Asset Allocation: Curves, currency and costs
More than anywhere else, the low and negative interest rate environment is shaping Swiss portfolios. But investment challenges are quite particular, finds Barbara Ottawa
At a glance
• A negative Swiss interest rate curve is translating into changes in institutional portfolios, but only slowly.
• As a safe haven currency, the franc makes FX-hedging expensive.
• Swiss institutions must restructure their portfolios to remove interest rate risk.
• New reporting regulations have led investors to examine the cost effectiveness of managers and strategies.
In a survey commissioned by the Swiss Funds & Asset Management Association (SFAMA), 60% of participants claimed that the negative interest rate policy imposed by the Swiss National Bank (SNB) is having a low to moderate impact on their investment decisions (figure 1).
And 15% of the 81 Swiss pension funds, who were interviewed in May, said negative rates are having no impact at all.
The researchers from the University of St Gallen said this was surprising. At the same time, they found more than 50% of pension fund managers were claiming to invest more in private equity and real estate as a response to negative interest rates, while reducing bond investments.
So perhaps what the “no impact” statement is lacking is the addition of “not yet”.
“Today, we are the global leader in negative yield as almost the whole yield-curve is below zero, even more so than in Japan,” says Serge Alarcon, head of institutional multi-asset portfolio management at J Safra Sarasin. “Most Swiss government bonds issued today will generate zero return for the next 10 years.”
He adds: “While many pension funds used to allocate a large portion of their portfolios to domestic bonds that yielded around 4% over the last 30 years, they now have to consider different asset classes.”
Werner Rutsch, head of institutional business at AXA Investment Managers Switzerland, agrees. “One of the most urgent tasks for Swiss pension funds is to reduce their domestic bond exposure, which in many cases still makes up around one-third of portfolios,” Rutsch says.
Swiss bonds are one of the legs on which Axa IM has built its Swiss institutional business. “The domestic bond market in Switzerland is a small market, but we were able to generate returns through our enhanced bond portfolio manager who is also managing larger portfolios for Axa Winterthur insurance,” explains Rutsch. “The interests of pension funds and insurers are often aligned in the current low-yield environment, with long-term liabilities.”
So interest rate curves are definitely one of the challenges in Swiss institutional asset management. Swiss government 30-year paper still yielded above 1% at the beginning of November 2014, when the prospect that Switzerland would have to deal with a Japan-like scenario was one that still seemed extreme to many. This is no longer the case, particularly since July 2016, when 30-year government bond yields entered negative territory.
“The situation in Switzerland is a mirror of a more global challenge, but more acute,” says Théodore Economou, CIO of multi-asset at Lombard Odier Investment Managers.
Indeed, the president of the SNB, Thomas Jordan, said at the end of September: “The SNB had to use the full innovative power within its mandate to develop and use new monetary instruments to fulfil its mission in the best way possible.” In January 2015, the SNB surprised the markets by cutting the Swiss franc peg to the euro. It introduced penalty rates for bank deposits and continued to lower rates.
“The yield curve is the big catalyst and it should trigger a rethinking of the way we set up portfolios,” says Economou. “Pension funds have to look at their liabilities and divide them into different goals according to needs like lower liquidity and higher growth for active members versus higher liquidity and security for retirees.” This outcome-orientated approach, as he calls it, has been adopted at Lombard Odier’s own pension fund. One effect in the fixed-income segment is an increase in hold-to-maturity positions to minimise trading in a less liquid environment. Another is an increase in diversification across the fixed income and credit spectrum.
Alarcon agrees: “Pension funds need to increase their range of asset classes and we see interest in senior loans, insurance linked bonds and even coco-bonds.” Additionally, bond portfolios are shifting into different markets to retain the risk mitigating role they had in balanced mandates: “For example, in the US the yield curve is still in positive territory,” notes Alarcon. “Even after FX-hedging costs, investors are better off than with Swiss bonds.”
Economou adds: “A major consequence of the extreme negative yield curve is that traditional does not equate with conservative any more, as conservative benchmarks would currently mean a 60% allocation to an index in which two thirds yield negatively.”
