silvio bencini

Silvio Bencini

Despite shifting and ambiguous regulation, a growing number of pension funds are increasing diversification by making larger allocations to alternative asset classes, writes Silvio Bencini

Italy’s fondi pensione negoziali (collective labour-contract based second pillar schemes) are adapting their investment policies as the new rules on investment limits issued in November 2014, came into force in May 20

Law 166 of 2014 (166/14) has been associated with a potential increase in alternative investments by pension funds. But it has also established a framework for investment in all kinds of alternative funds, both UCITS and AIFMD. 

The framework has also increased the limit for investment in alternative assets, changing the way they are defined. The limit increased from 20% of portfolios to be invested in closed-end funds to 30% in alternative investments. Before the adoption of the new rules, funds could allocate up to 20% to illiquid alternatives. The Eurofer pension fund has invested in real estate since 2012 and Laborfonds began investing in private debt in 2014, while Solidarietà Veneto made an allocation to private equity in 2014. 

The regulator, however, seems to have overlooked fondi pensione negoziali directly investing in liquid alternatives, such as loans and hedge funds. In fact, according to the original law on pension funds, contractual funds can only invest directly in closed end funds. A fund is allowed to buy shares of a private debt closed end fund with duration of 10 years. However, it can only invest in leveraged loans funds with weekly net asset value (NAV) pricing or a high yield fund with daily liquidity via a segregated mandate. 

At a glance

• Italian pension funds are adapting to a new regulatory framework.
• Revised and less stringent regulatory limits do not necessarily encourage diversification.
• Funds are slowly implementing new asset allocation strategies. 
• A number of investors have entered the alternatives space.

This limitation impacts on the ability of pension funds to invest in alternatives, and their ability to explore new asset classes through small allocations via direct investments in UCITS instead of making larger allocations through segregated mandates.

There are three changes in the 166/14 law that could impact on the asset allocation of pension funds. First, it scrapped the maximum level of assets of 20% for liquidity (cash and bonds with maturity shorter than six months); second, it reduced the maximum exposure allowed to non-euro currencies for each sub-fund from 66% to 30%; third, it removed the limits to investment in securities issued in non-OECD countries, opening up the emerging markets.

The first of these measures is mainly from a compliance perspective, because fund managers and custodians have been relieved of monitoring the maturity of short-term bonds to avoid breaches.

The second is a new constraint on the asset allocation freedom of pension funds, since the non-euro share of the global equity index is approximately 90%. Funds with a strategic asset allocation to global equities above 30% have been forced to divest part of the allocation to a euro-hedged benchmark. The only potential beneficiaries of this measure, which was opposed by most of the industry, are currency risk overlay providers.

The real opportunity comes from the third measure. It allows funds to buy debt and equity in countries where risk premia are still at reasonable levels.

Within this context, it is fair to say that fondi pensione negoziali have been more concerned with low interest rates than the opportunities offered by the new regulation. 

However, the current trends in asset allocation reflect themes: the search for new asset classes, new strategic asset allocations, new approaches to managing risk and the introduction of alternatives.

Looking for new asset classes 
So far, the search for yield has pushed funds down the credit rating scale, so euro government bond mandates are increasingly replaced by euro aggregate mandates with allowances for high-yield bonds, or even global aggregate mandates with currency risk hedges. A special role is given to US credit, owing to the higher yield levels, even after currency hedging. A convertible bond mandate, tendered last year, shows funds are looking for yield combined with convexity. With regard to equity, there is growing interest in small and mid-cap mandates, given lesser liquidity concerns and the size of premiums offered.

New ways for implementation 
Until 2015, there was a trend among larger funds towards a specialisation of mandates by asset class or geography with alternative ways to manage risk. Smaller funds maintained the simpler solution of dividing the assets by sub funds in equally benchmarked balanced mandates. At the beginning of 2016, the largest Italian contractual fund, Cometa, adopted a different approach, by launching public tenders only for multi-asset mandates. Equal shares of the assets will be assigned to each of Cometa’s sub funds. In this setting, the trustees set limits only to the maximum weight of the investable universe – which includes sub-investment grade credit and emerging markets – and the total risk to be borne by the fund. The asset allocation is completely delegated to the asset managers.

New ways to manage risk 
Moving to specialised instead of balanced mandates raises the problem of who is in charge of managing tactical allocation and responding to market volatility. The need for a long-term institutional investor to pay for protection from short-term volatility is debatable, but for funds with a monthly NAV short term performance remains a concern. This has been addressed in two ways. One is to implement, alongside or in place of the specialised mandates, further flexible-multi asset mandates with risk targets, which act as buffers to the entire portofolio (examples are pension funds such as Eurofer, Pegaso and Alifond). The strategy is usually implemented as the sum of a dynamic model with certain stop loss or risk limiting rules. The other is to wrap the specialised mandates with a risk overlay mandate (which is what Espero, Telemaco, Fondenergia, Fonchim, Laborfonds have done). Approaches can differ, and may include simple tail-risk management with a layer of out-of-the-money put options, a dynamic strategy with future contracts, currency hedging or a more holistic tactical asset allocation mandate. 

A changing approach to alternatives 
Alternatives are more complex than traditional investments, and most funds are too small to afford the costs of an internal investment team. Several attempts to group together in order to share the costs of manager selection and monitoring have been made recently, but with little success. Significantly, the two largest pension funds – Cometa and Fonchim, which could afford the costs – have not made any allocation to alternatives. 

Nevertheless, pioneers have decided to explore this new world. Beyond the funds already mentioned, which invested before the adoption of the new rules, there is Priamo, which has recently made an allocation to private debt, and Eurofer, which has added a core European infrastructure equity allocation to its alternative portfolio. 

Silvio Bencini is a managing partner at European Investment Consulting in Milan and investment adviser to Italian pension funds