When we think of Switzerland it is easy to become carried away with one central theme: liquid. Glaciers giving way to babbling alpine streams and pristine lakes; sturdy mountain cattle providing the abundant milk that flows into some of the world’s best chocolate and cheeses; the cheeses make us think of the delicious – and famously liquid – Raclette and fondue; wines which, though little known and understood outside Switzerland, are excellent, as is the vast array of fruit schnapps.
What is also little known and understood outside Switzerland – and to a degree in Switzerland itself – is the great Swiss paradox. As we wax lyrical about the country’s liquid properties, how can it be that Swiss pension funds are confronted with such illiquidity and so many restrictions generally when they try to invest their members’ money?
The answer to this question begins with a familiar tale. As in other markets, balanced management delivered disappointing results during and in the wake of the stock market turmoil and many of the larger funds have taken an interest in specialised management. What makes Switzerland decidedly unfamiliar, however, is that with 6,000 of the country’s 8,000 pension funds having assets of less than CHF10m (E6.4m), specialised management is not an option for most of the industry.
Jürg Roth, head of institutional clients at Credit Suisse AM in Zurich notes: “Although we have seen a shift to specialised management, it was not a significant one. Passive mandates on the other hand represent 50% of all new RFPs compared with around 30% four to five years ago.”
The fragmentation of Switzerland’s pension fund market has opened further opportunities, as Andrew Marks, vice-president at T Rowe Price Global Investment Services explains: “As many do not have the size and hence the resources to take on specialised management there has been an explosion of interest in multi-management.”
At present most of these funds are investing in an Anlagestiftung, effectively an investment foundation for institutions. Most of these are run by banks or insurance companies but there are also large pension funds such as Avadis, the ABB fund, which have set up an Anlagestiftung. At June 2005 the assets of these funds totalled CHF66.9bn, up 9.5% on the position six months earlier.
They also derive custom from the Sammelstiftung, formed independently through a consolidation of pension funds. They are transparent legal entities providing a vehicle in which pension funds pool their assets. However, some of these have grown to a size where they have the resources to take their own investment decisions.
This segment of medium-sized funds is often supported by independent investment fiduciaries such as Zug-based Altis Investment Management. “Funds in the range between CHF300-500m of assets under management are too small to do all the work themselves but too sophisticated to simply take ready-made multi-manager products,” says Richard Jacobs, director of portfolio management at Altis.
He adds: “This market is covered by investment fiduciaries servicing their clients using the multi-management concept. The operational platform is often still provided by the big banks.”
The success of fiduciary managers derives from the fact that institutional investors see the big banks as lacking independence. “The main players - Julius Baer, Pictet, UBS and Credit Suisse - often have 30-40% of their own product in their multi-management vehicles,” says Jacobs. “This lack of independence is not appreciated by the institutional investors. Fiduciary companies play an important role in providing end users with the independent management that they need.”
He adds: “We use several of the big banks’ operational platforms for our clients. Furthermore the big banks are well geared up for this. Credit Suisse and Julius Bear, for example, have had large dedicated desks serving intermediaries for a long time. The foreign players, such as Frank Russell, SEI or Northern Trust, should have good chances in the multi-management market but we haven’t seen much activity yet.”
When we look for reasons for the failure of active management we should also consider that of the typical pension fund allocation of around 30% to equities half will be invested in the local stock market. The Swiss market is highly concentrated, with the top 10 stocks accounting for up to 80% of the value of the market. “There is little information advantage to be had because everyone is covering them,” says Stephen Mills, member of the executive board at Schroders in Zurich.
Rudolf Lörtscher, consultant relationship manager at UBS Global Asset Management in Zurich notes: “Swiss pension funds are more globally diversified than in other markets, with 50% of the equity portion in foreign equities. The larger funds are more sophisticated so go for more international equities. One new trend is now to go more systematically into small and mid-cap stocks to achieve broader diversification.”
So how far will managers benefit from the move to indexation? Urs Landolt, a member of the management committee of asset management at Julius Baer in Zurich, says: “There is an increased trend among medium to larger-sized pension funds to have an indexed core of, for instance, Swiss equities and bonds and actively managed satellites such as emerging markets equities and high yield bonds.”
Observers estimate that the importance of indexation in the market may vary between 40% and 70% of assets under management.
The other reason for the move to passive is that funding levels have made funds more cost sensitive. “When managers achieved returns of 5-10% nobody cared about costs,” says Roth. “But, for example, a fee of 50 basis points out of a return of 2-3% is significant.”
Funding levels have fallen from upwards of 130% when the stock market was at its peak to between 95% and 105% at the end of 2004. Constantino Cancela, general director of Synchrony AM, the asset management arm of the Cantonal Bank of Geneva, notes that instead of building reserves pension funds consumed them by distributing returns to members. He says: “The second pillar was designed to protect against inflation and when it yielded double inflation people gained a false confidence.”
Funding levels for public pension funds tend to be lower – around 90%. “Here too there has been mismanagement; we have even seen fraud,” says Landolt. “The taxpayer guarantees the deficit. Private sector funds are questioning the validity of this. There is much discussion in parliament about this too.”
