Baltic States now making rapid strides
Asset growth in the Baltic States has been extremely rapid over the last year, in no small part due to the rapid economic growth these countries have experienced. Latvia currently has the fastest real GDP growth in the EU, 11.9% in the first nine months of the year. Latvian assets under management have grown briskly: up 53% on year to end-September in the second pillar to LVL113.6m (€161m), up 36% for the third pillar to €65m, and up 22% to €129m for investment funds.
"We are still very optimistic,"notes Sergey Medvedev, first vice-president at Parex Asset Management, the country's biggest investment fund manager.
In the second pillar the driving forces include rising salaries and the active role of banks and fund managers in attracting new members into the system. In the coming years a further factor will be the higher contribution rate. Until the end of 2006, of the 20% of gross wages allocated to pensions, 18 percentage points went to the state's PAYG first pillar and 2 percentage points to the second pillar fund of an employee's choice. From the start of 2007 the proportion going to the second pillar doubled to 4%, and by 2010 the shares will be split equally at 10%.
This year the State Treasury will cease its activity as a pensions fund manager. In a system peculiar to Latvia, the State Treasury was the sole fund manager from the start of the programme in July 2001 until private fund managers started operating at the beginning of 2003. Its share has since shrunk dramatically, from 160,000 clients in 2005 to 115,000 at the end of 2006, although it still accounts for around 10% of second pillar assets under management. The rules governing the transfer of the capital from its fund will be published next month, and in August the membership and assets will go out to tender among the private providers.
The third pillar system is still small, with less than 100,000 participants compared with the 900,000 enlisted in the second pillar, but with the standard of living rising, Latvian citizens have more disposable income to invest for their retirement. "Initially most of the members were work employees, but now you have more individual agreements," reports Medvedev.
The investment fund industry has benefited from an increased level of confidence and a higher level of sophistication, although as Medvedev points out, investment funds "are still treated as risky investments, with investors preferring term deposits because of the generally low level of understanding" However, returns on term deposits are currently below Latvia's relatively high inflation rate, the highest in the EU. "Investment funds and real estate are the only products to offer a real return,"adds Medvedev.
Pension funds have also invested a portion of their assets into investment funds, 14% in the case of the second pillar and 23% for third pillar funds. In 2007 the suite of investment funds available will increase with the introduction of umbrella funds. Fund managers will also be able to register sub-funds in different currencies and share classes. There will also be greater flexibility in real estate investment, including purchase of property via special purpose vehicles, which will make such funds more tax efficient and less risky.
In 2006 the main trend in the investment fund industry was a growth in the popularity of equity funds, up by 60% on the year in the first three quarters of 2006, and a fall of 17% in fixed income and bond funds. The opposite was the case for pension funds. The equity share of mandatory pension fund portfolios fell to 3.8% by the end of the third quarter of 2006 from 6.6% at the end of 2005, and to 4.6% from 7.6% for private pension funds. "This was due to a tough situation in the Baltic equity markets in the first eight months of the year," adds Medvedev. "At Parex there wasn't any big reduction in our equity allocation, which helped us recover in the subsequent two months when the Baltic market started to perform well."
In contrast to Latvia, Estonia's investment fund sector is far larger than the second pillar, with €703m in equity fund net assets at the end of September and €370m in debt funds, compared with €424m in second pillar pensions and €38m in third pillar schemes. The second pillar's 43% growth in the first nine months of the year reflected a natural increase of a system that is compulsory for all new entrants to the labour market as well as high rises in wages over recent years.
Equity funds had a similar growth rate. The two sectors are intertwined as the pension funds invest heavily in investment funds. Under the Estonian system providers must offer a conservative, pure fixed income fund and can also provide riskier funds with varying proportions of equities. At the end of September the mandatory pension funds had 42% of their assets invested in bonds, 23% in equity funds, 14% in equities and 12% in other investment funds, according to data from the Estonian Financial Supervision Authority. Alternative assets such as real estate accounted for less than 1%.
However, a new investment law introduced in November eases the formation of real estate and venture capital funds.
Lithuania's asset management industry is the youngest, having started in 2003. According to data from the Association for Investment Management Companies Lithuania, at the end of October assets under management totalled LTL2.03bn €589m), of which life insurance portfolios accounted for 32%, second pillar pension funds 31%, third pillar funds 3%, money market funds 2% and other funds 29%. Since the end of 2005 assets under management have grown by 79%.
"The growth rate has been fast but the penetration of investment management is still low, around 4% of savings," says Jonas Irzikevicius, director general and CEO at SEB VB Asset Management, Lithuania's biggest investment fund manager and second biggest asset manager after Hansa. "However, the low penetration is a major driver. The industry is quite young and we are still in the process of educating our customers. They are realising now that shifting assets from cash and deposits into other savings products may be beneficial. As pensions grow, so people are becoming more knowledgeable about mutual funds."
Equity funds are by far the most popular, accounting for 80% of mutual fund assets, SEB VB Asset Management adds.
Although entirely voluntary, the second pillar pension system has proved very attractive, with 605,491 clients at the end of October. The current market penetration is estimated at 63% of elligible participants. The rate of asset growth since the first funds were launched at the end of 2004 has been accelerated by the rising portion of compulsory social security contributions diverted into the second pillar, from 3.5% in 2005 to 4.5% in 2006 and to 5.5% in 2007. And this year participants will be able to switch funds.
Although there are 12 bank and life insurance providers, the market is heavily concentrated, with the two leading companies, Hansa and SEB VB, holding a combined market share of close to 75%. There is even greater concentration in the third pillar, with SEB VB accounting for close to 80% of assets under management. According to Irzikevicius, most third-pillar customers are individuals who can maximise the tax incentives. While the system currently has 17,600 participants, Irzikevicius estimates that a third of the 1.2m workforce would be a reasonable target.
Each provider must offer a conservative fund invested in government bonds and can also provide additional funds with riskier horizons. According to data from the Lithuanian Securities Commission covering pensions run by fund management companies, in mid-2006 medium-equity funds (with an equity portion of 30-70%) were the most popular, accounting for 56% of second pillar assets under management, followed by small small-equity funds (23%) and conservative funds(15%). The riskiest funds, with a 70-100% equity weighting, accounted for less than 2% of funds.
By instrument, debt securities accounted for 52% of portfolios, equities 7%, collective investments such as mutual funds 34% and cash and deposits 8%. "We have become gradually more conservative this year," adds Irzikevicius. "First, we significantly reduced our strong overweight in equities, avoiding most of the correction in May and June, and later returned to a moderate overweight." SEB VB uses mutual funds for its global investment and has started to diversify into alternative investments such as commodity funds.