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Counting the cost of a downturn

Irish pension funds find out the hard way that eggs really should be kept in more than one basket, Rachel Fixsen discovers

In theory at least, managers are committed to protecting pension funds through broad diversification. So how was it that Irish pension funds ended up so over-exposed to one small equities market, which represents less than a hundredth of the world market? The logic behind home bias is outdated and has cost the country’s pension funds dear, say consultants, and the lessons to be drawn are clear.

According to consultancy Hewitt Associates, 2007 was the first year since 2002 that Irish pension managed funds lost money, with the funds - measured by the Hewitt Managed Fund Index - posting a negative return of 2.5%.

In December, managed funds continued the slide seen in the previous month, returning -1.4% on the month. The losses suffered in the second half of the year amounted to 7.5%, more than erasing the 5% gains made in the first half.

The vast majority of Irish pension managed funds would finish the year with a loss, Hewitt anticipated, though it conceded that one or two exceptions were possible.

“The downturn in equity markets, following the sub-prime issue in the US in the second half of the year, is largely to blame for this return,” the consultancy said.

Hewitt said it was Irish equities in particular that had been behind the negative return, with the market’s heavy financial focus. The Irish equity market was down almost 25% in 2007, and Irish equities account for about 15-20% of the Pension Managed Fund index.

“One of the big characteristics of pension fund investment in Ireland has been a large proportion of assets in Irish equities,” says Ian Sykes, investment consultant at Watson Wyatt in Dublin. “On average, the country’s pension funds have had well over 10% of their money lodged in the domestic stock market.”

The fact that the Irish market is very heavily concentrated around banks and financial stocks, as well as the construction sector, has emerged as a problem, with both sectors having suffered heavily so far as a result of the sub-prime crisis. “We’re exposed to some very high risks,” adds Sykes.

In its Irish Pension Funds survey, Rubicon Investment Consulting notes that Irish equities represent about 15% of assets in managed funds, which is equivalent to more than 20% of the funds’ equity portfolios - even though the Irish stockmarket represents just 0.3% of the world market.

“Such an overweight position would be of concern for most unbiased investors, regardless of the market in question,” says Rubicon managing director Fiona Daly. “The financial sector makes up over 40% of the ISEQ index.”

However, Rubicon put the losses in their long-term context, observing that the investment horizon of most pension schemes was generally over 25 years. “Equities had historically given significantly higher returns over the long-term than bonds, property or cash, although this did come at the cost of greater volatility,” adds Daly.

Mercer presented data at the end of November, and it showed even at that point that pension funds in Ireland had eroded all of the €9bn gains they would have earned for the year. It also said the country’s pension funds had been hit hard because of the market’s high exposure to financial and housing-related stocks, with both sectors starting to suffer either due to the lower demand for housing, or the global credit crunch.

According to Mercer, around a quarter of its Irish clients have between zero and 5% exposure to Irish equities, and another 25-50% of clients were moving into three-year exit programmes to scale down their domestic equity exposure to a point when it only accounted for between 2% and 5% of assets.

Looking at a broader picture, figures from the pension fund survey of the Irish Association of Pension Funds (IAPF) show that equities accounted for 63.4% of pension funds’ assets; the average Irish equity holding, across all segregated, unitised and insured funds, is around 11%.

So why is it that Ireland’s pension funds have found themselves so over-exposed to the domestic equities market? Though most see the wisdom of diversification in theory, the conundrum has been that practical experience of recent years proved that the funds could make good returns from the domestic market, says Jerry Moriarty, IAPF director of policy. “They have done quite well out of it,” he adds. “There is always going to be a natural bias to your home market,” for any investor, because they are more familiar with the companies issuing the stock, he says. “It’s just a case of how much it should be.”

Sykes says that for a long time now, pension funds have intended to diversify towards euro-zone equities. The traditional reason for sticking to the domestic market was to avoid currency mismatching, but this argument evaporated with the advent of the euro.

And for several years, those pension funds that were slow to move towards the euro-zone managed to reap huge benefits from that hesitation. Irish stocks have powered ahead, with the ISEQ 20 index putting on around 65% in the two years to June 2007.

“If you think the Celtic tiger may now be past its prime and you are worried about its exposure to certain sectors, you may take the view that it’s time to diversify into euro-zone equities,” Sykes argues.

Many pension funds were already considering the move, but Sykes now sees this trend gathering pace. While Irish pension funds are moving to protect their assets from these risks, they are not doing this as a direct result of the market slump that has hit their asset levels in the last few months.

