Pension fund of the year: AP3

Risk Awards 2018: Swedish fund proves that shunning ‘sin stocks’ can pay

Marten Lindeborg

Peter Phillips

At a time when investors are debating whether sin stocks should pay a premium, AP3 seems to be proving the opposite – there’s money in virtue.

The Swedish government pension fund has returned about 11% annualised over the past five years, with a Sharpe ratio of 2.2 in the first half of 2017, and 1.6 last year – much better than most hedge funds.

Over five years, the fund has beaten its benchmark of a balanced portfolio of bonds and equities by an annualised rate of 2.7%.

All the time, it has invested only in companies and assets it sees as virtuous, ranked by its own list of strict environmental, social and governance (ESG) criteria.

“I don’t think classical asset pricing applies to ESG at the moment,” says Fredrik Giertz, AP3’s senior manager of quantitative strategies. “In the classical [model], ESG is a risk and one should get paid for holding companies with lower ESG characteristics. I don’t think that’s the case. I think the market prices ESG inefficiently and you can use that in your favour to screen good companies from a quantitative perspective.”

AP3 invests the bulk of its portfolio in risk premia such as size, value, quality and low volatility – carrying out its own research into what consistently yields a premium.

Giertz says there is no downside to limiting itself to good ESG investments because these premia exist in both good and bad companies. Meanwhile, AP3’s own research suggests classical models of asset pricing actually undervalue companies that score well for ESG criteria, as firms with good governance able to comply with environmental and social regulation behave a bit like quality stocks.  

“In the quality premium we don’t necessarily know the drivers. In ESG there is quite a strong logic [as to] why environmental companies should earn a higher return, because they have to adapt to new regulations and a different future. Companies that can’t manage this in a good way will suffer,” he says.

We’re quite certain that divestment is not helping the world because if we sell, someone else will buy. So we tell companies: your carbon footprint is this size. If a carbon tax happens in the future, how would you transform your company to be more sustainable?

Marten Lindeborg, AP3

That runs against research that has suggested so-called sin stocks such as tobacco, alcohol and arms companies do better than other stocks because investors demand higher returns to hold them.

Annualised excess returns for sin stocks above equity markets were 11% between 1970 and 2007, according to a 2008 paper by Frank Fabozzi et al. Annualised underperformance of ESG equities can be up to 3% between 1992 and 2007 versus other equities, a 2009 paper by Harrison Hong and Marcin Kacperczyk suggests.

But a 2017 paper by David Blitz and Frank Fabozzi finds that the alpha of sin stocks disappears when controlling for five risk premia. Giertz says the company has done similar research and any premium based on a lack of demand for sin stocks would be small.

“A lot of classical investors don’t think about ESG. They may say they do but I don’t think they actually employ this in the investment process,” he says.

Pressing for change

AP3 shuns completely some companies that fall short of its ethical standards. Company holdings are weighted based on its own set of ESG scores. Rather than divest in whole sectors, it presses companies to behave responsibly.

“We’re quite certain that divestment is not helping the world because if we sell, someone else will buy. So we tell companies: your carbon footprint is this size. If a carbon tax happens in the future, how would you transform your company to be more sustainable?” says Marten Lindeborg, deputy chief executive and chief investment officer at the fund.

AP3 votes in 800 overseas annual general meetings and owns majority stakes in key domestic firms, such as three Swedish real estate companies. “We want our real estate companies to be a role model for the rest of the real estate market. We tell companies they benefit from making buildings green and energy efficient,” says Lindeborg.

The fund started researching the volatility premium six years ago before expanding its allocation to other areas. “It went really well, so we decided to try to harvest some more academically driven risk premia, such as value, momentum, and carry,” says Lindeborg.

It now allocates to such risks in equities, sovereign bonds, credit and foreign exchange, and researches, trades and manages more than half of the allocation internally. It also invests in alternative risk premia, taking long and short exposures, half of which it also manages internally.

AP3 has further ambitions. As a whole the fund is carbon-neutral but it wants to halve its carbon footprint on listed equity and credit, compared with 2014. The pension fund also wants to triple its holdings of green bonds from Skr10–20 billion ($1.2–2.4 billion).

“Priority number one is our returns target, but everything is done through the eyes of ESG,” says Lindeborg.