our active asset management has contributed SEK 4 billion to the Swedish pension system, which means that we have met our goal to generate an annualized active return of 0.5 percentage points.
The second half of 2007 was marked by widespread uncertainty and high price volatility that had a particularly harsh impact on the fixed income market but also affected equities and foreign exchange. This unrest triggered a continued downward trend in the US residential mortgage market.
Mortgage loans have often been packaged in so-called structured products with poor transparency, making it difficult to analyze who has borne the year's massive credit losses. This has also undermined confidence in the financial system and led to increasingly steep rates for interbank lending. Furthermore, heavy losses have been incurred by a number of large international banks.
Several central banks have intervened to preserve market liquidity but have been unable to avert the crisis and there is a mounting fear that it will have repercussions for the real economy, making the prospect of recession in the
US appear more and more likely. This triggered a downward slide in long-term interest rates during the autumn, particularly in the US. Prices also tumbled on the majority of global stock markets, including the Japanese and Swedish, while the bourses of emerging markets have fared better.
In the foreign exchange market, the US dollar fell sharply against most other currencies and the Swedish krona edged down slightly against the euro. Because the Fund's holdings of fixed income securities consist of bonds with very high credit ratings, the fixed interest portfolio has not been damaged by any credit losses stemming from the mortgage crisis.
In 2007 the Fund reported positive results for the fifth consecutive year with investment earnings of SEK 9.7 billion, of which SEK 870 million comprises active return. The Fund's total return after expenses was 4.6%, a satisfactory level considering the state of the market albeit considerably weaker than in the past four years.
This means that over the past five-year period we have achieved an annualized return of 11.7% after expenses, which is significantly higher than the Fund's target range of 5.1-6.1% and well above the minimum level necessary to ensure the long-term stability of Sweden's pensions. Since the Fund's inception in 2001, we have delivered an annualized return of 5.0% after expenses. In 2007 the Fund's net assets grew from SEK 207.1 billion to SEK 218.8 billion, compared to the SEK 134 billion we were given to manage seven years ago and net contributions of SEK 20 billion since that time.
The aim of active management is to earn a higher return by diverging from the composition of the strategic benchmark. The Fund's internal active management is conducted in five units, Tactical Asset Allocation, Global Macro Allocation, Equities, Fixed Income and Foreign Exchange.
The units have clearly defined targets and risk mandates and use autonomous decision-making processes. This makes them completely independent from the actions of the other investment units, leading to greater diversification and a lower total level of risk.
Externally, we have 19 active managers in charge of Japanese, Asian, US and emerging market equities, as well as US credit bonds. The aim of active management is to outpace the benchmark return by 0.5 percentage points per annum, a goal we fell somewhat short of in 2007 with an active return of 0.4 percentage points. Return weakened slightly in the second half of the year due to general uncertainty and turbulence in the financial markets.
The Fund's in-house management produced solid results for the third year in a row and accounted for the entire active return, while the aggregate contribution from the Fund' external managers was neutral following a run of healthy returns after expenses in the years 2004-2006. Of our internal units, fixed income management was the top performer with returns well above index. Swedish and European equities also posted solid returns.
The Fund's risk-adjusted return over the past five years, measured as an information ratio, is 1.1, which widely exceeds our goal of 0.3 and indicates management of good quality.
In the past year the Fund invited tenders for external management of Japanese equities and five new managers were appointed and funded. We have also commenced a tender process for new equity managers in the Pacific region with the intention to fund these in the spring of 2008. The Fund's motive for these recurring procurements is to further improve the scope to achieve a competitive active return.
Much attention during the year has been devoted to the Fund's long-term strategy, a process conducted in a unit that since year-end 2007 is called Portfolio Strategy. This unit is responsible for our ALM studies (Asset Liability Management) and for providing a basis for the Board's mid-term decisions (2-10 years forward).
Portfolio Strategy plays no part in our active management and has its own decision-making process, but collaborates with other investment units to ensure access to the Fund's top expertise in its development projects related to the strategic benchmark.
The Fund's strategic benchmark basically represents the long-term strategic asset allocation that is expected to give the Fund the best prospects of meeting its obligations in the Swedish pension system. The current strategic benchmark was selected in 2001 following an in-depth ALM study with a very long time horizon of around 50 years. In 2007 the Fund began working on a new ALM study that expected to be completed in the first half of 2008.
The Board of Directors decides on adjustments in the composition of the strategic based on our mid-term market expectations. In the first half of 2007, exposure to North American equities was reduced by 4 percentage points with a corresponding increase in other developed regions and emerging markets. A decision has also been made to adopt dynamic strategies for continuous reweighting of the strategic benchmark with respect to the share of equities and bonds and the currency spread in foreign exchange exposure.
Evaluation of incentive schemes
Första AP-fonden favours the use of long-term share-based incentive schemes by companies to align the interests of their senior executives with those of the shareholders. But in order for these schemes to have the intended effect, a number of criteria must be met.
One such criterion is the achievement of clear and measurable targets related mainly to the company's profitability in order to qualify for allocation. Another important requirement is that the incentive schemes are evaluated from a shareholder perspective and that the resulting costs and other effects are reported to the shareholders, which has so far been done only as an exception. A study carried out by the Fund in association with researchers from the Swedish Institute for Financial Research and the Stockholm School of Economics (Handelshögskolan), shows that these evaluations must be performed by the companies themselves (read more about the study on page 45). Several companies carried out ambitious evaluations in the autumn of 2007, and I hope that many others follow their example so that both companies and their shareholders can assess the effectiveness of these schemes.
Ethical and environmental compliance
Since 2002 Första AP-fonden has been working actively to influence companies that can be associated with infringement of international conventions, and in many cases the Fund's efforts have been successful despite limited resources. At the beginning of 2007 we set up a joint Ethical Council together with AP2, AP3 and AP4 in order to coordinate our SRI analysis of environmental and ethical compliance in the foreign companies where the funds have holdings. So far, I feel that this cooperation has been very successful. It enables us to work more effectively without any increase in costs and gives us greater leverage to influence the companies in that we together represent much larger investment holdings.
Outlook for 2008
In the past year I decided that it was time for me to leave the Fund, which was no easy choice since I have truly enjoyed this exciting and varied job full of interesting challenges. During my six years in office I feel that we built up a strong, global and competitive asset management organization characterized by expertise, dynamism and an outstanding corporate culture.
Over the past five years we have exceeded the Board of Directors' target for total return by a wide margin. Our annualized active return for the same period is 0.5 percentage points, which is also in line with our established targets and corresponds to investment earnings of SEK 4 billion.
Both the government evaluation and a yearly comparison by the Canadian information company CEM show that our results are competitive from an international standpoint.
I would like to end by thanking all of the Fund's employees for their invaluable contributions during my time in office, and to wish both them and my successor Johan Magnusson good luck in the future.
Stockholm, February 2008
William af Sandeberg