Switzerland: Sitting pretty
Emma Cusworth charts Swiss pension funds' allocations to domestic equities
Swiss pension funds' domestic equity holdings have performed relatively well during the financial crisis, due in no small part to the higher exposure to small and mid-caps necessary in such a concentrated market. The relative weakness of the US dollar and euro also hit foreign equity allocation in Swiss franc terms.
Why then are Swiss schemes not building allocations to domestic equity? The answer is risk. With funding levels hovering below 100%, few schemes can afford to increase risk despite the need to achieve 3.9% return to break even.
The UBS Pensionskassen Barometer shows domestic equities returned 3.08% in the year to the end of September versus -1.62% for foreign equities, based on average allocation levels.
Because the Swiss market is so concentrated, most pension funds use the SPI, which includes 230 names, as their main domestic equity benchmark.
The four largest Swiss companies, Nestlé, Novartis, Roche and Credit Suisse, already account for 54% of the SPI. Using the large-cap SMI, which tracks only 20 names, would significantly increase single-stock risk.
"The small/mid-cap segment, which represents 15% of the Swiss market, is the cyclical risk component," Beat Widmer, CIO for Deutsche Asset Management in Switzerland, says. "Its effect on the SPI is significant. Over the last 10 years small/mid-caps returned 60% while large caps stagnated (+5%)."
This outperformance, coupled with the high single-stock exposure to Swiss large caps, means many pension funds are overweight small and mid-caps. Mercer's head of investment consulting for Switzerland, Sven Ebeling, says some schemes may be as much as 10% overweight.
The Swiss market has another inherent advantage: Switzerland has an abundance of high-quality multi-national companies.
"These large companies are seeing most of their growth in developing economies and therefore offer exposure to emerging markets, but with lower risk," according to Olivier Ginguene, CIO of Pictet's balanced business. "The result of the mid-cap and emerging effects is an index that is well-balanced to benefit from global growth," Ginguene says.
However, the strong international focus of many Swiss companies feeds currency volatility through to the SPI. Transactional losses, where costs are incurred in a strong currency while sales are in a weak currency, are problematic for margins and, in extreme cases, can threaten survival.
Stefan Meyer, analyst at UBS wealth management research, says: "Translation losses, where profits earned abroad are worth less in Swiss francs, have been less severe, but on average around 75% of sales of the 80 largest listed Swiss companies are produced abroad, mainly in US dollars and euro. Consensus earnings forecasts for Swiss companies have been down around 1-1.5% per month, which we largely attribute to currency-related losses."
Despite this however, Swiss equities have not underperformed. On a currency-adjusted basis, the SMI is roughly in line with the Dow Jones Industrial Average year-to-date.
Currency fluctuations have also been an unpleasant side effect of diversifying into foreign equities, which has been encouraged by consultants and investment managers alike.
According to Stefan Angele, head of investment management at Swiss & Global: "The currency impact on performance, and therefore on pension funds' ability to meet their liabilities, has been huge this year. The euro and dollar lost ground against the Swiss franc, meaning schemes suffered an additional loss on their foreign currency investments."
In August, the UBS Pensionskassen Barometer showed foreign equity returned -6.36%, which was due to a slight fall in markets, but mainly the weakening of the euro and US dollar (domestic equity -0.51%).
Extreme currency volatility has caused two reactions from pension funds. Mercer has seen more schemes considering hedging currency exposure in equity portfolios, previously only applied to fixed income.
Others are reconsidering foreign equity allocations. According to Bucher, the good historic track record of Swiss equities is the most common argument from clients against further diversification abroad.
"Hopefully we will see more of an increase in the average currency hedging ratio in the future rather than a move back to the former mindset of running a significant home-bias in the equity exposure," says Ebeling.
Swiss pension funds have made a significant move away from their old home-bias. Domestic equity allocations have halved from 22.75% in 1998 to 10.25% (June 2010) based on figures from Complementa.
"Some pension funds have even gone as far as getting rid of the ‘domestic' category all together and either leave it up to their active manager to decide what proportion of Swiss equity to hold or just hold market weighting levels," Ebeling says.
Despite the general decrease, Peter Baenziger, CIO at Swisscanto, says home-bias is still strong with holdings clearly overweight Swiss equity relative to the main global market indices. "Foreign equity has not outperformed for any sustained period during the last 25 years," he says.
In fact, few schemes are making any real changes to equity allocations as appetite remains generally low.
During 2008, Swisscanto figures show 70% of schemes ignored rebalancing rules, allowing equity allocations to fall below strategic limits. Some buying has returned, although this is predominantly very cautious and designed to return to strategic levels.
"The 28.4% rebound since the beginning of 2009 has helped stabilise equity allocations," Ebeling says, "but there has not been any aggressive buying even among those below their lower limits."
Even considering their relative outperformance, few schemes are expected to build allocations to small and mid-caps.
"I don't understand why Swiss pension funds don't have more exposure to this segment, which should be key to any investment approach," Carl Lee, Head of Blackrock's Specialist Equity team says.
"Small and mid-caps should always beat large caps," he continues, "But I also don't expect to see that changing as there has been no increase in risk appetite. The Swiss financial community has been shaken over the last 18 months, which has not entirely washed out of the system. It takes time for confidence to return and until it does, we will not see any real move."
In fact, market recovery could mean lower equity allocations as schemes try to manage risk. "In today's stronger markets we may see some selling of equities as schemes attempt to regain a neutral stance relative to strategic weights," Baenziger says. "We haven't seen this happen yet, but risk levels will become too high so they may take profit as things improve."
The problem for many Swiss schemes is reduced risk capability in light of funding
shortfalls. Complementa research shows that Swiss schemes' average weighted funding ratio was 97.6% at the end of June. According to Ginguene: "Although buying into equity would be rational in terms of expected return, it also raises the risk profile and schemes cannot afford to lose money with funding levels below 100%.
"In the short term, there will probably be a move towards domestic equity by Swiss schemes due to risk constraints and currency effects," he concludes. "The emerging and mid-cap effects on the local market will also be attractive and those following more conservative strategies have been the winners in recent years. Concentration risk in the local market poses a considerable problem, however, so schemes will simply have to diversify long-term."