Continental European pension funds are poised to shrink their domestic allocations still further in favour of European assets over the next three years, according to new research we have carried out.
These results are based on replies from 184 pension funds in 11 countries, including the UK, with assets under management amounting to e712bn.
The continuing march into Europe will occur in both equities and bonds, but the most dramatic shift will take place in euro-denominated equities. European pension fund respondents (outside the UK) currently allocate some e149.5bn to this asset class (just over one fifth of their total assets). However, they indicated that they would boost this allocation to one third of assets by 2003.
In another of the survey’s chief highlights, respondents said that their allocation to alternative investments was set to double over the next three years, with private equity and hedge funds being the front-runners.
The survey underscores the continued strong appetite for equity investing among Europe’s institutional investors. In particular, it shows their willingness to venture away from the safe haven of their own domestic markets in order to benefit from the broader range of opportunities that Europe has to offer.
Hand in hand with the trend to broader European equity strategies goes European funds’ growing tendency to invest by industry sectors. This has become a dominant theme in the past few years, as sector rotation has been a key driver of equity returns. A sector approach was favoured by just over half (53%) of respondents, against little more than a quarter (26%) that chose to invest primarily by country and 14% by region.
In general, this trend was more marked among countries with the narrowest domestic equity markets. These small markets are subject to strong sector bias, so pension funds compensate by investing in companies listed elsewhere in Europe. For instance, 88% of Danish funds and 80% of Belgian funds chose a sector approach. By contrast, 35% of pension funds in the relatively well developed Swiss market (which is outside the Euro-zone) chose to invest by sector.
Style is still an unpopular way to allocate assets in continental Europe and was picked by only eight funds among the respondent base. Style is more accepted in the UK, with 19% of funds saying they invest this way.
Though the survey promises large flows into euro-denominated investments, it is not clear whether these are euro-specific mandates or whether they are part of broader pan-European investment strategies.
The choice of benchmarks also points to a broadening mindset on the part of Europe’s institutions, with nearly three quarters of respondents’ assets (excluding UK funds) benchmarked against a pan-European index, while only 22% are measured against a narrower, Euro-zone specific benchmark. The attitude among many funds seems to be that if they are investing outside their own borders, there is little sense in limiting themselves to the Euro-zone when the rest of Europe also offers good investment opportunities. Nevertheless, funds acknowledge that pan-European mandates are complicated by currency considerations.
The build-up in Europe seems to be mainly at the expense of domestic assets and though domestic equities are set to decrease slightly, domestic bonds are likely to take most of the hit. Respondents on average indicated that they intend to run down their domestic bond portfolios from 17% of total assets (e121bn) to 11% by 2003.
Among the most dramatic moves in this direction will be made by Scandinavian pension funds. Swedish respondents said that they would decrease domestic bond allocations from 37% to 28% over the next three years, while upping their Euro-zone equity allocations from 11% to 18%.
Danish respondents indicated that they would be taking equally drastic steps, slashing domestic bonds from 44% to 28% of their assets and increasing Euro-zone equities from 14% to 18%.
Another of the survey’s highlights underscores the growing appetite for alternative investments among institutional investors in Europe. Survey respondents indicated that they were looking to double their allocation to alternative assets by 2003 – though admittedly from a very small base (1% of total assets at present). Even so, a doubling of the e7.12bn pot that respondents already have allocated to alternatives is not insignificant, given that the market is relatively immature.
These seismic shifts are likely to change the balance of power among investment managers, as the pool of potential mandates expands in some areas and shrinks in others. Domestic bond managers – the big local banks and insurers – may well lose out as assets migrate abroad if they fail to adapt their strategies. On the other hand, international equity managers appear to be in a good position to benefit.
Trends in outsourced mandates give some more clues as to how managers may be placed to take advantage of the changing appetites of Europe’s pension funds. Survey respondents have awarded some e350bn, or 48% of their assets, in external mandates to third- party managers.
The most popular asset classes for outsourcing among this group of pension funds are alternatives (89% outsourced), followed by foreign equities (63%), domestic equities (62%) and euro-equities (56%). Alternatives and Euro-zone equities are also the categories poised for the biggest boost in allocations, which must be good news for investment managers.
While balanced management is still very much alive and kicking in Europe, there is plenty of demand for specialist managers. In Europe ex-UK, respondents’ outsourced assets are split exactly 50/50 between balanced and specialist management. A balanced approach is still especially popular in France, where 81% of respondents’ outsourced assets are managed in this way. Surprisingly, despite their sophistication, Irish and UK funds also seem to find the balanced approach far more comfortable than do most of their continental counterparts. Irish respondents gave half their outsourced assets to balanced managers, while the figure for UK funds was 43%.
By contrast, specialist management wins hands down in the big pension markets of the Netherlands and Switzerland – Dutch respondents said that 72% of their outsourced assets are run by specialist managers, while the corresponding figure for the Swiss was an astonishing 94%. Of those external mandates, global equities and bonds were most popular in the Netherlands, while Swiss funds handed out more in alternative investment mandates than in any other asset class.
These are likely to be strong future growth areas for managers, as European institutions continue to search for ways to boost their returns. When pension funds (including those in the UK) were asked to rank specialist mandates in order of future attractiveness, their responses showed a strong appetite for private equity and hedge funds. The worry here is that demand will outstrip supply, as most of the best managers have limited capacity and are already oversubscribed.
Bond strategies with the potential to enhance yields also appear to be poised for rapid growth – corporates, euro-denominated and global high yield bonds all ranked high on respondents’ list of favourite future mandates. Corporate bond managers have already seen an explosion in demand, with corporates already accounting for 4% (some e14 bn) in respondents’ outsourced assets.
Notably absent from the list of must-have mandates are emerging markets, which is not surprising given their stormy performance in recent years. So while Europe’s pension funds are willing to venture further afield, their appetite for risk is not without limits.
Philip Robinson is a senior consultant at Watson Wyatt, based in Reigate, UK