“I would expect the trend that has already been occurring to continue - the move away from Irish equities towards euro-zone equities,” he says.

Even though the allocations of Irish pension funds to domestic equity are still relatively high, Jennifer Richards, head of Standard Life Investments in Ireland, observes that they have reduced their exposure significantly since the euro took over as the national currency unit. “Before that, there was a currency reason for holding domestic equities,” she says, adding that in the pre-euro days, allocations to the sector were around 35% of total assets.

Though there is no denying the Irish stock market has suffered as a result of the sub-prime crisis, this has been largely through the indirect effects of the financial malaise, Richards asserts. “There hasn’t been a direct link with sub-prime, because the financials don’t seem to be exposed directly to US sub-prime loans,” she says. More general economic factors have been at work.

“There has been a slowdown, and the tightening of lending in the interbank market has clearly had an impact; there is obviously a knock-on effect in the Irish market primarily because of the large financials focus,” she says.

Neither Irish pension funds nor their asset managers are suffering any direct effects of the sub-prime affair and related credit difficulties, says Oliver Fahey, head of pensions marketing at AIB Investment Managers in Ireland. It is only the market depression that is taking its toll.

Brendan Johnston, pension director at Eagle Star, agrees, saying the banks that make up so much of the Irish market are probably not as affected by the whole debacle as is assumed externally.

The Irish National Pension Reserve Fund (NPRF) has not suffered any direct impact. “We have little or no exposure, and we haven’t taken direct write-downs as a result,” says Ronan O’Connor, head of risk and asset allocation at the National Treasury Management Agency (NTMA), the body responsible for managing the reserve fund.

Richards says the exposure by pension funds to the domestic market has long been seen as too high, and although funds have been aiming to rebalance it, the boom in the Irish market has been a disincentive. “It has been working the favour of Irish pension funds for a long time, so that has been a theoretical discussion,” she says.

Some asset managers have reacted to the weakness in stocks both in Ireland and abroad. Bank of Ireland, for example, had come back to a neutral weight on equities, according to Daly. But it was hard to know what to do in conditions like these. “If you get out now, you’re just going to crystallise your losses,” she says.

What the market needs is more information about which institutions are affected by the bad loans in the US, and just how badly. “Once the impact is known, the market should normalise,” says Daly. “Then investors will start focussing on fundamentals, and people will be able to put proper valuations on equities.”
 
Daly also sees a move away from geographical allocation among pension funds. “There’s more of a recognition that we are looking at a global economy, and investors are looking more at emerging markets, starting to realist that places like China and India are thriving,” she says.

Passive investing is also drawing in the pensions euros. “There has been a move towards passive; maybe people will think about splitting up active in some areas and passive in others,” Daly suggests. “These are all things that may be revisited, but it’s hard to say how it will pan out.”

While the sub-prime crisis is a market event that will eventually work its way through the system, she says it is also a wake up call for pension funds, and an opportunity for them to protect themselves in the future by making changes to the way they invest.

According to Daly, the biggest lesson pension funds could learn from the upheaval is that they need to consider where they are investing their money relative to their liabilities. “It may give people the impetus to look at alternative assets,” she predicts. But many Irish pension funds are quite reluctant to move into these asset classes at all. “They’re not well understood or seen as easy to measure,” she says. It is important to focus on the level of risk. “If they’re not following a matched strategy, maybe they’ll think about that.”

While most Irish pension funds see Ireland as their home market, the NPRF regards the euro-zone as its domestic market. Therefore, it has less that 1% of its investments in the Irish stock market, compared to the 15-20% of assets that Irish institutions as a whole have lodged in Irish equities, says O’Connor.

He adds that Irish pension funds have been intending to diversify more for some time, but because the Irish economy has been performing well until quite recently, moving out of the domestic investment scene has not been attractive. Now, however, it is tricky for many pension funds to unwind their large positions in Irish equities.

“They are finding it difficult to find buyers,” says O’Connor. “There’s an overhang where pension funds are overweight and there are no natural buyers at the moment.”

Sykes contends that what has happened to the markets should be taken as an opportunity for pension funds in Ireland to consider their exposure to risks more generally. “I would say the issue of being exposed to risk in a few sectors has always been there, and should be dealt with as a matter of priority - this has just highlighted the fact,” he says.

“Do Irish trustees really take risk management seriously? Have they had a look at other areas of the portfolio, and how exposed are they to certain types of risk?”

