Asset Allocation: Underprepared for change
Dutch pension schemes are grappling with challenges which may slow down much-needed asset allocation shifts, finds Carlo Svaluto Moreolo
At a glance
• Compliance with domestic and international regulation keeps investors busy.
• Hedging choices are key as interest rates and inflation rise.
• Investors are gradually embracing alternatives.
• The impact of pension fund consolidation will continue to be felt.
The global economic outlook seems to be improving and the financial markets are beginning to offer significant opportunities again. For Dutch pension funds, this should be time to review strategies and build portfolios that are more in tune with the current environment.
But the pension industry is entangled in challenges that constrain investment behaviour. This may prevent pension scheme boards from taking advantage of the opportunities brought about by a stronger economy.
Regulation is the trickiest obstacle keeping Dutch pension schemes from restructuring their asset allocation. Both domestic and international regulators are adding requirements for pension schemes, drawing attention away from long-term investment strategy.
Investment managers and consultants are discussing how to address these challenges. Carl Kool, investment strategist at BlackRock in the Netherlands, says that the European Market Infrastructure Regulation (EMIR) and its implications for liability-driven investment (LDI) strategies are monopolising client conversations.
EMIR foresees central clearing of over-the-counter (OTC) derivatives, such as interest rate and inflation swaps. European pension funds are currently exempt from complying. However, from August 2018, they will have to post daily variation margin (VM) for centrally-cleared OTC derivative transactions. The only accepted form of VM is cash, which means that funds will have to maintain sufficient liquidity on their balance sheet. Kool notes that Dutch pension funds have low cash holdings, as the bulk of the assets are invested in sovereign-issued fixed income as part of LDI strategies.
“Pension funds have a few options to generate sufficient liquidity. They could increase cash holdings, enter the repo market or switch out of the high quality bonds they hold into swaps. All have pros and cons. It is important to start preparing the portfolio now, as the market moves faster than regulation, and counterparties that are not exempt are already moving towards central clearing”, says Kool.
Max Verheijen, head of financial markets at Cardano, says that the firm is working to ensure clients are compliant ahead of implementation. Most of the contracts have already been amended, as counterparties have embraced the changes.
For Verheijen, the focus is on implementing LDI strategies. Cardano applies dynamic LDI strategies that take advantage of price differentials in matching bonds and swaps. Optimising the choice of hedging instruments is important at the moment, as the market braces itself for the eventual phasing out of the European Central Bank’s quantitative easing (QE) programme.
“In recent months, clients that built hedges with bonds have started to take profits and shortened the duration of their bond portfolios, exchanging the bonds with swaps. In the event of QE tapering, that will reverse again”, explains Verheijen. Similarly, well-funded clients are thinking about inflation risk. With inflation rates picking up, pension schemes are considering whether to increase their hedging.
However, it must be noted that hedging decisions are not only influenced by views about the future trajectory of rates and inflation. Leonique Van Houwelingen, head of BNY Mellon’s asset servicing business for continental Europe, says that some hedging choices have proved to be wrong. Many pension schemes have lost money as a result, and have become “far more cautious” in their behaviour.
In LDI, the choice between bonds and swaps is not that straightforward, according to Van Houwelingen. “We do not see much activity beyond very straightforward interest rate hedging or currency hedging,” she says. “Whereas in the past years, there was potential for investment in some of the more exotic derivatives, we no longer see that.
“Pension funds only do the necessary hedging, and even that is a difficult decision. Even the larger funds are left with few positions in derivatives, and they can be very inactive. But, it is difficult to say something generic, as there is a variety of different situations,” Van Houwelingen continues.
Whatever the direction of interest rates and inflation, liability management will continue to grab funds’ attention. Verheijen notes that figures from the De Nederlandsche Bank (DNB), the pension fund regulator, state the average hedging level is between 30% and 70%. Verheijen says that Cardano’s clients are at the higher end of that range, between 70% and 80%. The DNB’s figures suggest that many schemes are under-hedged.
Eventually accepting alternatives
Conversations regarding the asset side of the balance sheet are focusing on the introduction of alternatives, according to BlackRock’s Kool. “The challenges posed by the low return and low yield environment remain, despite the more positive market outlook. Investors are responding by opening up the asset allocation to alternatives,” he says.
This is welcome, since Dutch pension schemes have been reluctant to invest in alternatives other than real estate and mortgages. This does not take into account the largest pension schemes, which have significant experience in alternative investment markets.
