Stockholm (HedgeNordic) – The historically low bond yields in the decade following the 2008 financial crisis have led many institutional investors to look outside traditional asset classes in their search for yield. The current investment climate, dominated by uncertainty around slowing economic growth, rising inflation and interest rates as well as geopolitical tensions, has strengthened the case for relatively illiquid categories of real assets such as real estate and infrastructure.

“There have been two main drivers of the huge shift into alternative assets in recent years,” says Magdalena Högberg, Head of Strategic Asset Allocation and Quantitative Analysis at the Fourth Swedish National Pension Fund (AP4). First, “institutional investors have been increasing their allocation to alternatives in the light of the very low bond yields, which has been driving the yields on alternatives down and prices and valuations up,” she elaborates. “The other driver, the one that we have been focusing on a bit as well, is the search for inflation protection and finding assets that make the portfolio more robust for different macro regimes.”

“Institutional investors have been increasing their allocation to alternatives in the light of the very low bond yields.”

During 2021 and throughout 2022, AP4 further strengthened its investment portfolio’s robustness through a continued larger allocation to unlisted real assets. This asset allocation decision has been specially adapted for AP4’s main economic scenario best described as “muddling through,” characterized by a gradual adjustment to an environment with relatively modest economic growth and weak productivity development from a historical perspective. At the same time, this allocation is designed to have stronger outcomes in AP4’s alternative economic scenarios, one of high inflation and weakening economic growth that the world is living through at the moment.

“The other driver, the one that we have been focusing on a bit as well, is the search for inflation protection and finding assets that make the portfolio more robust for different macro regimes.”

AP4’s Categorization of Alternatives

As there is no one common definition for alternative investments, different investors would often have their own unique definitions of alternatives and may classify specific alternative investments differently. In its investment portfolio worth about SEK 528 billion, AP4 does not have a separate alternative assets portfolio. Instead, AP4 looks at the underlying drivers behind each asset class and does not differentiate between exposures with the same underlying factor exposures but different forms of listing.

“We look at private equity as part of the equity allocation and private debt as part of the fixed-income allocation.”

“We look at private equity as part of the equity allocation and private debt as part of the fixed-income allocation,” explains Högberg. “The allocation to private equity, for us, is about complementing the listed equity part of the portfolio and finding investments that are hard to access in the listed markets,” she continues. “Investing in private equity is about getting exposure to a different sleeve of the market composed of companies that are not listed or see no benefit from a listing. We use our private equity allocation extensively to access investments exposed to our thematic research, and we also find this allocation is particularly valuable for the portfolio considering that we have seen a trend of declining number of listed companies for a number of years.”

Similarly, the allocation to unlisted credits has the objective of getting access to credit risk premia beyond the listed marketplace. “AP4’s unlisted credit investments are about diversification of credit risk and yield, of course,” says Högberg. In the unlisted credit space, AP4 tends to “focus on middle-market segments that are not as exposed to growth compared to a general run-of-the-mill investment-grade allocation.”

AP4’s Separate Real Assets Portfolio

AP4, however, has defined real assets, such as real estate and infrastructure, as a separate asset class generally associated with long-term and comparatively stable cash flows that have a strong inflation protection embedded in them. “These assets offer stable returns and diversification of risk, and are suitable components in the portfolio of a long-term investor such as AP4,” according to Högberg. “Real assets, for us, include assets that we feel have some sort of inflation component inherent in their characteristics. But one of the key roles of our real assets portfolio in this environment is obviously diversification,” says Högberg.

“Real assets, for us, include assets that we feel have some sort of inflation component inherent in their characteristics. But one of the key roles of our real assets portfolio in this environment is obviously diversification.”

AP4’s Head of Strategic Asset Allocation goes on to emphasize that the benefits and characteristics of a real assets portfolio are more nuanced than a top-down view can suggest. “The characteristics of a real assets portfolio are determined by the type of assets and the type of contracts associated with the underlying assets,” explains Högberg. “Depending on the exact specifications of those two variables, as an investor you can get an asset with more equity-like features or a more defensive asset with an inflation component embedded,” she elaborates.

“For us, the main objective for the increasing allocation to real assets has been to get access to stable, real cash flows that are hugely beneficial in an inflationary environment, and to diversify the portfolio,” says Högberg. These inflation-protection and diversification characteristics stem from “long-term contracts or regulated returns that are tied to inflation, as well as combining that with a demand that is rather insensitive to what is happening with economic growth.”

“For us, the main objective for the increasing allocation to real assets has been to get access to stable, real cash flows that are hugely beneficial in an inflationary environment, and to diversify the portfolio.”

For investors looking to protect their portfolios against rising inflation by allocating more to real assets, Högberg suggests keeping a close eye on valuations. “If we go into the type of environment we have been experiencing over the last couple of months, a key aspect when creating that type of exposure is keeping track of the valuation of the asset,” emphasizes Högberg. “You don’t want to find yourself in a situation where you have bought assets that should be good diversifiers in theory, but end up having huge sensitivity to interest rates because of extreme valuations.”

Supporting the Energy Transition

At the end of 2021, AP4 had 15.4 percent of its SEK 528 billion portfolio allocated to real assets, with about two percent allocated to infrastructure and the remaining bulk to real estate. Despite normalizing bond yield, AP4 plans to increase its exposure to real assets even further. “We are planning to increase our exposure to real assets to up 20 percent from a current level of about 15 percent even if we have higher interest rates,” Högberg tells HedgeNordic.

“If interest rates normalize, the trend of investors allocating more to alternatives may revert at some point and investors will allocate money into bonds again.”

“If interest rates normalize, the trend of investors allocating more to alternatives may revert at some point and investors will allocate money into bonds again,” she argues. “If we find ourselves in a place where we have interest rates at four or five percent in a couple of years, that will obviously impact the way we allocate to alternative investments.” And yet, real assets and other alternatives will have a place in investor portfolios even in an environment of higher bond yields due to their diversification benefits, according to Högberg.

“We are on the road to increasing our real assets allocation, mostly within infrastructure.”

“We are on the road to increasing our real assets allocation, mostly within infrastructure,” says Högberg. The new investments are channeled mostly into energy transition-related infrastructure projects. Through Polhem Infra, an investment company jointly owned by the Swedish buffer pension funds AP4, AP1 and AP3, AP4 has previously invested in the Skaftåsen wind farm, one of the largest wind power projects in Sweden, and Scandinavian district heating player Solör Bioenergi. The three AP funds recently made a new commitment to Polhem Infra to invest in sustainable infrastructure in Sweden. AP4 also made a co-investment in one of the largest independent project developers in solar energy in the United States together with infrastructure private equity firm Antin. The Swedish pension fund during 2021 also made a commitment to Meridiam’s latest European infrastructure fund, which will be investing in renewable energy and other sustainable infrastructure projects across Europe.

“Given that our unlisted investments are something that will stay on our books for a very long time, we always make sure that we make investments that are aligned with our long-term belief in the transitioning to a sustainable society.”

“Given that our unlisted investments are something that will stay on our books for a very long time, we always make sure that we make investments that are aligned with our long-term belief in the transitioning to a sustainable society,” argues Högberg. “We are transitioning into a sustainable society, and we see a huge opportunity for investments in unlisted assets to provide support for that transition to actually happen,” she continues. “We have a very long-term horizon and believe it is important to support the energy transition, also by investing in the alternative asset space.”

This article features in HedgeNordic’s “Private Markets” publication.