The safe haven conundrum
One specific Swiss problem is pointed out by Alexei Jourovski, head of equities at Unigestion: “Decisions by the SNB are also influenced by external factors because of the Swiss safe haven effect, and this makes it even harder to predict future developments in currency trends.” This makes currency the second Swiss challenge.
According to data from the consultancy Complementa, the share of foreign investments in Swiss pension funds’ portfolios has steadily increased since 2008, reaching new historic levels of over 47% in 2015 (see figure 2). The peak before the financial crisis had been around 35%. At the same time, exposure to foreign currencies continued to decline from 20% eight years ago to just over 17%.
However, as Jourovski points out, “some clients are systematically hedging their whole equity portfolios while others are hedging based on the underlying equity on a country-by-country basis”.
“In some markets, like Japan, the currency has some countercyclical effects. So from a risk point of view hedging is not necessary; in fact, it can even increase volatility,” Jourovski explains. But he stresses all these factors have to be weighed against the type of portfolio a pension fund has, as not all styles adhere to the same market correlations. This added complexity is worth the effort to immunise equity returns from currency distortions, to impose better tail-risk measures, and to save on hedging costs, Jourovski adds.
Rutsch names FX-hedging as “a major handicap” and says it is penetrating many asset classes. But, as funds seek to diversify their real estate portfolios abroad in order to re-allocate money from domestic bonds, he expects pension funds to build foreign exposure and leave currency unhedged for now.
Cost cutting à la Suisse
Particularly for hedge fund managers like Nicolas Rousselet, head of hedge funds at Unigestion, costs are a major issue.
“To be honest, before the TER [total expense ratio]-transparency regulations, nobody had really looked at hedge funds’ cost-return ratio much, because in the past the returns had been very high,” he says.
Two years ago, the newly established Swiss top supervisory body Oberaufsichtskommission (OAK) decreed that all Pensionskassen must report TERs on their investments. Asset managers that could not provide this number were to be listed in a so-called ‘black box’ within the pension fund’s annual report.
“The impact of this can only now be fully felt,” says Rousselet. “It has become much more important to be more selective when investing in hedge funds, as the selected ones really have to have an impact on your return.”
Some risk premia can be accessed more cheaply than through funds, such as risk-factor strategies, leaving more money to pay for alpha generating managers, Rousselet adds, observing “clear demand from some pension funds that are not return seekers but are looking for uncorrelated yield”.
He continues: “Some investors have figured out that they do not need to be invested in hedge funds at all but are rather looking for unconstrained bond mandates or multi-asset total return structures.”
Economou points out: “The rethinking triggered by negative interest rate means investors are not just looking at minimising cost but maximising efficiency and return relative to fees.”
For Rousselet the “new ability of institutional investors to break down the stream of returns helps them make more informed decisions”.
Jourovski agrees: “Switzerland is quite a cost-conscious market so they like passive, but the more sophisticated pension funds have realised the downside of cap-weighted indices, like high concentration or the high momentum-bet.”
Additionally, he sees investors seeking greater diversification to achieve better downside risk control and for control over ESG risks. For Jourovski, this is part of an overall trend to include more qualitative elements in risk management: “People are not just questioning value-at-risk or volatility, but also additional risk dimensions.”
At Safra Sarasin, Alarcon confirms an increasing interest in environmental, social and corporate governance (ESG) criteria, albeit to a lesser degree than other parts of Europe. “In the actual implementation, ESG is not about complete exclusion or a pure best-in-class approach. It is much more about improving long-term returns and managing risks,” he says.
A brave, but complex, new world
A new view on risk management also has to translate into a new strategic asset allocation paradigm, says Alarcon: “You need a long-term view and [need to] manage shorter term risk or exploit the opportunities from that.” One case in point he mentions is the change in short-term versus longer-term volatility: “Between 2011 and 2014, volatility in Swiss equity markets was quite similar if measured daily, weekly, monthly or quarterly. The current situation shows higher volatility when observing daily or weekly data.”
