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Switzerland: The big squeeze: active vs passive

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Emma Cusworth asks if active management is stifled by the concentrated nature of the Swiss market

Swiss pension funds have increasingly indexed domestic equity and bond exposure in recent years. As interest rates and risk appetite remain low, funds will have to squeeze assets for every possible unit of return.

Active management would seem a natural fit, but does concentration in Swiss markets limit outperformance potential?

BlackRock's active Swiss Opportunities fund has produced average annual returns of 11.3% since inception in September 2005. Over the same period, annualised returns for the SPI and SPI Extra were 1.5% and 4.8% respectively.

"That is almost a 9% premium net of fees, which is pretty material," says Carl Lee, head of BlackRock's European specialist equity team. "Markets are not efficient so opportunities exist for active managers, especially in small and mid-caps."

However, active strategies generally focus on fewer securities, increasing single-name risk, especially in bond markets, where illiquidity and credit risk are paramount.

Martin Oetiker, senior vice president at Banque Syz, says: "If a manager has the skills to consecutively pick the right issuers and duration this strategy can be very successful, but with the higher issuer-specific tracking error, the severity of a possible credit event is definitely greater."

Banque Syz Swiss Government Bonds Indexed fund returned 6.97% per annum over the last three years.

Security selection has become crucial in fixed income. Historically, generating alpha was mainly about curve and duration management.

"During the crisis the most important success factor has been managing credit as interest rates and credit risk moved significantly," says Juerg Bretscher, Swiss bond portfolio manager at Vontobel. "This has proven the case for active management."

The relationship between issuers' debt and corresponding index weight exacerbates the impact of concentration. "Equity concentration at least corresponds to economic value," says Olivier Ginguene, CIO of Pictet's balanced business. "For bonds, the bigger the debt, the bigger the risk, but the bigger the position in the index. The effect of an event like GM could be lethal."

The recent indexation trend pushed allocations towards companies and governments borrowing more frequently.

According to Bretscher: "Investors are not aware of the problem. General Electric's triple A rated bonds, for example, have reached 10% of the SBI AAA weight." In March 2009, S&P cut General Electric's credit rating from AAA to AA+.

Concentration also creates illiquidity, which normally favours passive management. Beyond government bonds liquidity dwindles, particularly for longer-dated and lower-credit bonds. "Thus, successful active management in the Swiss bond market is very difficult," says Sven Ebeling, Mercer's head of investment consulting Switzerland.

Illiquidity also increases transaction costs as trading has a greater market impact. "Active strategies, which require frequent trading, don't make sense," Oetiker says. "The Swiss bond market therefore offers only limited potential to create alpha."

However, Bretscher argues, outperformance from successful active security selection can offset transaction costs. "This is not the case with indexing," he says.

In equity markets, while single-stock risk is higher in active management, the index is heavily exposed to sector risk.

Beat Widmer, CIO for Deutsche Asset Management in Switzerland, explains: "Nestlé, Novartis, Roche and UBS represent 51% of the SPI, hence the performance of the Swiss market depends on sectors, whether they are en vogue or not. Currently, the Swiss large-cap index is underperforming European peers due to its pharma and bank exposure."

Despite the need to increase returns across asset classes in the low-interest-rate environment, Swiss pension funds are increasingly turning to passive management.
Peter Baenziger, CIO at Swisscanto, says: "We are likely to see a trend towards chasing carry, alpha and — as the last measure — increasing equity exposure. Despite this, we do not see a trend towards active management."
 

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