The quest for alternatives has intensified, according to Stefan Cornelissen, head of institutional business at M&G Investments in Benelux, the Nordics & Switzerland. A wider range of pension schemes are considering opportunities in private assets, particularly debt, and real assets, including real estate and infrastructure.
There is a growing interest for other alternative assets such as leveraged loans, asset-backed securities, direct lending, private equity and distressed debt. A growing number of schemes are building exposure to these. However, the shift is gradual, notes Cornelissen.
He explains: “In general, Dutch pension funds are under a lot of scrutiny, from the regulator, the media and the public. Some are suffering or feel threatened by low funding ratios. Consequently, many investors are afraid of doing things that no one else is doing.”
Peer pressure is so strong that Dutch funds tend to engage in herding behaviour, he adds. The shift to alternatives is real, and that is where funds will find yield and be rewarded appropriately for taking risks. “But, they are moving in a very controlled manner”, concludes Cornelissen.
Frans Verhaar, who oversees business development for international consultancy bFinance, also sees a clear trend of Dutch pension funds accessing private markets for the first time. The firm focuses on medium-sized pension funds, most of which are still new entrants into alternatives.
The trend of investment in domestic mortgages continues unabated, according to Verhaar: “There is a lot of demand for mortgages and large allocations are still being made. Interest in Dutch mortgages is also coming from overseas.
“The interesting thing is there is only a limited number of providers. Spreads have come down due to high demand, but demand has not fallen significantly, which signals that investors still think it is worthwhile to invest.”
In parallel with the hunt for alternative sources of yield, many pension funds are pursuing portfolio ‘simplicity’. This is a shift observed by Alexander van Aken, head of client services at fiduciary manager SEI, among medium and small pension schemes.
Van Aken suggests that investors are trying to rationalise portfolios by returning to more traditional allocation models, where equities, bonds and real estate form the major building blocks.
“There are several reasons behind that. Some alternative investments, particularly hedge funds, have not performed very well, despite investors paying high fees for them,” says van Aken. “More importantly, pension schemes are focusing on costs, and facing demands for transparency from regulators and members. Board members are required to show knowledge of the asset classes they invest in.”
BNY Mellon’s Van Houwelingen identifies the same trend: “Larger pension schemes are looking for yield, which drives them towards alternatives, including private equity, real estate and private debt. But, for the majority of smaller schemes there is a tendency to go back to basics and simplify portfolios. Pension schemes need more safety and predictability of expected returns.”
These contrasting views form a complicated picture. On one hand, pension funds are being asked to become more sophisticated in their investments, while, calls for transparency and cost reduction drive them towards simpler allocation models.
The fact that many funds are pursuing recovery plans to fill funding gaps – as required by the regulator – means they cannot increase portfolio risk. This requirement does not match well with current environment. Markets are moving into a ‘risk-on’ phase, but yields from traditional matching assets are low. SEI’s van Aken describes it as a typical “catch-22” scenario.
Consolidation among pension funds is another structural trend that could have profound implications on investment. Concentration is being explicitly solicited by regulatory authorities, and has been for years. Over the past 10 years, the number of pension funds has fallen from over 800 to just over 300. Some estimates see these falling by another two-thirds or more over the next decade.
Observers agree that fewer, but larger, pension funds invest more efficiently. Larger organisations can afford more staff and resources, which lead, in theory, to more focused and improved strategies. Larger funds can also access better investment management services.
In turn, a more consolidated pension fund sector could support the economy better by investing more efficiently in assets such as infrastructure and private debt. Bfinance’s Verhaar says: “There larger you are, the more likely you are to implement an allocation to private markets, because you need skills and people in that market. It’s not an investment that can be made from the boardroom.”
Of course, there are many who hope that consolidation will slow down. Some contend that forcing this measure beyond what the market naturally desires is wrong. The regulator has even suggested a ‘correct’ number of pension funds – about 100.
But the idea that the regulator should dictate this does not appeal to many. Again, there are contrasting forces at play. The regulator would like to oversee fewer pension funds, the investment management industry is not happy about a reduction in potential clients.
Verhaar points out that there is another aspect to the debate, which has to do with overall market efficiency. He says: “I guess there are pension funds that are simply too small to operate, so they outsource heavily. This has driven the growth of fiduciary management. Larger pension funds have a bigger budget to hire staff, and can become more sophisticated as a result.”
“But at the same time, being very large is not always an advantage. If you become too large, you essentially become the market. Can you really exploit the opportunities that the market offers, if you are that large? Hopefully, we will be able to create a middle ground of pension funds that are well-equipped for the future.”