Although funding levels generally might be what Rolf Banz, chief investment architect at Pictet Asset Management in Geneva describes as “paradise” compared with some of Switzerland’s neighbours, it has nonetheless reduced the appetite for risk.
According to figures provided by CSAM, ex-ante volatility of pension fund asset allocation was 7.75% in March 2000. This decreased to 5.3% in March 2003. However, it had recovered to 6.4% by March this year.
But low funding levels also put pressure on funds to boost their coverage. “More people think in terms of absolute returns,” says Jean Keller, CEO of 3A Alternative Asset Advisors, a part of Banque Syz in Geneva. “There is far more appetite for high-risk products with a tracking error of 8% or more. Those who do index plus 2-3% have had a hard time and are all failing.”
As Landolt notes, “there is an increased trend among medium to larger sized funds to have an indexed core of Swiss equities and bonds and satellites of emerging market equities and high yield bonds”.
Currently the yield on a 10-year government bond is around 1.9%. This has added some urgency to the search for new sources of return. As René Sieber, director at Dynagest in Geneva explains: “Swiss pension funds were among the first in Europe to use hedge funds. But given their shrinking expected returns pension funds are moving more to foreign equities and bonds.”
But how well equipped are Swiss funds to consider foreign markets? Marks notes: “We are all conditioned by our environment. Swiss pension funds have grown up with their domestic stock exchange, which is limited in size and has never presented style considerations. To some degree, these limitations of the domestic market may help explain the widespread scepticism about style investing on both a philosophical and practical (in terms of assets invested) level, although the latter of these is primarily driven by other factors such as volume of assets.”
Pension funds are also shifting to private equity and commodities. “The low yields have also generated interest in alternative sources of fixed income revenue such as structured products,” says Roth. “The problem is that the boards of many smaller pension funds do not understand the new products and if they don’t understand they would rather say no.”
The market is very illiquid in bonds. Part of the reason for this is the debate that has been under way since 2000, at all levels of Swiss society, concerning national endebtedness. “For example, the State of Geneva is CHF15bn in debt,” says Keller. “And one in two people in Geneva know that. So government - at federal and state level - have been pushing for deleverage, and this means fewer bonds.”
A testimony to the importance placed on this matter by the people is the growth in popularity of the ultra-right Swiss agrarian party which advocates that government should not spend more than it earns. It now has 20% representation nationwide.
The corporate bond market in Swiss francs is also very limited. “As the business of large companies like Nestlé and Novartis is largely foreign, they tend to issue bonds in foreign currencies,” says Keller. A typical portfolio is 70% invested in bonds of which two thirds will be in Swiss francs. “Given the illquidity the spread is high – up to 40 basis points, your investment starts with a huge handicap,” says Cancela.
Not only are the bond issues few and far between, as Alexandre Kuhn, director at Dynagest points out, the liquidity in the secondary market for Swiss franc domestic issues is almost dead. “The absorption by institutions is almost immediate and because of the illiquidity of the market the policy tends to be buy and hold.”
He adds: “So there are two options: you can either buy and hold because the market limits other strategies - and if you try to sell you won’t be sure to find a buyer because of the broad spread; or you can go for passive management of government bonds.”
As a result of the illiquid market in Swiss franc-denominated bonds we are seeing a move to foreign corporate bonds hedged back to Swiss francs and euros. “There are more issues and hence more liquidity in the foreign markets,” says Lörtscher.
But this too poses challenges: “You don’t have to use Swiss government bonds, but but there is a reluctance on the part of some funds to consider the more exotic part of the fixed income world,” says Mills.
Yves Delaporte, executive vice-president at Lombard Odier Darier Hentsch in Geneva counsels caution: “The main thing is the risk profile. So we have not advised an aggressive move to alternatives to compensate for the low yield on government bonds. We have moved to alternatives to achieve upside but minimise downside.”
Illiquidity is a major factor affecting Switzerland’s institutional investors. Just like the bond market, Switzerland’s real estate market is also difficult to penetrate in efficiently due to lack of movement and poor accessibility.
In Switzerland real estate was used as by pension funds as a substitute for equities which for long time were not considered suitable for pension funds. Its attractiveness lies in its steady yield of around 5% and being supported by low financing costs where a 10-year fixed loan at can be had at a rate of 3%.
There are a number of ways institutional investors can invest in real estate. One is direct investment, but given that investments tend to start at around CHF100m, a fund would need a size of around CHF500m to be able to consider this option. Smaller funds can invest in a real estate management company although these tend to offer very little diversification. They can also invest in a real estate fund but given that demand vastly exceeds supply these funds demand a premium of anything up to 25%; or they can invest in real estate foundations but there is often a long wait for these.
The illiquidity of the market is due to a number of factors. Firstly, there is no trading in hotels, which have tended to be family owned and commercial property tends to be owned and leased back. “A large part of the real estate market for pension funds has been residential,” says Keller. “But the problem with the residential market is that there is no event: in London one can visit 50 houses a day but in Switzerland people don’t own houses and if they do they own them for life. And it is difficult for the pension fund to know what things are worth when they don’t change hands.”
