To date, the impact of EMU has not been significant for UK pension funds. Concerns have been raised over administrative implications - for accounting records, portfolio valuations, etc. - but there has been relatively little focus on strategic issues.

The introduction of a Minimum Funding Requirement and the need for a Statement of Investment Principles have been the main catalysts for funds to review strategy. This is normally done by an asset / liability study, leading to the adoption of a bespoke benchmark in which three decisions are required:-

p How much should be invested in equities overall?

p What should be the split between UK and overseas equities?

p What is the appropriate benchmark for overseas equities?

The introduction of the euro would potentially impact on the third of these decisions. However, most major European currencies have traded within relatively tight bands for some time and the introduction of a common currency makes little difference in practice.

Benchmark

Currently, most UK funds use the FT/S&P Europe ex-UK Index as the most appropriate performance benchmark for European equities. The 11 countries who are joining in EMU this month account for around 70% of that Index by market capitalisation. Although narrower indices are being introduced to reflect the performance of these 11 participants, from the perspective of a UK investor, there seems very little logic for change.

Tactics

Many pundits have argued that the introduction of the common currency will make European markets (particularly of the 11 EMU participants) much more attractive in investment terms, given the increased cross-border competition. However:-

p We would argue that this is a tactical" view which, if deemed appropriate, should be expressed by an active manager within his portfolio.

p Funds are already significantly overweight Europe relative to a Global index. Europe accounts for around 60% of the average UK fund's overseas equity exposure; by contract, European markets account for around 22.5% of the equivalent index!

Investment Management

This is the area of greatest change. In anticipation of EMU, most (though not all) managers have shifted the emphasis of their process away from country selection, primarily towards a pan-European sector approach. It is too early to judge the success of this change.

Looking Forward

It is interesting to consider what will happen if (or should it be "when?") the UK joins in EMU. to our mind, there are two key issues:-

p How quickly will UK equities and European equities be merged into a single pan-European portfolio?

p If this does happen, how will this impact on investment outwith Europe? International markets (outside Europe) currently account for less than 7% of a typical UK fund - providing relatively little diversification. Should this exposure increase (perhaps at the expense of the pan-European exposure) and, if so, how should any increase be allocated?

Fortunately, time (and the benefit of experience with the euro) would appear to be on our side!

George Henshilwood is partner at Hymans Robertson in the UK"

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