Investment decisions based on a long-term investment horizon
The belief that exposure to financial risk has a positive impact on investment returns over time is based on theoretical and empirical research in financial economics. Risk assets like equities have delivered much higher returns in the last 100 years than fixed income securities with low credit risk. 

Based on results such as those shown in the table above and analysis of future scenarios, AP3 has calculated expected returns on a wide variety of assets. We also analyse the risk, measured as volatility, inherent in our investments and how returns may correlate over time. Projected returns, risk and correlation are then used to create an optimal portfolio that meets our target of a 4% return over time at a minimum level of risk – a portfolio that offers the highest riskadjusted return. As we construct the optimal portfolio we consider the statutory restrictions on our investment strategy and our prerequisites as an institutional investor as described in the table below. These prerequisites give us competitive advantages that we can use to raise returns and reduce portfolio risk.

The portfolio is designed in line with the long-term investment strategy and has relatively high exposure to risk assets. This is because projected real returns on fixed income assets with a high credit rating are below our 4% target. Historic and current real yields on treasury bills and government bonds are significantly lower than 4%.

Since inception in 2001, AP3 has sought to compensate for the higher risk associated with risk assets by diversifying risk in line with our investment philosophy. Risk diversification raises risk-adjusted returns and reduces our vulnerability to sudden fluctuations on financial markets, particularly the equity market. Many of the major changes we have introduced since 2001, for example increased exposure to property and other assets offering real returns, can be seen in a diversification context.

Strategic allocation – medium-term investment horizon
The static portfolio that results from the long-term investment process is not a model portfolio that we seek to maintain in all market situations. We constantly analyse the current portfolio to see if we can change it to increase the likelihood of reaching our target return of 4%. This analysis is via an investment process that uses a medium-term horizon based on projected returns over one to three years.

We believe it is possible to forecast returns over the medium term – a view supported by research. We operate a strategic allocation policy because we have seen how returns on different assets vary considerably over a 1-3 year period and that longer periods of time may be required to achieve the long-term target return. There have been periods in the past during which equities have underperformed bonds over the course of several decades. Risk premiums are not constant but vary considerably over time.

Alpha – short-term investment horizon
Short-term positions are our third investment process and are known as alpha management. Here, the aim is to generate returns that in the short-term exhibit little correlation with the return on the total portfolio. This low correlation means alpha management can increase asset diversification and hence increase our risk-adjusted returns.

A structured approach is vital for successful alpha management. Risk-taking needs to be balanced between various different strategies and we continually need to develop our methods for achieving alpha returns. Since 2008 our asset management model has been based on separation of alpha management from beta management (financial market exposures). This approach means our alpha managers can focus exclusively on position-taking and makes it easy for us to evaluate their performance.