The Swiss don’t own their own houses because the big owners are the pension related insurance companies and pension funds. “For example, the City of Geneva pension fund has around 25% residential real estate in its pension fund,” Keller continues. “Most large housing projects are sponsored by a local government pension fund.”
The illiquidity of the market does not mean that funds lack sufficient investment in real estate. On the contrary, as Banz points out: “On average funds have 17% of their assets invested in real estate,” he says. “Most funds have too much real estate - too much because it is not diversified. Most of their property is in Switzerland but Switzerland is small. This is an argument for diversification into international property.”
As with equities and bonds, the solution might indeed be to invest more in foreign assets. But here too Switzerland’s institutional investors are frustrated because, as Keller points out, “the exposure to foreign investments is being eaten up by foreign equities and bonds due to the limited opportunities in the Swiss stock and bond markets.”
Foreign investments as a proportion of the total pension fund portfolio are limited to 30%. Foreign companies issuing Swiss franc denominated bonds would also be counted as a foreign risk. There is also a limit of 50% on equities.
It is possible to obtain flexibility in these limits from the local cantonal authority if one can demonstrate a good level of funding and guarantees from the sponsor. “Switzerland is a very pragmatic country,” says Mills, “but it is more the exception than the rule because not all funds are able to provide these insurances. So I would rather there were no limits at all. In any case some of the limitsare outdated.”
Investment strategy is also limited by the minimum guaranteed rate of return, currently 2.5%, which pension funds need to achieve each year. The consensus among managers is that it should go. “It is a political rate not an economic one,” says Banz.
Mills goes further, saying: “Whatever the level, the guaranteed rate is a blunt instrument and it encourages market participants to avoid the fundamental funding and management issues. It is largely an arbitrary number and forces pension funds to focus on the calendar year in their investment strategies.”
He adds: “Arguably it can be considered as counterproductive because pension fund managers could hide behind it and say we have got the return so we are doing our job. It has not prevented underfunding, for example. So setting a guaranteed rate is not the same thing as regulating pension funds.”
Daniel Muntwyler, head of institutional clients at Sustainable Asset Management (SAM) in Zurich highlights another way in which the guaranteed rate constrains investment strategy.“If the system was more long-term and market oriented it would be more predictable,” he says. “Now it is a bit too political. This creates much uncertainty in the market”.
Like the regulations concerning investment limits and the minimum return, those that were recently introduced to bring more transparency of fees have also frustrated asset managers. The new rules will enable pension funds to see what proportion of the fee is spent on distribution and how much on asset management. “There will be more information but how useful will it be?” asks Banz. “It is just another example of the regulators controlling what can be controlled as opposed to what should be controlled.”
He adds: “There is too much focus on costs and not enough on performance. What’s wrong with management subsidising a fund to get it off the ground? Furthermore, percentages do not give the complete picture and may lead to misunderstandings. For example, a smaller management fee may mean that it is a bigger fund. The regulator is bashing the industry over the head because the total expense ratio for each fund sold here as a percentage of net asset value has increased. However, the regulator has not noticed that we are now using more exotic funds. The regulator assumes that the market is a cozy oligopoly when in fact it is very competitive.”
But it’s not all frustration on the regulation front. Official approval was recently granted for rebates that asset managers negotiated on mutual funds to be passed on to institutional investors, although the practice had been tolerated in the past. “This is very positive because it allows the use of mutual funds within mandates,” says Banz. “This will encourage more open architecture.”
In a competitive market like Switzerland fees are bound to be an issue; it is not surprising that this has been aggravated in the challenging market conditions that prevailed recently. “Certainly it was more of an issue over the last couple of years when underperforming managers were offering dumping fees to enable them to keep or win business,” says Mills of Schroders. “Some are still very aggressive on fees because their products aren’t so strong.”
Mills is concerned that access for foreign managers to the local market remains restricted in certain areas. “Some large pension funds say that they will not work with the foreign houses. We have a Swiss team managing CHF2bn in Swiss equities, but some pension funds still say that they want a Swiss bank. They may know the local manager personally; it is a political decision at sponsor level, but is it in the interest of the beneficiaries?”
But Marks of T Rowe Price has some sympathy for the attitude towards foreign managers. “It still surprises me how many managers build business development strategies for new markets on single factor analysis,” he says, “the single factor being size of the pension fund asset pool. This is lunacy, as it fails to take account of competition, fee pressure, cultural factors and product fit considerations. Many of these factors are crucial in the Swiss market and the country has seen more than its fair share of short-lived, frenetic sales campaigns by Anglo Saxon managers, who initiate and cease activities in the market within a two year timeframe. If I were a Swiss pension fund manager I would be pretty cynical about foreign managers.”
Jacobs believes that the growth in fiduciary management will open the door to foreign specialist managers. “Fiduciary consultants’ raison d’être is their independence; their ‘best of breed’ philosophy would be impossible without foreign specialist managers in their selections.”
This trend is encouraging, but the more fundamental issue facing the market is over-regulation. Political shifts add concern in this regard. Time they all tried to go a little more with the flow, perhaps?