From a strategic perspective it is of the outmost importance that the Fund’s asset management is permeated by a good risk culture. This demands a high level of risk awareness among both internal and external managers.
Although the past year was exceptional from a risk perspective, the Fund has been able to monitor risks throughout the year and adapt its guidelines and limits accordingly thanks to well established routines and processes. The steps taken by the Fund in response to the financial crisis are described in the section Looking back on 2008 while this section describes the Fund’s risk management in more general terms.
Known risks – required for investment
Each proposal for investment in a new instrument or fund is preceded by exhaustive research. An investment is made only if the Fund understands and can calculate the risks it is associated with, provided that the risk is deemed acceptable. The decision to invest also depends on the availability of processes to measure, manage and control these risks. In practical terms, this means that the Fund does not invest in any structured products in the form of sophisticated derivative instruments and has been highly restrictive in its involvement with hedge funds.
Risks in two stages
A certain level of risk is necessary to generate the return required by the Fund’s mission. Risks arise at the actual time of investment. The Fund’s risk selection can be divided into two stages: First, a decision is made on the Fund’s long-term portfolio composition, the ALM portfolio. At the next stage, active investment decisions are made to deviate from the ALM composition in the short term. Together, these two investment stages result in the Fund’s de facto asset mix.
Analysis of risks at the first stage takes place within the ALM study that provides a basis for the Board’s choice of ALM portfolio (see section The pension system demands high returns). As a result, day-to-day risk management is devoted mainly to the risks arising in implementation of the ALM portfolio and the active investment decisions made in order to deviate from this portfolio.
The most significant risks can be broken down into three groups – investment risks, administrative risks and operating risks.
Investment risks
Investment risks include market risk, liquidity risk and credit risk, all of which arise through the Fund’s ownership of different types of assets.
Market risk
The Fund’s most significant investment risk by far is market risk, i.e. the risk for a decrease in the value of an asset. When the Fund invests in a share, this is based on the belief that the share price will rise. But share prices, like those of all assets, are volatile and can naturally also decrease. Market risk can be quantified and is typically measured in terms of standard deviations.
Market risk can be expressed in both absolute terms, i.e. compared to a wholly risk-free portfolio, and as the difference relative to an index, so-called active risk. The relevant index for Första AP-fonden is the strategic benchmark, which means that active risk consists of the risk between the actual portfolio and the strategic benchmark. Market risk is related to the positions taken in the portfolio, but also to the general level of volatility in the capital markets.
The Fund calculates both realized risk, based on past price movements, and forecasted risk. The latter is often of greater interest, since it gives an indication of the level of risk in the Fund’s current positions. For this purpose the Fund uses a well established commercial risk system and proprietary models to make risk forecasts.
Liquidity and credit risk
Liquidity is the risk for a low volume of trading in an instrument, which can lead to large differences between buy and sell prices and therefore higher transaction costs, or that it will simple not be possible to sell an instrument at the desired time. The Fund manages this risk through rules regulating which securities may be purchased, meaning that the Fund invests primarily in highly liquid securities. In the case of equity investments, the permitted investments are defined through the choice of index. There are limits governing what percentage of the investments may be made outside index or in an individual security.
Credit risk is associated with investments in bonds and the risk for cancellation of payment. To limit this risk, the Fund may invest only in bonds with a rating of at least BBB and normally has the bulk of its fixed income investments in AAA-rated securities.
Administrative risks
Administrative risks include counterparty risk, management risk and system risk, all of which arise when investments are made in the financial markets.
Counterparty risk
Counterparty risk is the risk than parties with which the Fund enters into a business transaction, primarily banks, will be unable to meet their obligations to the Fund due to insolvency or other reasons. The Fund manages this unavoidable risk by doing business only with counterparties that have undergone a thorough credit assessment. The requirements for these counterparties are that they have a strong financial position and high credit ratings and are domiciled in politically stable countries. Aside from spreading risks between a number of different counterparties, risk is minimised through the use of exposure limits. Because counterparty risks can be substantial, this management follows a structured yearly process.
Första AP-fonden has ISDA agreements (International Swaps and Derivatives Association) with all banks, which means among other things that derivative positions can be netted (buy and sell transactions with the same bank can be set off against each other) and that exposure risk is thereby decreased. In addition, the majority of the Fund’s cross-currency transactions are paid via CLS Bank, which eliminates the risks that otherwise arises when settlement of buy and sell currencies does not take place simultaneously.
Management and system risk
Management risk includes all risks that arise when the Fund transfers responsibility for management tasks to an external party, such as the risk for incompetence or dishonest practices. This risk can be limited through in-depth evaluation of potential candidates by the Fund’s external management unit when seeking new managers, and by using multiple managers in each market. In addition, the Fund carries out a yearly review of all managers that includes personal visits.
System risk refers to other risks that arise in transactions and storage of financial instruments, where other parties in the financial infrastructure are involved. This includes the risks associated with use of a bank, clearing house, etc. These risks are managed partly through rigorous evaluation and partly by being clear and proactive when drafting contracts.
Operating risks
Operating risks are the risks of losses arising as a consequence of human factors, inadequate systems, inefficient routines and instructions and insufficient control. Effective IT support is therefore critical. The Fund’s large transaction flows are handled in a financial system, Dimension, whose functionality and availability is deemed high. To minimize the operating risks associated with business transactions, these are executed electronically to a large extent. A continuous effort is also made to upgrade and update systems and routines, and to successively automate manual work steps. On a regular basis, the Fund conducts large-scale review of operating risks in which all units participate.
Independent monitoring
The Fund’s risk management unit is responsible for identifying, measuring, controlling and reporting all risks. The unit is headed by the Fund’s Compliance Officer, who executes risk control and is charged with monitoring compliance with laws and the executive decisions of the Board and Managing Director.
