Asset allocation of pension funds in Europe will shift towards greater diversification out of domestic assets, with particular emphasis on equities, as a result of European monetary union.
In a City University Business School report I put together I looked, critically at the implications of the Euro for the investment management industry. The report surveyed the opinions of 25 major fund management organisations in Eur-ope, who manage a total of $870 bn assets for a wide range of clients. This represents 18% of a $4,732 bn industry.
Nearly 95% of those European fund managers surveyed expected investment by pension funds in non-domestic assets to increase, with an overall shift towards equities from bonds. In most Continental European countries, there are strict currency matching rules which require 80% of assets to be denominated in the currency in which liabilities arise. The disappearance of currency risk will change the investment perspective for pension funds and other pools of assets where currency matching is practised. The geographical scope of currency matching constraint will widen to encompass the entire Euro-zone, thereby increasing the scope of asset diversification.
EMU will prove a significant stimulus to increased investments in European equities and will fuel an equity investor culture throughout institutional and retail investors. Growth and increased correlation in European stockmarkets is foreseen. The fund management in-dustry predicts that sector allocation and stock selection will in-crease as a source of driving ex-cess returns relative to country allocation. As a result, fund managers’ European equity processes are expected to change with growth in credit analysis teams, further incorporation of quantitative techniques, and increased usage of European emerging market equities and bonds in pension funds.
Pension funds must focus on the practical implications of EMU for funds. Diversification from domestic securities to other countries requires greater awareness and understanding of other investment opportunities. The modification of pension and insurance funds’ asset strategy on the arrival of the Euro will require a number of existing domestic fund managers to widen their expertise from domestic ass-ets. International fund managers and other investment consultants are well placed to provide advise on the issue of diversification in a Euro-denominated environment.
Strategic consolidation in the existing fragmented European fund management industry is expected. Those fund managers with sufficient capital, broad investment capabilities, wide distribution networks, and innovative skills in terms of products, client servicing and technology will benefit. The hunt for these key success factors will lead to an increased wave of fund management mergers and acquisitions.
As pension funds become more sophisticated in their investment strategies, they will drive a harder bargain with financial service providers. Over 65% of fund managers surveyed predicted that institutional clients will become more discerning in terms of investment performance, service quality and price.
The fund management industry sees monetary union as part of the trend to globalisation and convergence of investment markets. EMU will only act as a powerful accelerator on the existing industry dynamics. Inhibiting factors such as delays in implementing investment decisions and the natural risk aversion of pension funds will still exist in the short term. However, EMU will enable pension funds to expand significantly by increasing the capacity for investment within and outside the European Union.
Christian Elsmark is responsible for European institutional marketing and sales at Rothchild Asset Management Limited, London.