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Bonds are good, but are equities better?

For a strategy initially deemed by many in the pension world as rash and foolish, Boots’ decision in 2001 to move its entire fund into bonds has proved pretty canny. To date the strategy has produced savings on paper of e1bn.
Although no European fund has publicly ‘done a Boots’‚ there’s plenty of evidence that stock market turbulence has driven some funds towards fixed income. And among funds that have maintained their strategic allocation to equities, many have sought to compensate for poor equity returns by diversifying into more adventurous categories including corporates and higher-yielding bonds.
A recent research note on the UK life insurance and pension fund industry, revealed a dramatic fall in the percentage of assets held in equities. According to investment bank CSFB, UK life assurance and pension funds now hold 51% of their assets in equities, down from a historic high of 80% in 1994.
European funds appear to be reflecting this shift. ATP, the e28.7bn Danish labour market supplementary pension scheme, cut its holdings in equities from 45% to 35% following disappointing second quarter results. Bjarne Graven Larsen, chief investment officer at ATP, says the move was down to increasing equity volatility.
ATP, which claims the aim of the move is to reduce the risk of the overall portfolio, has increased its foreign currency bond holdings almost 50% last year while increasing its share of domestic bonds by a couple of percentage points. It also holds roughly 6% of its assets in index-linked bonds.
Dutch telecoms pension fund KPN has cut its equity holdings twice last year from 56% to 31%. A year ago it cut equity investment 10 percentage points and then a further 15 as equity markets continued to slide. Hans Hokke, managing director of TKP Pension, which oversees the e3bn KPN fund, says the first cut was due to financial difficulties and the need to avoid topping up the fund.
The second cut was due to a contingency plan specifying that falling below a certain coverage level would automatically trigger the sale of equities. Hokke says the move has made savings of e300m on paper. “The return on the equity portfolio last year was 20%, on fixed income it was 10% and, in total 25% of our assets were switched from equity to fixed income.”
Others have moved out of equities, not out of frustration but almost under duress. Swedish insurers have been forced by regulators to cut their equity holdings and favour interest-bearing investments. Towards the end of last year, and in reaction to an average underfunding of 10%, regulators announced it was giving insurers three years to build up funding levels to 105%. A number have announced a dramatic cut in their equities.
A similar edict from the Dutch regulator PVK means many local funds have been obliged to sacrifice equities at a time when they least want to. Nowhere is this reluctance more apparent than at KPN, which has in place the opposite of the contingency plan mentioned above.

Hokke says once the coverage hits a certain (undisclosed) level again, the fund will automatically reverse the change, selling bonds and buying equities. “In the end, everyone on the board of trustees is convinced that the return on equities should be better in the long run than the return on fixed income.”
One of the upshots of a greater emphasis on fixed income is the strategy many funds are employing. Norway’s e79bn Petroleum Fund sold more than e16.8bn worth of government bonds last year to buy non-government bonds, including corporates. Following a change of investment strategy by the Ministry of Finance, the fund says this adjustment will continue in 2003.
Swedish national fund AP1 has also tweaked its fixed income weighting. Head of communications Nadine Viel Lamare says it has switched from using a market weight to a GDP weight to cut exposure to Japanese bonds. Sister fund AP3 has gone one further and pulled out of Japanese fixed income altogether.
PGGM, although it has maintained its level of equity holdings, has altered its fixed income strategy and in the past three years started to invest in more unusual bonds including emerging markets, high yield, corporate and inflation-linked.
At the latest count, of the fixed income allocation, 75% is in government bonds, 22% in investment grade credits and 3% is in high income bonds and this could potentially change after the latest ALM study is completed this year.
In Ireland, benchmarked funds have, according to Tom Murphy at Mercers, reduced their equity holdings by an average of between 10% and 20%. With surplus cash for bonds, funds are beginning to consider a more diversified approach and have also shown an interest in more exotic fixed income.
The Irish market remains relatively under-supplied. At present, there is a lack of long-dated corporates and there are only two Irish inflation-linked issues, both small and very tightly held. “If someone were to issue more, it would be very welcome,” says Murphy.
While few funds confess to buying more equities, there remains a steadfast faith in them as an asset class. A recent Merrill Lynch fund manager survey suggests both fund managers and pension funds across Europe believe Euro-zone equities are undervalued.
Reporting last year’s results in January ABP, the e135bn Dutch fund for civil servants, said it would be sticking to its strategy despite a 7.2% drop in capital value. Chief investment officer Jean Frijns said at the time that three years of bear market was no basis to change investment strategy. ABP remains confident equities will outperform fixed income in the long run and that bonds are relatively overpriced.
PGGM has also stuck with its strategic allocation. “We work on a strategy that is based on an ALM study, the latest of which said that for a fund of PGGM’s nature, the best balance between equities and fixed income was 45% and 30%. We still strongly believe that, in the long term, equities will give us the best results,” says Ellen Habermahl, a spokesperson at the fund.
Some funds have gone a step further and decided to build up their equity holdings, albeit tentatively. AP1, the e12.8bn Swedish national pension fund, has decided to transfer its 3% real estate holding into hedge funds and private equity. Explaining the move last month, Managing director William af Sandeberg said a new ALM study backed the decision to maintain a high equity holding to ensure a solid long-term yield.

The buffer fund will not be required for another 10 or 20 years. “With all the statistics we have for demographic and economic changes, we should not be investing any more in fixed income. We’ve made several stress tests and so on and we discovered that if we were to invest just in fixed income, we would not be able to fulfil our mission,” says Viel Lamare.
Despite the worst bear market for 30 years, managers retain their confidence in equities. Recent strategies reflect market conditions rather than a loss of faith. Their common refrain is that they’re investing long term and that markets will bounce back. Certainly, the cause of equities in the UK is unlikely to be helped by Watson Wyatt’s announcement that it is recommending its clients diversify out of equities and into alternatives such as property, high yield, emerging debt and even hedge funds.
And this month, Dutch funds have to go public with details of their benchmarks and investment strategies, both of which should make for interesting reading. “The company pension funds are likely to make quite dramatic changes to their asset allocation so that they can run a lower risk profile,” says Hans Rademaker, managing director of investment management at the e17bn MN Services.
Managers concede that Boots’ strategy has paid off but, nevertheless, most question its longevity. One Irish pension manager says: “What its strategy from now on will be, that’s really interesting. It’s a great time to be investing in equities.”

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