Economou adds: “It is time to rethink allocations to unlisted markets, as they make up a lot of the global market capitalisation.” And regarding investment limits he stresses the Swiss BVV2/LPP2 regulations for pension funds are “in large parts prescriptive, not restrictive”. He adds: “It is only the interpretation of these rules that has led to a low allocation to private equity.”
While the negative interest rate environment may yet not have immediately impacted Swiss institutional portfolio decisions, the monetary and regulatory changes it has brought with it have increased the complexity in asset management.
“Demands on institutional investors’ professionalism have increased because a decade ago a CEO could make 4-5% return by doing some asset allocation on Friday afternoon,” says Rutsch. “Today, pension funds of a certain size, also public ones, have CIOs or dedicated investment board members. This is actually long overdue.”
Swiss Federal Railways fund raises fixed income risk
• Location: Bern
• Invested assets: CHF17.1bn (€15.5bn)
• Membership: 56,400
• Pension fund for employees of the Swiss railway system
• CEO: Markus Hübscher
Pensionskasse SBB (PK SBB), the fund for employees of the Swiss Federal Railways, has approached the low-interest-rate environment proactively. The CHF17.1bn (€15.5bn) fund, has lowered its conversion rate from 5.8% to 5.22% from 2016. It also lowered its discount rate to 2.5%.
But, the work cannot stop there. Markus Hübscher, CEO of PK SBB, says the fund is moving towards a new target asset allocation. “Funnily enough, we are going to increase our fixed-income allocation and reduce equity.” This is because the fund is looking for yield in riskier areas of the fixed-income market, increasing exposure to corporate bonds and high yield bonds. The fund, he adds, is also building an emerging market debt allocation from scratch. “By shifting into riskier bonds, we believe we can improve our expected portfolio return. But, in order to keep the risk budget that we have in place, we have to reduce the equity allocation,” says Hübscher. As a result, the fixed-income allocation will move from 61% to 68%, and the equity allocation will be reduced from 22.5% to 15.5%.
The equity portfolio will be cut across the board, without divesting from specific sectors or geographies. Hübscher says that the fund tries to earn risk premia, but adds: “In certain markets, we hope to get some additional return through active management. For example, in high yield, we chose active instead of passive management because the benchmarks used by active managers cannot be replicated by passive managers. Yet these benchmarks produce higher returns in the long term.”
The rest of the portfolio will be kept constant. The fund allocates 10.5% to real estate. Most of the allocation (9% of the overall portfolio) is in Swiss real estate, split between residential and commercial property. This is lower than the average allocation of Swiss pension funds, which stands at around 22%, as Hübscher points out. There is a 6% allocation to alternative assets, consisting of private equity and infrastructure investments (2%), hedge funds (2%) and insurance-linked investments (2%).
The unhedged currency allocation currently stands at 9.2% and consists of exposure to the Japanese yen, the US dollar and the euro. Hübscher explains: “We do not expect any return from our currency allocation. Leaving these currencies unhedged simply improves the overall portfolio risk from a diversification point of view.”
When it comes to formulating expectations of returns, PK SBB works with scenario analysis and currently identifies four situations, according to Hübscher. The ‘negative interest rates’ scenario sees negative interest rates continuing into the future. In the ‘stagnation’ scenario, the economy is not growing, but rates edge higher, or at least do not continue to fall. There is a ‘low growth’ scenario, with higher rates, and an ‘unorthodox’ scenario, which would see central banks implementing unconventional policies such as helicopter money. In the latter scenario, interest rates would increase faster. Hübscher says: “Our expectations have actually shifted towards a more negative situation, meaning we expect interest rates to stay lower for longer than we did a year ago. We therefore expect lower growth and lower rates both in the short and in the long run.” Originally, the fund also had a ‘normalisation’ scenario in which the economies would return to the ‘old normal’, but Hübscher says: “We believe it is unlikely to take place over our time horizon of five to 10 years, therefore we dropped that completely.”
For Hübscher, the efforts to reform the Swiss pension system are going in the right direction. “What has changed in the past 12 months is that there seems to be a broader agreement that this reform is not enough. So, after this reform has been completed, we hope successfully, we will have to look at the next reform immediately,” he adds. There is less clarity, Hübscher says, in terms of what the next steps will be, although increasing the retirement age should be on the agenda.
