Andreas Larsson discusses Swedish pension asset allocation trends. As the appetite for alternative investments is increasing, investors must have the capacity to hold the associated liquidity risks
During the last two years, we have seen an increased focus on asset allocation among Swedish long-term investors. Prior to the financial crisis of 2008, asset allocation decisions were based on a long-term strategic perspective. Many investors felt that the static long-term strategic allocation strategies couldn't capture new investment opportunities and financial threats that had emerged in the aftermath of the crisis. Instead, focus shifted towards a more dynamic asset allocation approach that puts emphasis on current market conditions and allocations in a medium term view. Adjustments in investment policies have been implemented to make the asset management more flexible and proactive to potential medium term investment opportunities. This change has played a significant role for the allocation trends during the last years.
Seeking active return
Traditionally, Swedish institutional investors' fixed income investments have been concentrated in long-term Swedish bonds, with the majority in government bonds. Partly because of liability matching purposes but also because there hasn't been any actual need to actively find other alternatives. With government bond rates at historical low levels and economic uncertainty in the market, investors have started to diversify their bond portfolios, spreading the risks among different markets and sectors and actively searching for fixed income investments with stronger return opportunities.
After the credit crunch, many investors saw the mispriced and stressed credit market as an investment opportunity. During 2009 investors started to allocate a large part of fixed income investments from government bonds to highly liquid global investment grade bonds. As corporate bond valuations have gone back to more normal levels this exposure has been reduced. Instead, emerging market debt is attracting investors. The relatively high yields in that market - along with the fact that the economic outlook for many of the emerging markets is more stable - is an important reason for the large inflows.
Inflation concerns have made investors increase their allocation to inflation-linked bonds. With these low real bond yields, however, investments are primarily seen as a hedge for a future high inflation scenario.
Pension funds with funding surpluses or funds that have had less regulatory liability matching requirements, have started to adopt a more absolute return focused strategy within fixed income investments. With rising Swedish government bond yields, bond portfolio duration has been reduced. For others, using derivatives to hedge liabilities have been a more common strategy. By using derivates and overlays to reduce unwanted risk, pension managers can be more flexible in their portfolio management, which creates additional possibilities for active returns.
Home equity bias
In a period characterised by quantitative easing programmes and market stimulus, equity allocations has picked up. Within equity investment, Swedish institutional investors continue to have a relative strong home bias. Even though Swedish equity only makes up approximately 2% of the global equity market, it is not unusual to see allocations up to one-third of the equity portfolio. From a historical perspective, Swedish equities have been one of the best performing markets. That was also the case during the 2009 and 2010 market upturn where the Swedish stock market almost doubled in value. Large allocations to Swedish equities were one of the contributing causes for many investors to quickly regain losses from the financial crisis. But, strong performance has not been the only reason for investing in the asset class. The positive Swedish economic outlook and the lack of direct currency risk has attracted the local investors to the asset class.
However, the small and concentrated Swedish equity market is also more volatile compared to the diversified global equity market, and has the tendency to underperform against large developed markets in a global equity downturn. In a situation where equities are under pressure, markets start to drop and investors begin to review their equity exposure, reducing Swedish equities is probably where they will start. During the tremulous beginning of 2011 we have seen some investors starting to decrease their overweight in the asset class.
Allocations to emerging markets equities have increased substantially over the last couple of years. From merely being considered as a small exotic flavour to the portfolio, the asset class now makes up a significant part of some investors' equity allocations. Improving equity diversification and exploiting the strong return opportunities that the market offers are some of the reasons behind the trend. Increased strategic allocations to emerging markets have also been a consequence of the ongoing global economic shift and the long-term economic growth prospects of the emerging markets. Some of the large Swedish corporate pension funds have also seen their own company become more active in emerging markets. Hence, adjusting the portfolio to the new economic world map has been a natural step.
During the last year, we have seen investors taking more active decisions in managing their currency risks. Currency hedging strategies have been used to systematically reduce risks and also in an opportunistic way. Before, investments in foreign fixed income securities (if any) and absolute return assets denominated in foreign currency where normally currency hedged. The currency exposure in assets like foreign equities was regarded as a part of the total overall risk diversification. But, with the volatile development in the currency market and the strength of the krona, investors have started to hedge a part or in some cases even all of the currency exposure in foreign equities.
We believe institutional investors are up against a few challenges during the coming years. Not only do they have to navigate their portfolios in a continuously uncertain market environment where policy makers might drive asset prices, making political risk a big factor. They also have to meet their long-term return objectives with regulators restricting their short term risks.
It is not unusual to see portfolio absolute return targets around 3.5% to 4.5% expressed in real terms. In many cases the return targets originates from an era where the expected return on risk free assets, (the real long-bond yield), were around 3%. Today, the real long-bond yield is approximately 1%, and even though investors has made a lot of changes in their portfolios (more flexible allocation strategy, increased allocation to emerging markets equities and bonds) it will be difficult for them to achieve their objectives. To improve the return profile investors could either increase their equity allocations, which will also have a significant impact of the short-term risk, or find other sources of long term return.
Alternative investments have drawn institutional investors' attention for some time. But after the credit crunch many investors have been somewhat reluctant to invest in illiquid assets, allocations to alternative asset have been fairly unchanged. Within this broad asset class hedge funds are usually the main investment category. Over the last few years investors have primarily focused on transparent domestic hedge funds that invest in liquid markets and are zero-correlated to the equity market. Unfortunately, the numbers of managers who can meet these requirements are few, which make it harder for investors to build up any large portfolio allocations.
We have also seen investors starting to express more interest towards property and infrastructure. The inflation-linked components of these assets are attracting investors, particularly with the threat of high inflation around the corner. We believe that alternative assets will play an important role in investor's portfolios in the future. But to increase the asset allocation, investors also have to make capacity for liquidity risks in investments polices and try to fully take advantage of their long-term investment horizon.
Andreas Larsson is a consultant at Wassum in Stockholm