Heads above water
The Swiss pension fund market faces a dilemma. The recovery in stock markets last year lifted the heads of the second pillar pension funds above water.
According to Swissca’s survey of 180 public and private pension funds, cash ratios - in other words, coverage - had improved on average from 100 to 104 by the end of 2003.
Yet because the pension funds’ average allocation to equity is relatively low – between 25% and 30% according to the survey , many of them can only partly meet their reserve requirements.
Markus Wirth, head of marketing at Swissca in Zurich, says: “The important thing is that the risk ability is now quite low. If a pension fund has an equities exposure of only 25-30% it needs coverage of 115 to 120. Pension funds are going to need equities if they are to generate enough income.”
Asset allocation in Swiss pension funds has been remarkably stable over the past 12 months, asset managers say. This is borne out by the latest Credit Suisse AM(CSAM) Swiss pension fund index which shows that overall allocation to equities was 33.8% in the second quarter of this year compared with 31.2% in the same period last year.
Jürg Roth, head of institutional sales at CSAM in Zurich suggests that this stable asset allocation picture is partly a reflection of the way Swiss pension funds operate: “Because of their organisational structure pension funds are rather slow at making decisions. The pension fund board, which carries responsibility for setting or changing the strategic asset allocation usually only meets a few times a year, which was fortunate during the last equity downturn.
“They decided to decrease the equity proportion in their portfolios by the beginning of 2003. But before they began to sell, the markets recovered and equities went up. As a result the coverage of pension funds improved dramatically. Last year 40% of pension funds had under coverage. Now the figure is around 10% - and all because they didn’t sell equities quickly from their portfolios.”
Now pension funds appear to be content to leave their equity allocations at their currently modest levels. Dominique Fässler, responsible for institutional client relationships at Vontobel Asset Management in Zurich says this is because pension funds have objectives other than generating returns: “For the time being pensions fund are managing their risks rather than their returns. After a period of 15 years in which the equity portion of the portfolios has continually grown, this growth has come to a stop. Whether this is a temporary or a more permanent halt it’s hard to say. But some quite large pension funds in the country have less equity now than they had two years ago. So it seems that risk management has become the name of the game.”
Fixed income is still the single most important asset class in pension fund portfolios, with a total of 43.7% in bond weighting, compared with 45.9% a year ago. Asset managers like CSAM are trying to persuade pension funds to make this allocation work harder with products that include inflation-linked and insurance-linked bonds and target return products or TOPS - collective credit risk in short duration portfolios.
“We try to diversify the fixed income exposure into different sources of revenue, and we have seen high demand for this,” says CSAM’s Roth. “But the major part of portfolios is still invested in higher grade corporate bonds and government bonds. So there has been no dramatic shift into the newer type of products.”
Yet the pension funds’ reliance on traditional fixed income investments will not meet their needs. Currently they need to return 4.5% simply to keep their assets and liabilities in kilter. However, the yield of the Swiss fixed income portion in the asset allocation is well below 4.5%.
How can pension funds earn a better return from their fixed income allocation – limited by the regulations to 50% of their portfolio? Fässler at Vontobel AM says that pension funds are now looking at securitised real estate for better returns.
“Securitised property - property investment funds - which has a better yield than bonds is replacing Swiss fixed income to a certain extent,” he says. “This can partly compensate for the shortfall in traditional fixed income yields.”
Another solution to the problem of low fixed income yields, which has been adopted by the larger pension funds, is to take a core-satellite approach to portfolio management. “We have seen a tendency in the past to index the core and on the other hand increase the tracking error of peripheral investments with a significant tracking error,” he says.
Balanced mandates still predominate in Switzerland, says CSAM’s Roth. “The largest chunk of money is still in balanced accounts. But there is a division between smaller and medium sized pension funds, which are still invested in balanced accounts, and the large pension funds with assets of CHF 1bn and larger, which have specialised mandates.”
The use of core-satellite divides on rather different lines, says Udo Von Werne senior vice president at Pictet Asset Management in Zurich: “Overall, in the French speaking part of Switzerland, where consultants typically have less impact than in the German-speaking part, there is still the dominance of Swiss balanced mandates. In the German-speaking part, more and more pension funds are really trying to embrace the core satellite concept, with the core being indexed or enhanced indexed.
“On the balanced side, due to the disillusionment with most active asset managers, an increasing number of searches throughout the industry has been shifting towards more enhanced indexed or fully indexed balanced mandates. Pension funds will then try to beef up these mandates with truly active satellite products. Those satellite would include absolute return type of products, like private equity and real estate.”
For some pension funds the aim is not to replace a balanced portfolio with a specialist or core satellite portfolio but to add value to it Andreas Schlatter, head of institutional and wholesale business at UBS Global says: “This is an idea which is gaining momentum. Pension funds can add value to their balanced portfolios by opportunistically adding the right asset classes such as high yield, European corporates, maybe hedge funds as a strategic asset class, and other interesting revenue drivers.”
Swiss pension funds have not generally followed the example of, say, the UK where balanced funds have been split up into segregated accounts. The reverse may be true. Swissca’s Wirth says: “Some years ago a lot of funds changed to category mandates - equities or bonds - to generate added value. But now the actively managed mixed mandates are back with allocations to alternative investments and currency overlay. It’s not a return to balanced mandates. It’s balanced plus.”
Some asset managers now detect a polarisation of pension fund investment strategies with some funds looking for exposure to beta - market risk - and others searching for the alpha – pure active manager risk. Von Werne at Pictet says “Funds may not follow the traditional approach of selecting managers but will do their allocation based on actively budgeting alpha and beta risk.