Migros Pensionskasse maintains its strong focus on portfolio diversification
• Location: Zurich
• Invested assets: CHF20.6bn (€19bn)
• Members: 82,000
• Defined benefit (DB) pension scheme for employees of the Migros group
• CEO: Christoph Ryter
Faced with a period of higher than usual correlation between asset classes, many have questioned the added value of diversification. But, judging by the results posted by the Migros Pensionskasse, diversification pays a handsome premium.
The CHF20.6bn (€19bn) pension fund makes diversification the main pillar of its strategy. Christoph Ryter, CEO of the Migros Pensionskasse, and former president of Switzerland’s pension fund association (ASIP), says: “We do not believe we can identify a precise scenario for how the Swiss and global economy will develop, so we stick to our strategy of very broad diversification.”
The DB fund, which is still open, manages the pension savings of employees of the Migros retail group. As of the end of August, the return for 2016 was 3.9%, higher than the 3.6% return of its benchmark. The coverage ratio was 122.7%. Returns over the years have fluctuated, owing probably to the swings of Swiss capital markets, and the decision in January 2015 to cut the peg between the Swiss franc and the euro. The return for 2015 was 1.6%, down from 7% in 2014. However, the coverage ratio has always stayed in the region of 120%, well above target.
In broad terms, under the strategic allocation 40% of assets is invested in fixed income, 30% in equities and 30% in real estate. In each asset class there is a core allocation and a satellite allocation of 5% of overall assets. Within fixed income, the challenge is that a larger portion of bonds, if held to maturity, will give a negative return. “In general, in fixed income we try to accept slightly more risk to enhance our returns,” says Ryter. But again, the safest solution is to diversify, according to the CEO. That is why the pension fund is rebuilding its allocation to mortgages, particularly Swiss ones, as well as loans. “The advantage of mortgages is that they are valued on the balance sheet at a nominal value. Because of that, the volatility associated to the asset class is lower compared to other fixed income instruments.”
The equity portfolio is split between Swiss (8%), global (17%) and satellite equities (5%). A quarter of the overall portfolio is allocated to Swiss real estate assets, 80% of which consists of residential and 20% of commercial assets. Swiss real estate has performed well, leading many to question whether there are any returns left. But Ryter says: “We are very cautious in how we value our real estate assets. And the Swiss market is somewhat different from other countries. A large number of people rent rather than own their home and, as a result, investment in residential assets is much less volatile than commercial ones.”
The strategic allocation also includes investments in international infrastructure, mainly through collective vehicles, and private equity. Ryter explains that the approach is not biased towards active or passive investment. “We have a risk-aware approach. I would not say that we have a quite a big portion of true passive investment, meaning full replication of an index. At the same time, we do not want to be too far from the benchmark. We want to invest in an active but carefully risk-controlled manner.”
The Migros Pensionskasse’s strategic asset allocation has been in place for several years. The slight changes in the portfolio have often reflected wider market sentiment, as well as the return and coverage ratio targets. The strategy is working. But not all funds are in the same position, and Ryter says their problems cannot be solved by changing investment strategies alone.
He says: “Not all problems of pension funds can be solved with just slight changes in asset allocation. In addressing the major problems, which are increasing longevity and low returns, we have to consider the pension promises. We may have to increase contributions, decrease benefits or increase the retirement age at systemic level. This is much more important than making small shifts in asset allocation.”
This is where the current reform discussions become important, adds Ryter. The appropriate solution, he says, is a blend of measures that includes a lower conversion rate.
Yet, Ryter believes the Swiss pension fund industry is capable of facing the finer challenges in pension management, particularly keeping costs down. The system has achieved an increase in transparency and cost reductions thanks to recent reforms.
“More than 99.5% of investments are cost transparent for the average pension fund, according to a survey by ASIP, and costs are in the region of 48bps,” says Ryter. He says this benchmark accounts, as well, for a number of small funds that use intermediaries such as consultants or collective investment vehicles. “This is not a bad result,” he says.