Whatever the geographical spread, their assets are certainly very heavily invested in equities. If stock markets were to crash, pension savings could be decimated. Funds should be considering increasing their bond weightings, as schemes in several other countries have, Sykes suggests.

“Although that’s been talked about, I’m not sure the majority of schemes have made much progress with it. They should consider what other nasty surprises might be out there and what the effect could be.”

Moriarty also believes last year’s experience will focus minds on the need to diversify. “It’s an area which trustees would be quite aware of anyway - risk and return - it’s a constant thing they need to be monitoring,” he says.

However, he points out that diversifying equity investments across a broader geographical universe is not a cure-all either. These days, he explains, equities markets around the world have very strong links and often move together. “If you’re just investing in another equities market in another zone, you’re not going to get that pure diversity,” he says.

More generally, Alan Hickey marketing director at Setanta Asset Management cautions that any exercise to spread equities investments more widely has to be done carefully. “Diversification is always a benefit, but you have to make sure you diversify into quality assets,” he says.

Fahey agrees that Irish funds have to learn more about risk. “There’s a real heightened awareness among pension fund trustees in particular of monitoring and being aware of risk in their portfolio,” he says. But knowing about the risks in an investment portfolio is not a simple matter, he warns. “It’s difficult, because almost by definition, you won’t be aware of it. It’s up to trustees to be fully au fait with what they hold.”

In a world of increasingly complex financial instruments, Fahey finds the goalposts have moved ever further away from trustees in their efforts to get a grasp of portfolios. “It is extremely difficult for trustees to understand the financial details of some of these instruments,” he says. “Most trustees are part-time, and that puts the onus on asset managers and investment consultants to explain things and not take anything for granted.”

Some pension funds in Ireland have increased the amount of fixed income investments they hold relative to equity, Fahey says, though this is largely an exercise in liability matching rather than diversifying across asset types. “Certain sponsors are very much aware of this, because of accountancy regulations,” he says. But the move to fixed income has probably been slower than generally anticipated.

“Some of the bigger pension funds are looking at LDI,” says Johnston. “But the question is which investment to choose.” The league tables produced by Hewitt, Mercer and other consultancies are the resources used by funds to make their decisions, he says.

For pension funds in Ireland, the main focus is managed funds, he adds. “There is some movement towards hedge funds, but not very much.”

Johnston sees little shift in terms of which asset managers the pension funds the pick. “Things haven’t moved much,” he says. “Local managers have done quite well in terms of investment management, and international managers would be looking for business.”

But Fahey stresses that shifting the weight of assets towards fixed income and away from equities is not likely to help in reducing exposure to a general market slump. “There is quite a link between all financial instruments,” he says.

Last year at least, bond markets provided some relief to pension funds, since yields rose around 0.5% over the year, shrinking the value of liabilities, Hewitt said in its managed funds survey. “Therefore, for most relatively immature defined benefit pension schemes funding positions should have improved over the year, by 5-10% ignoring improvements in mortality,” according to the firm.

Though Fahey sees lessons for investors to learn from the sub-prime crisis and the effect it has had on equities prices, he emphasises that it is very difficult to protect yourself against something that is unforeseen.

“You have to put the link between assets and liabilities to the forefront of your mind,” and trustees must also be aware of their sponsor covenant, and judge how confident they are that the sponsor would step in to fill a deficit, he says.

But where will the ailing markets go from here? It seems that rarely has the future movement of financial markets been quite so opaque. If there is one thing market watchers agree on, it is that nothing is certain now.

“There’s a lot of uncertainty in the stock markets globally,” says Daly. The jitters may have started with the banks and others in the financial sector, but now the wariness has spread to other industrial sectors too. “Nobody knows what the final impact will be.”

Neither does Fahey claim to have a crystal ball. “There is the fear that there will be some unknown, some financial instrument that the banks hold,” he says. “It would be a brave person who would say we’ve heard the worst.”

It will take time for all to be revealed. “We need to go through a full cycle of quarterly reporting and annual reports,” Fahey insists.

Richards says the investment team at Standard Life is cautious about the road ahead. “Generally, we’re looking at the credit situation and conscious there’s no short-term solution,” she says. “It’s going to be impacting on financial markets for a while yet.”

The fact that some major institutions, such as Citi, are moving to take loan losses onto their books signals an improvement in the markets, but in the future investors will have to accept that it will be much harder for businesses across sectors to borrow money, she says. “While there’s an improvement in liquidity, we’re looking at the impact this will have on companies.”

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