With some SEK 460 billion under management across virtually every asset class and region, Andra AP-fonden (AP2) stands as one of the largest pension funds in Northern Europe. As part of its strategy to diversify away from the Swedish business cycle and safeguard pension savings for future generations, AP2 has incorporated emerging markets – both equities and bonds – as core components of its investment portfolio. However, AP2 has chosen to pursue this exposure through an in-house systematic approach, valuing advantages such as cost efficiency, greater control, enhanced transparency, and scalability, among others.

Outlier with High Emerging Market Exposure

Kristian Hartelius, Head of Quantitative Dynamic Allocation at AP2, observes that allocations to emerging markets in Sweden are generally quite low, with AP2 standing out as “an outlier, even among the AP Funds,” as emerging market equities make up 12 percent of its overall portfolio. This limited exposure among peers reflects the prevailing belief that emerging markets are riskier investments. “While it is true that emerging markets carry more risk, they also offer higher expected returns,” Hartelius explains. “Admittedly, these markets have trailed developed markets over the past decade, but we still believe that the expected returns moving forward are higher.” He also expresses concern about the heavy concentration in American mega-cap tech stocks, further reinforcing the need for global diversification, including allocations to emerging markets.

“While it is true that emerging markets carry more risk, they also offer higher expected returns. Admittedly, these markets have trailed developed markets over the past decade, but we still believe that the expected returns moving forward are higher.”

Kristian Hartelius, Head of Quantitative Dynamic Allocation at AP2.

“When we model scenarios where the buffer funds may be most needed, emerging markets naturally emerge as a key diversifier away from the Swedish business cycle, especially when considering demographics and macroeconomic factors,” argues Hartelius. “Emerging markets represent an independent story in the world, driven by positive demographics, expanding middle classes, and growth fueled by these factors, making them a vital diversifier,” he elaborates. While he acknowledges that emerging markets have been more challenging as an allocation in terms of returns, particularly as developed markets – especially U.S. tech companies – have outperformed recently, the team at AP2 “continue to view emerging markets as an important diversifier with a role to play in our portfolio.”

“Equity investing is particularly well-suited for in-house management by our small yet highly skilled team out of Gothenburg…”

Kristian Hartelius, Head of Quantitative Dynamic Allocation at AP2.

As Head of Quantitative Dynamic Allocation at AP2, Kristian Hartelius helps co-ordinate a team of 12 professionals responsible for managing allocations in developed market equities, emerging market equities, and emerging market debt using a systematic approach. “Equity investing is particularly well-suited for in-house management by our small yet highly skilled team out of Gothenburg, which includes PhDs in mathematics, statistics, economics, along with computer scientists and programmers,” considers Hartelius. “With a team of around 12 people, we’re able to efficiently handle a wide range of markets and large amounts of capital by leveraging data and advanced algorithms.”

Country Selection: AP2’s Distinctive Approach to Emerging Markets

For equity investments in Sweden, where AP2 has a physical presence, AP2 employees can attend AGMs, engage with management teams, and meet with CEOs to conduct more in-depth fundamental analysis. “In emerging markets and even in developed markets, we lack the resources and reach to implement the same level of in-depth fundamental analysis ourselves,” notes Hartelius. “However, by excelling in quantitative portfolio management, we can manage equities globally in a consistent and risk-controlled manner.” Approximately half of AP2’s investment portfolio is managed through quantitative strategies.

The Asset-Liability Model (ALM) serves as the strategic framework that aligns AP2’s investment strategy and asset allocation with its obligations, while optimizing returns and minimizing risks. As part of this process, the ALM guides the allocation across various asset classes, with “equities – including emerging market equities – representing key components in this optimization,” according to Hartelius. For its emerging markets allocation, the AP2 team has developed a country framework to help guide investment decisions and determine which markets to prioritize.

“Generally, the more markets, the merrier as you get greater diversification,” says Hartelius. However, there are instances where certain countries may be excluded. “Sanctions, poor financial outlooks, or unfavorable country profiles may all lead us to avoid specific markets,” he explains. Other reasons for exclusion include the expectation of better returns elsewhere, operational challenges such as corruption or high entry costs, and transaction hurdles. “Sustainability considerations also play a key role,” he emphasizes. “At AP2, we have dual objectives: maximizing financial returns for the pension system while promoting sustainable development. As a result, investing in some countries may not align with our sustainability goals.”

“Sanctions, poor financial outlooks, or unfavorable country profiles may all lead us to avoid specific markets. Sustainability considerations also play a key role.”

Kristian Hartelius, Head of Quantitative Dynamic Allocation at AP2.

AP2 has a framework in place to screen for human rights risks, ensuring that the Fund’s investments align with the UN Guiding Principles on Business and Human Rights. “We screen for countries that may not meet these standards and consider whether we want to invest in them for these reasons,” explains Hartelius. If human rights or sustainability issues arise, the team evaluates their options, including assessing how they can influence positive change. This might involve leveraging their position to engage with authorities and companies through dialogue. However, there are certain countries that get excluded from the investment universe, including Saudi Arabia, Myanmar and Belarus.

Harnessing Multi-Factor Models

The next step in the process is to determine how to allocate investments to eligible countries. Given AP2’s systematic approach, the team has developed a multi-factor model that also considers factors such as carbon emissions and carbon intensity. “As we are strategically committed to achieving net zero in a way that benefits our long-term pensioners, we have developed Paris-aligned multi-factor benchmarks,” explains Hartelius. “We gather extensive data on factors and carbon emissions from companies, aiming to expose the portfolio to those factors that offer the highest returns, while simultaneously managing and controlling the portfolio’s carbon intensity.”

“We gather extensive data on factors and carbon emissions from companies, aiming to expose the portfolio to those factors that offer the highest returns, while simultaneously managing and controlling the portfolio’s carbon intensity.”

Kristian Hartelius, Head of Quantitative Dynamic Allocation at AP2.

The multi-factor model used by AP2 provides exposure to traditional factors such as momentum, quality, and value, as well as carbon-related factors, while adhering to the geographical distribution of weights in the MSCI Emerging Markets Index. “We don’t take directional bets between regions, but in terms of security selection, we may choose to overweight or underweight certain securities, potentially deviating from the country weights in the parent index,” says Hartelius.

The investment process follows a two-step approach. First, the team constructs a benchmark based on long-term, slow-moving factors, and then engages in an alpha generation process that includes weekly or bi-weekly rebalancing, all while carefully managing risk. Given the more limited liquidity in emerging market equities, AP2’s models also account for transaction costs and market impact. “We’ve developed quite sophisticated models over time to ensure we size positions correctly without significantly affecting market prices,” Hartelius adds.

By leveraging a data-driven, multi-factor model, AP2 is able to navigate the complexities of emerging market equities, balancing exposure to traditional factors such as momentum, quality and value with sustainability considerations. This approach, while mindful of the challenges associated with liquidity and market impact, enables AP2 to effectively construct and scale its equity exposure to emerging markets, all while maintaining cost efficiency, enhanced control, and greater transparency.