Domestic investment: Returns, but at what cost?
Daniel Ben-Ami looks at the difficult balance between investing in Swiss assets and going international
At a glance
• Investments in Swiss government bonds face negative yields across the curve.
• Swiss equities are widely seen as expensive.
• The low-interest-rate environment has pushed up domestic property prices.
• But any move into foreign assets runs the risk of an adverse currency shift.
Although Swiss pension funds have a low home bias, local investments still make up a substantial proportion of their portfolios.
By far the largest investments, with an average of about 25% of total holdings, are Swiss franc bonds, according to Credit Suisse. The obvious problem with these is they offer a negative yield, so poor returns are guaranteed. It is not just official rates that are negative but much of the fixed-income yield curve. Even yields on 10-year bonds are negative at present (see figure 1). “It’s absolutely crazy, the 10-year bond rate for govies is minus 0.3,” says Hansruedi Scherer, a partner at PPCmetrics, a consultancy in Zurich.
However, there are less obvious problems as well. The most pressing of these is a lack of liquidity. “The Swiss bond market seems to be very illiquid at the moment,” says Scherer. In his view, this makes it easier for small pension funds to pursue an active strategy in Swiss bonds than it is for larger funds.
Alain Barthel, the head of Swiss institutional business at UBS Asset Management, takes a similar view about domestic fixed-income. “If you look at the liquidity of the Swiss bond market, you have to work hard to find solutions”.
That creates a strong incentive to invest in foreign-currency-denominated fixed-income issuance but, to ensure liabilities are matched, hedge back into Swiss francs. However, such an approach can entail significant costs, particularly with current uncertainty about currency movements. That might explain why, according to Credit Suisse, there seems to be no upward trend in the allocation to foreign bonds. If anything, it has fallen slightly from an average 8.79% in the third quarter of 2014 to 7.59% in the final quarter of 2015.
These figures suggest that, overall, there is a lot of hedging back into francs. Credit Suisse put the franc component for Swiss pension funds at 78.63% in the final quarter of 2015. The next represented currencies were the dollar, at 7.37%, and the euro at 3.68%.
The average holdings in Swiss equities have been stable between 13% and 14% of total assets. Switzerland, of course boasts large multinational companies as ABB, Nestlé, Novartis, Roche and Zurich Insurance. These offer international exposure, since a large proportion of their earnings originate from overseas, but pay out in francs.
Clearly these can be seen as safe assets for Swiss pension funds. “Nobody ever gets fired for buying Nestlé,” says Kevin Gundle, chief executive officer of Aurum Funds.
However, the advantage of investing in such stocks has pushed up prices. “The Swiss equity market is quite expensive,” says Ungestion’s chief executive officer, Fiona Frick. She points out that “it mainly consists of quite defensive stocks”.
Going down the capitalisation scale also brings problems. Smaller companies are often more domestically oriented. In addition, Stefan Beiner Publica’s head of asset management, points out that with Swiss mid-caps “there could be a liquidity issue”.
Real estate has long played a larger role in Swiss pension funds than domestic equities. Credit Suisse puts the average holding at 22.4% at the end of 2015, up on the previous two years, but does not break this down into foreign and domestic components.
Professor Peter Meier, the head of the Centre for Asset Management at ZHAW, says ultra-loose monetary policy has artificially inflated property prices. “The real estate market is overshooting because of low interest rates,” he says. For that reason, he argues that it is close to its peak in the cycle. In his view, this is the sector where there is the strongest case for going global.
Peter Zanella, the head of benefits and retirement solutions at Willis Towers Watson in Zurich, says property is the key investment class in Switzerland. “I know for the international community it’s an alternative investment,” he says. “Here, it was traditionally always an important asset class.” He shares Meier’s view that now might be the time for pension funds to increase their global property weighting.
Another possibility is for pension funds to increase their holdings in alternative investments such as private equity or hedge funds. Since they constitute less than 6% of the average portfolio this would seem an obvious move.
But again there is a catch. Although alternatives may be attractive, they also tend to be more expensive to manage. That does not sit well with an industry that carefully scrutinises costs.
“At the end of the day it’s a bit of a paradox,” says Barthel of UBS. “If strategies deliver more returns and thus have a higher TER it should theoretically be beneficial for pension funds.”