“If funds are negative about the market they will probably reduce beta risk to almost zero and try to generate returns through exposure to alpha, if there is true alpha out there, with beta neutral, long-short type of funds. If pension funds want beta exposure they can probably purchase it relatively cheaply through indexed funds.
“What already has become very popular is to just to take pure beta risk. Ten years ago 95% of all asset managers provided ‘traditional’ active management, ie, mixing alpha and beta risk. Today demand for pure beta strategies has strongly increased and can be estimated as high as 30%. A clear reflection of this trend is provided by the performance of our quant team that manages indexed equities. They have seen spectacular growth in funds over the last five years from around CHF3bn to almost CHF10bn today.”
Von Werne says this polarisation could lead to a reduction in the number of asset managers in Switzerland. “ This concept would clearly threaten mediocre traditional active managers offering a mixture of alpha and beta, with tracking errors ranging typically anything between 1% and 3%.”
The market recovery may have bought these managers some time, he suggests “The temporary improvement in equity markets during 2003 and 2004 has lead to an improvement in cost income ratios, and that has taken the pressure off a lot of asset management firms to further streamline their product offering and rethink strategic direction. But depending on how the markets go forward, that could be a pressing issue in the not too distant future.”
Issues like alpha/beta separation reflect a change in pension fund attitudes, says Schlatter UBS Global AM: “Pension funds have begun to think about the fundamentals of managing their portfolios. They are asking themselves, ‘Shall I manage a liability benchmark portfolio and focus on real positive returns and no big losses, or shall I emphasise on actually beating a peer benchmark?’ At the moment it is at a theoretical level but might eventually turn into some real action.”
Three years of negative returns have encouraged an interest in risk budgeting and diversification, says Charlotte Kaladjian, responsible for the Swiss institutional client business of Morgan Stanley Investment Management. “Pension funds have learned from their difficulties and experiences that diversification and risk budgeting is really key to portfolio construction. Diversification will remain a priority for Swiss pension fund, and I don’t expect any swing back to portfolios of only Swiss fixed income and Swiss equity.”
The new risk-aversion has created a demand for strategies like tactical asset allocation and products like convertible bonds. Louise Henckel client adviser to institutional clients in Switzerland at JP Morgan Fleming AM says: “Convertible bonds are a product that seems very attractive to pension funds both over the last 12 months and going forward. They have offered excellent risk-adjusted returns for those pension funds with less risk appetite. They’re attractive because they offer some upside participation in the equity market with downside risk protection via a bond floor. “
Pension funds are also diversifying into real estate, she says. “Several pension funds investing in domestic Swiss real estate are starting to monetise some of their direct investment in real estate and put these funds back into indirect real estate investments. They are also looking outside Switzerland and looking at investment in pan-European and US real estate.”
Hedge funds, as non-correlating assets, could provide the diversification pension funds require. Yet allocation is still low. The CSAM Swiss pension fund index shows that allocation to alternative investments has grown from 1.2% a year ago to 1.8% today, representing CHF9bn of a total assets of CHF500bn
Erwin Brunner, founder of Brunner Invest, which runs five Irish-based and one Swiss-based funds of hedge funds with assets of CHF500m, says that with a sideways market expected over the next five years pension funds will have to increase their allocation.
“Today there are not that many great asset classes to choose from. I have come to the conclusion that probably for my clients long-short and equity hedge are the correct asset classes.
Brunner has tried to persuade his pension fund clients to switch from long only into long/short. “I try to go step by step, convincing pension funds to put one third of their equity portfolio into long/short.” The equity market recovery has not helped, he says. “A year ago it was easier to sell long-short funds. Now with a good long-only year it has been more difficult. If we have another bad year it will be easier.
“The problem with the Swiss pensions law is that it doesn’t mention the word hedge fund. So pension funds are very uncertain,” he says. However, he predicts that in three years 70% of pension funds will be invested in hedge funds instead of the present 10%.
Interest in hedge funds has been blunted by the boom in guaranteed products, Brunner suggests. “The guaranteed product with zero coupons and a triple A bank guarantee is seen as a substitute for hedge funds. Guaranteed products can even be hedged against Swiss francs so that pension funds can sell them to their board as Swiss bonds.
“A pension fund does not need that product. I don’t think a pension fund where people work 10 or 15 years should invest in such products.”
Other asset managers tend to agree. Von Werne at Pictet points out that “the investment banks that have sold guaranteed products to pension funds are supported by the fact that, based on current legislation, the investment horizon of a pension fund in Switzerland is artificially shortened to a calendar year, although obviously the average investment horizon of a pension fund is substantially longer.
“Therefore a lot of funds are buying protection. But we try to make investors aware that this protection comes at a price and that over the longer term the premium can eat up quite a bit of the return which is needed to achieve a pension fund’s ultimate objective.
“So although there is definitely a demand for such product, we wouldn’t offer them proactively because we think that overall if you look at the pro’s and cons it really doesn’t pay off and doesn’t match the longer term needs of pension funds.”
Swiss asset managers expect that in the new economic environment Swiss pension funds will have to treat hedge funds and other absolute return strategies more seriously. “Hedge funds are actually delivering this idea, but you can go beyond hedge funds and offer absolute return strategies with liquid elements,” says Schlatter of UBS Global AM. UBS Global AM has already launched an absolute return bond capability and plans to launch an absolute return balanced capability this year - taking the uniquely Swiss concept of ‘balanced plus’ one stage further.