Spain: A new age of discovery
Spanish pension funds are breaking with traditionally conservative investment practices as they strive to achieve positive returns in the low-interest-rate environment
• Occupational pension funds are seeking new asset classes and investment styles to lift returns and hedge risk.
• Fixed income durations are being lowered to protect against expected interest rate rises.
• Fixed income returns in non-euro-zone markets have been reduced by the euro’s appreciation.
Spanish pension funds are venturing into uncharted waters just like the Conquistadores sailed west 500 years ago in search of El Dorado.
Continuing dismal bond performance, added to perceived interest rate risks, is forcing more Spanish occupational funds to seek returns from new asset classes and management styles.
“The allocation to return-seeking assets is the highest since 2008,” says Álvaro Molina, head of institutional investment, Aon Hewitt. “We have seen an increase in the allocation to European equities, diversified credit, real estate and private equity.”
Molina says an increased allocation to alternative assets is widespread among Spanish funds: “Many funds, which had no or very limited exposure to alternatives, are increasing their allocations, and we expect this trend to continue this year.”
He adds: “Exposures to illiquid assets such as private equity, private debt and real estate funds are now more common. We also expect an increase in allocation to certain hedge fund strategies as volatility increases.”
David Cienfuegos, head of investment, Spain, at Willis Towers Watson, says that relative-value and absolute-return mandates are probably the most commonly researched. “But, we are beginning to see a growing interest in alternative beta,” he says. “This is something boards of trustees have been mulling for a while, but it seems that after the current market performance for bonds, pension funds in Spain are seriously considering this move.”
Fixed-income investments amount to just over half of portfolios, with half of this in Spanish government debt, according to the country’s Investment and Pension Fund Association (INVERCO).
“Govies are seen as a high-risk, low-return asset,” says Jon Aldecoa, consultant at Novaster. “In this sense, the allocation is not increasing while the assets mature. What is attracting some interest is active fixed income, with leverage, propositions, which would normally be with big international managers.”
He says a notable change in asset allocation has been an increase in the cash position: “Many investors have reached their limits on equities and alternatives but do not want to take risks in fixed income.”
And he says that while there is an extensive market for Spanish government debt, there is no market for regional debt: “In some cases, because of the imbalance in their budgets, and in others because of the small size of the issuances.”
According to figures from Mercer , the best returns for the first half of 2017 came from equities, with euro-zone shares returning a median 7% and non-euro-zone shares 2.7%. The next best performer was alternatives, with a 2.2% return.
“A significant part of alternatives is invested in private equity, which is performing very well too,” says Xavier Bellavista, principal at Mercer. “The impact of euro appreciation – especially versus the US dollar – is affecting the performance of non-euro-zone fixed income, the only asset class with negative performance – of -4.6% – for the year to date. Non-euro-zone equity is obviously also affected by the euro’s appreciation, but the good performance of the underlying assets means the overall performance is still positive.”
“The equity rally of the end of the year contributed a lot to a good final performance,” says Aldecoa. “But despite the current low level of interest rates, the fixed-income allocation has not hurt the global return. The expectations about equity markets and the economy are mainly positive about continental Europe.”
Indeed, this optimistic outlook extends as far as to increase exposure to Italian government debt, in the face of renewed concern over the perceived weakness of its banking system.
Aldecoa says: “We have seen some interest in Italian government debt, as it offers positive yields at short maturities, which is not the case for Spanish public debt. However, exposure to the Italian banking system was already quite limited.”
Bellavista agrees: “Some managers are using Italian debt to benefit from its higher spread, as they used to do with Spanish debt from 2012 to 2016.”
There is, however, less optimism about Brexit. “The Brexit developments are being closely followed by most pension fund managers and control committees, and we have been very active providing information and analysis to our clients,” says Molina. “The perception is that the consequences of the Brexit are still unclear and we have not yet seen significant asset allocation decisions based on potential consequences of Brexit in the financial markets.”
“Brexit is definitely affecting asset allocation,” says Aldecoa. “I don’t think that there is a problem with sterling, and there aren’t problems with the managers based in London. The question is the uncertainty about the future of the economy in the UK, especially about small and medium-sized enterprises.”
Statutory system assessed
Closer to home, the parliamentary committee monitoring the Toledo Pact agreements finished its review of Spain’s pensions system earlier this year. However, its recommendations had not been published at the time of writing.
The review is an analysis of the statutory pensions structure, but, says Aldecoa, could have implications for private pensions. “In the long term, there should be an increase in coverage of the occupational systems,” he says. “In a more mature pensions industry, we should expect an increase of the risky assets allocation, as at present, investment policies are still quite conservative.”
In the short term, however, pension funds have to contend with interest and inflation risk. “Everybody expects and fears the short-term effects of an interest rate rise,” observes Aldecoa. “Most investors are reducing durations, increasing the cash position, and investing in absolute return funds and in other active fixed income funds.”
Bellavista agrees: “Most of the managers in Spain have been expecting a rise in interest rates, so most of them are maintaining lower durations in the funds in comparison with their benchmarks.”
He says the average duration of fixed-income investments in pension funds is 4.5 years, but if cash investments are included, the duration of the overall portfolio reduces to 3.5 years.
“However, since interest rates have already risen in the past six to 12 months, some managers are taking some short-term tactical decisions to increase duration,” he adds. Of course, duration is not the only way to hedge against rate rises.
“While durations are below neutral levels, maturing bonds are also being replaced by floating-rate bonds,” says Molina. “Furthermore, interest rate risk is being managed more actively with the increasing use of fixed-income futures.”
Cienfuegos says that professional conversations with clients and managers show that large Spanish pension funds are keen on limiting exposure to the latent risks perceived in traditional euro-zone bonds, mainly core, although fewer participants consider Spanish government bonds attractive at current valuations.
“So we are seeing a trend to consider other options,” he says. “We know large pension funds are looking at diversifiers, primarily hedge funds and smart beta, to avoid interest rate risks.”
But diversification has its drawbacks. “Investment strategies of Spanish pension funds are becoming more global and more diversified,” says Molina. “This presents challenges in portfolio construction for the local pension fund managers who have to search for management expertise in regions or assets that they are less familiar with. In some instances, the investments are implemented passively using exchange-traded funds (ETFs) or indexed funds, especially in developed market equities.”
He adds: “Active managers are being used in markets with higher potential for alpha generation, diversified credit, absolute return strategies and global fixed income. We expect this trend to continue.”
In fact, pension funds appear to be taking a more proactive approach altogether. “Active versus passive management is an on-going discussion that in some cases we have reactivated with clients this year,” says Bellavista. “Meanwhile, a significant percentage of funds in Spain are actively using options strategies to protect their equity investments.”
Another debate among pension funds is currency hedging, says Bellavista: “Funds with a significant exposure to non-euro-zone assets may put some kind of hedging in place to protect between 50 and 100% of the currency exposure.”
Aldecoa says: “We expect a limited increase in risky assets, such as equities and private equity, and an increased exposure to emerging markets and to real estate. However, the approach is very cautious as in many cases valuations are high.”
But investment returns are not the only consideration, he points out. “Some big schemes could set up ‘impact portfolios’ composed of equities, thematic mutual funds and private equity and linked to some of the UN’s sustainable development goals,” he says.