Behind only the Netherlands, Iceland boasts the highest pension asset-to-GDP ratio of any OECD country – coming in at 128% in 2011. However, unlike in the Netherlands, the mandatory, defined benefit pension system suffers from a significant home bias, investing in an economy that, in 2008, saw a banking system collapse and imposed capital controls. Achieving a diversified portfolio, while remaining conscious of risk, is a difficult undertaking for the funds comprising the ISK2.4trn (€15bn) pension system.

Marinó Tryggvason, head of institutional asset management at the Arion Bank-owned ISK132bn Frjálsi pension fund, notes that a large amount of money flowed into domestic equities, private equity and, eventually, real estate post 2008. Frjálsi now allocates around 9% to listed shares, compared to a pre-crisis absence of domestic holdings.

Gunnar Baldvinsson, managing director of the ISK138bn Almenni fund, tells a similar story, highlighting that the need to invest domestically results in a less diversified portfolio. “We are happy that we have managed to hold on to our foreign assets,” he adds, although the fund’s DB section has seen foreign exposure fall below 20%. “At the same time, we are concerned, since the capital controls reduce the ability to spread risk by investing in a number of economies with different risks.”

The significant ownership of Icelandic equities by pension funds has not gone unnoticed by the Icelandic financial regulator, FME. Björn Ásgrímsson, a senior risk analyst in charge of monitoring the pension sector says that the industry’s 35% stake of the total domestic market cap will not, due to the long-term buy-and-hold mentality, deepen the market. “They are such big, long-term investors, so they are not actually deepening the market. More players are needed to achieve this.”

Ásgrímsson adds that the pension sector is faced with the problem of where to invest ISK130bn of contributions per year. Where some allocate to equity and real estate, Kári Kárason of the ISK143bn Stapi says he is cautious of the listed market. “We’ve had a fairly conservative investment policy over the last few years – we’ve not been willing to participate as much as many other funds in the equity markets, which is limited to very few companies and prone to a bubble forming.”

He acknowledges that their exposure to Icelandic government and municipal debt, which accounting for over half of assets, may have impacted performance, but stresses that it is important to gain clarity over how the capital controls are affecting asset prices.

Baldvinsson, also chairman of the Icelandic Pension Fund Association, is also worried about a bubble. “The capital controls can affect the price of the domestic market and lead to a rise in excess of intrinsic value.” He warns the industry that it is vital to be careful selecting domestic investments.

Kárason says Stapi has been considering infrastructure for two years, an asset that is “very interesting for pension funds”, but has yet to act. “There is a large need for investment in infrastructure in Iceland,” he notes. “Now that the government is heavily in debt, this is a space that fits well for pension funds.”

While Kárason sees a future for public-private partnerships, Tryggvason points to a bond issue by Landsvirkjun, the national power company, which is held as part of Frjálsi’s infrastructure portfolio. “It’s not a big allocation – maybe 1-2% of assets. But that may change in the next few years.”

Looking beyond the domestic market,  Greenland is also interesting. “The opportunity set is enormous,” says Kárason. “If you look at Greenland, there are more and more opportunities there to exploit resources now, but there is no infrastructure.”

He argues that Iceland should benefit from being the country closest to these unexploited resources. “We think we can service what is happening in Greenland from here. This is also a theme that could develop over the next few years.”

Kárason says heavy metals and oil need exploration, as well as the construction of smelts to take advantage of the reserves.

However, resource exploitation is not an area the funds see as the exclusive purview of Greenland. “Obviously, people are looking for oil east of Iceland.”

Tryggvason sees other heavy industry developments as possible in the domestic market, and highlights domestic energy projects. “When I say energy, there are a few projects that are still blueprints, but there is some interest this year in building, on a smaller scale, aluminium smelters – and there is some discussion about how to finance all these projects.

“We could offer loans or even equity,” he argues, but views the fund’s allocation to real estate as more significant, with the domestic exposure only built up since 2008.

However, he says fund managers made a persuasive argument as to why it was a worthwhile commitment. “The real asset prices were 30% less than building new real estate – so, if we’d ever had economic growth again, it would have been a good investment.”

While the fund went from no exposure to 5% “quite rapidly”, no further investments have been made over the last year and a half, as core Icelandic commercial holdings are now trading at construction cost, making it harder to achieve the strong returns offered to early entrants.

The question remains as to whether the Icelandic market can maintain such rapid inward investment, and what would happen once the currency controls are lifted. Tryggvason accepts that the outflows to overseas assets would “change everything for the outlook of the current account of the nation”, but believes that investors can stay ahead of the bubble as long as good GDP growth figures are realised.

Gylfi Jónasson of Festa (see How We Run Our Money in this issue) remains unconvinced that the controls will be lifted anytime soon. “I’m realistic,” he argues, “It depends very much on how they will resolve the issue of the banks.

“However, even if they did [lift controls], I am sure it would be gradual, where pension funds would not be given priority and, actually, put back in the queue.