Icelanders do not consider themselves part of Europe and that attitude may well be borne out by the local capital markets. While the Continent has experienced a miserable start to the third millennium, stocks on Reykjavik’s ICEX experienced a far gentler swipe from the bear following the bull run of the 1990s.
Local bond yields have remained generous too, averaging over 15% since 2000.
So all in all, the average pension fund here has received negative returns for the past three calendar years, but only about 2% annualised. That has come as a shock to a group more used to a positive 7% but nevertheless seems mild punishment in comparison with international peers.
Indeed, Belgian, British and Swiss schemes might have wished they had been prescient enough to go to Iceland sometime during the last decade for the sake of diversity.
The full equity index only lost about 20% of its value from mid-March 2000 to the end of 2002 but over ten years to the same date, Iceland’s quoted companies have together grown 350% in value. In fact the current revival started way back in 2002 and this year the market looks on course for a 40% rise, so grumblings are few.
Privatisation programmes and some excellent individual company performances give local investors cause for contentment. One star performer has been Pharmaco, a generic drug manufacturer which has averaged 50% growth over the last three years; 130% this year to October alone. In November Pharmaco announced the launch of a US subsidiary.
Looking ahead, pension funds are cautiously optimistic on local stocks. The kind of explosive growth demonstrated by Pharmaco, for instance, is not expected to last. There are also interesting decisions to be made on big names such as Baugur, the international retailer, as it is involved in take-over activity and hence the stock exchange has decided to remove it from the key ICEX-15 index, Iceland’s most liquid.
The trend has been for pension funds to overweight the ICEX-15 and enjoy handsome returns because the universe is small enough to be lifted by the handful of excellent performers like Pharmaco. The spate of takeover activity and consequent delisting and removals may mean more selective investing, however, with an added factor of risk when investing in the non-index names as funds benchmark their domestic performance against the ICEX-15.
Beta-risk is part of a wider worry regarding local investments: are the good times over at home and should funds look more overseas? Thorgeir Eyjolfsson, managing director of the pension fund for commerce, Lifeyrissjodur Verzlunarmanna, believes that select Icelandic stocks will continue to outperform in 2004 and that local bonds will be more attractive than foreign ones. Kari Karason, managing director of the Nodurlands, or Northern Provinces, pension fund is also pretty optimistic on local bonds for at least another twelve months. He believes that unlike the local equity market, there is sufficient liquidity in local bonds to attract foreign investors and this will be of benefit to local players too.
Julius Baer is one foreign player that has held up to 5% in Icelandic Government bonds for clients and benefited from the exposure.
According to Stephen Lucas, head of business development, Europe at Julius Baer, there is a case for Icelandic funds coming the other way. Global government bonds hedged into Icelandic Krona have actually outperformed local government bonds over the last full ten years annualised. Annualised progressively since 1996, global bonds hedged into Krona have always been stronger. Julius Baer calculates that were local funds to allocate 20% to hedged global bonds alongside local government debt, returns would have been 0.1% better. But more significantly, risk would have decreased from 4% for a 100% local holding to 3.3%.
There is little correlation according to the calculations between Icelandic and hedged global government debt, a fact that Karason acknowledges.
Bonds may be investors’ asset of choice during hard times but in the past, Icelandic funds were attracted to foreign equities predominantly. Investment in non-Krona-denominated holdings only began substantially in 1994 and at first there was no rush to diversify abroad. Eventually Iceland’s pension funds were seduced by the global growth story of technology, media and telecoms nonetheless. Locals bought into pooled products of well-known US and London-based asset managers. Average fund returns peaked at 12% in 1999, 4% more than the next best year, and by 2000 allocation to foreign investments stood at 22%. So although there was the same style bias exhibited by other European pension funds, Icelanders had never quite got to the same allocation levels. Today levels of non-Krona denominated holdings are reapproaching 20%.
Clearly some of that will be in global bonds as well as equities - with a greater recognition of style bias - but local funds are also keen to diversify into alternatives. Karason believes that private equity is beginning to look attractive now. He is not concerned about the location of potential investments, either US or Europe - although they would almost definitely be fund of funds – because Icelanders are used to currency overlay programmes. He thinks that valuations are low and there have been a lot of sell-outs. For his fund, buy-outs would be core, with some venture capital and possibly some mezzanine funding.
Icelandic funds can afford to look at diversification because cashflows will be positive for years to come. For a population of under 300,000 there are pension fund assets of almost E9bn (ISK790bn). Compare with an island of a similar name and geographical size: Irish occupational funds are only three times bigger in total value than Iceland’s while Ireland’s population is ten times greater.
Iceland has twice as many people under 15 as over 65 and so demographics look healthy. Lucas expects the occupational market to grow by 10-15% per annum but he cautions that foreign asset managers have to take the time to understand the local market in order to win the trust of the pension funds. They are not part of Europe, after all, and that is the first thing to remember.

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