Spain: Focus on safety first
Pension funds are reducing their risk levels in response to uncertainties generated by Spain’s failure to form a government, Brexit and Italy’s banking crisis, writes Gail Moss
At a glance
• Spanish occupational pension funds are reducing equity exposure and diversifying globally.
• Within fixed income there is a shift to alternative credit such as emerging market bonds.
• Allocations to alternatives, such as hedge funds and private equity, are being increased.
The absence of a functioning government for Spain – following two inconclusive elections in the past year – has prompted extra political uncertainty for the country’s pension funds, already pondering the effects of Brexit and the continuing Italian banking crisis. So it is not surprising to see occupational pension funds adopt a safety-first asset allocation strategy.
“The main changes in asset allocation imply a reduction in the funds’ level of risk,” notes Xavier Bellavista, principal at Mercer. He says this has been happening over the past few months, anticipating the different uncertainties which were expected for 2016 – for example, interest rate decisions and Brexit.
“When these events happened, we did not see many short-term reactions; most of the occupational pension funds had already reduced their level of risk,” he says. “However, they are monitoring the situation to see if they need to further adjust or reduce it.” Specifically, he says that both EU and non-EU equity exposure in portfolios has been trimmed.
According to Mercer’s Pension Investment Performance Service (PIPS), EU equity exposure fell from 18.7% in June 2015 to 17.6% in June 2016, while non-EU equity exposure went from 13.7% to 12.2% over the same period. EU fixed-income assets also fell from 47.2% to 45%, while the asset class which increased most was cash, from 10.4% to 15.5%.
Bellavista adds: “However, the significant increase in the investment in non-EU fixedincome assets which we saw last year has not increased further in the past 12 months, although it has consolidated as a significant asset class among occupational pension funds in Spain.”
A general trend to reduce overall equity exposure has also been noted by Willis Towers Watson (WTW), which is seeing clients at least considering a shift abroad in the fixed-income sector.
“As corporate and government yields continue to sink in Europe, pension funds are reconsidering their overall geographical exposure, and pension funds in Spain have started to increase allocation to global bonds, with a certain bias towards US fixed income,” says David Cienfuegos, head of investment, Spain, WTW.
But some local loyalties still persist. “Allocations to peripheral debt remain dominant in fixed income, despite the Spanish political crisis and Italian banking crisis,” says Alvaro Molina, director, institutional investment, Aon Hewitt. “And Spanish regional debt is still present in most Spanish fixed-income allocations. While Catalan debt is out of favour due to perceived political risk, other regional issuers are being used to capture some yield, in addition to Spanish government bonds.”
But, more generally, it is not only the geographical aspect that attracts pension fund investors to global fixed income. Cienfuegos adds: “The larger pension funds seem to have an appetite for alternative credit such as emerging market bonds, high yield or loans, as traditional fixed income in Europe offers more challenges than opportunities.”
And this keenness to initiate or increase allocations to innovative products is mirrored by an attraction to alternatives as a whole. “Pension funds have been increasing allocations to alternatives, mainly private equity and alternative credit,” says Cienfuegos. “They are thus increasing exposure to the illiquidity premium, although the amounts are still quite negligible compared with equity and traditional fixed-income allocations.”
“Many pension systems are reducing their allocation to traditional fixed income, either govvies or investment grade,” says Jon Aldecoa, director general, Novaster. “The alternatives are direct lending programmes and some high yield. We have not seen special interest for multi-strategies or similar investment options. There have been some investments in relative, absolute value and diversified growth as an alternative to fixed income.”
He adds: “There is also a clear interest in increasing the risk asset class through private equity. In this case, approaches are becoming more sophisticated, looking for secondaries or co-investment funds. There is also some interest in non-listed real estate as another way to diversify.”
Aldecoa says the past year has been difficult for returns, especially from the traditional asset classes. “Dividends – American and emerging markets – are providing some returns,” he notes. “The Spanish govvies have lately been providing capital gains too, but these are limited and risky. Some alternatives invested in the latter part of the financial crisis, and real estate, are also being repriced upwards, but they have still a small allocation.”
Cienfuegos considers the worst-performing ‘assets’ are probably the opportunity cost of having excluded long-term, high-quality bonds from pension fund portfolios. “It is true that the investment case for 10-year German bunds, for instance, is difficult to understand,” he says. “However, tail-risk hedging is always key for defined contribution (DC) pension funds, and therefore consciously excluding the whole exposure to long-term, high-quality bonds from the portfolio, even at negative nominal returns, has weakened the overall risk-hedging contribution.”
But have recent events in Europe made things worse? Spanish pension funds’ exposure to both UK and Italian markets is limited, says Cienfuegos, so events there have not really affected asset allocation decisions.
But they could lead to a rethink, he says. “The current economic landscape and the financial status quo in Europe as a whole are very likely to trigger a thorough review of their strategic asset allocation and asset-liability management, especially as lower-for-longer interest rates leads to a decline in income generation and increases the difficulty in meeting pension fund objectives,” he says. “Larger pension funds have already started this review.”
A further strategic issue is the long-term direction of interest rates. “We are not seeing consensus over interest rate expectations among fiduciary managers,” says Molina. “Most occupational pension funds have investment policies that allow positioning the fund in the one-year to five-year duration range, and today we see a wide dispersion within that range.”
But he adds: “Overall, Spanish occupational pension plans are DC plans, with investment policies that permit limited exposure to interest rate risk, so it is not a relevant issue as in other pension markets.”
Meanwhile, in terms of specific allocations, the next 12 months look likely to bring more of the same. “We expect occupational pension funds to increase allocations to alternative assets,” says Molina. “Hedge funds provide useful diversification, in particular global macro/CTAs [commodity trading advisers]. As seen during the Brexit sell-off, long-short or systematic macro hedge strategies can help cushion portfolios from the bursts of volatility that are heading our way.”
“Hedge funds provide useful diversification, in particular global macro/CTAs. As seen during the Brexit sell-off, long-short or systematic macro hedge strategies can help cushion portfolios from the bursts of volatility that are heading our way”
Bellavista says: “Over the next year we expect funds to continue working to diversify their funds, especially looking for alternatives to fixed-income assets. We don’t expect a significant change in the main asset class exposure, but an increase in the underlying asset classes – for example, absolute-return fixed income, private debt, convertibles, and high yield.”
He also expects an increase in responsible investing. “Occupational pension funds in Spain have always been leaders in responsible investment, and the trend is continuing,” says Bellavista. “We see more funds and managers adhering to the UN Principles, but also funds having better tools to screen their portfolios and joining UN initiatives.”
In the same vein, improved governance could be imminent. “Some of the largest funds are taking action to reinforce their governance, for example, setting up investment committees with increased dedication and hiring investment consultants,” says Molina. “We expect this trend to continue, as those funds with higher governance levels have proven to obtain better risk-adjusted returns than their peers.”
Looking even further ahead, asset allocation could undergo fundamental changes if a new legal option is implemented by pension funds, according to Cienfuegos. Last year, occupational pension funds were allowed to introduce a liquidity clause allowing members to access their savings after 10 years.
However, the vast majority of pension funds have not yet taken advantage of this. “But if most pension boards were to approve this clause, the time horizon for pension funds would change dramatically and the allocation could potentially be completely affected,” says Cienfuegos.