Index houses' expertise will be in demand, predicts John Minderides of Barclays Global Investors
EMU Big Bang, new benchmarks for Europe - European plan sponsors sell domestic bonds and buy international equities, happy days for investment bankers and brokers, Ferrari sales rocket, Maranello stop taking orders, Schumacher becomes a non-executive director of Barclays.
"January 1 1999, introduction of the euro, confusion, apathy, falling liquidity, investors stay away. Low cross border flows, further European banking consolidation, Ford sales increase, Schumacher switches to Indy racing."
These are probably two ends of a spectrum, but the diversity of opinions on asset flow scenarios and investment behaviour post January 1 1999 have been immense. Changes in investment styles and categories, client benchmarks and pension fund trading patterns have most certainly been exaggerated. To fulfil the predictions of some broker research, the Netherlands would need to sell $21.5bn of Dutch equities on January 1 1999 to rebalance their portfolios to a pan European weighting. Representing 5% of the Dutch equity market, half of pension fund's Dutch equity holdings and more than half a year's trading volume, this would obviously be difficult: the liquidity effect on share prices, and the feedback this will have on asset weightings, have apparently been ignored. Potentially the most damaging effect of this type of approach is signs of analyst equity re-rating based on assumed pension fund re-balancing; these are early days yet. What is clear is that life will be different.
The net losers from this analysis are the capital markets of the EMU 'in' countries that have developed pension provisions. Hence the Netherlands is earmarked for massive domestic equity disinvestment, whilst Germany, with an undeveloped pensions market, is expected to be a big winner. The increased flow into German equity will not only be due to domestic demand for increased pension provision, but also the need for Dutch pension plans to buy non-Dutch euro equities.
This approach ignores some fundamental pieces of information: liquidity, EMU and investor inertia, the speed of pension reform and most importantly the axiom for pension plan sponsors to match liabilities when making their investment decisions and setting benchmarks. An alternative scenario could be that the speed of German pension reform creates net inflows to the Dutch equity market; the need for an increase in equity issue could be the catalyst for an equity bull market in Europe until 2010. Plan sponsors will not switch benchmarks overnight on January 1.
With the introduction of the euro - stage 3 of EMU - a single currency is born, but the path to full monetary and financial integration across Europe is only part trodden. The development of European wide pension schemes denominated in euros satisfying the needs of members in all countries is still some way off. Plan sponsors need to match the liabilities of scheme members, and on January 1 1999 these will still be predominantly domestic. Europe-wide liabilities will only develop with increased synergies in capital market activity, economic development, regulation, taxation, and freedom of labour movement; in effect, the move towards Europe becoming more like a single economic entity.
Whilst evaluating the potential flows in a static situation makes interesting headline reading, actual asset flows in Europe over the next five years will be far more complicated. To cloud the issue even further, this activity will be radically different from the perspective of four broad classes of pension investors.
Those EMU 'in' countries with developed pension markets, such as The Netherlands, do not need to increase equity holdings; but in an EMU world they will need to diversify their euro denominated European equities, mainly through selling Dutch and buying international equity, particularly that of non-EMU countries.
For those EMU 'in' countries with under-developed pension provision pension reform will require ever increasing equity participation. This effect will far outstrip the need for domestic funds to diversify their equity holdings. The increasing demand that this will generate can be met by liquidity driven increases in valuation or an increase in equity over debt issuance. Thus these countries' equity markets are likely to be beneficiaries of EMU.
The UK, with its equity dominated capital market and highly developed pension fund industry, will still be deeply affected by the introduction of the euro despite remaining outside EMU for at least the next five years. In the short term country effects will continue to dominate, and thus offer considerable opportunities. Over longer time horizons minimum funding requirements and falling diversification from investing in euro denominated equities will increase pressures for UK pension funds to divest themselves of European equity. This will be additionally impacted by UK's EMU entry, in which UK equities will become euro denominated as the distinction between EMU country equity markets continues to blur. The UK will in effect go through two conversions.
For non-European investors the introduction of the euro marks the start of a single European market with decreasing diversification, but greater opportunity for economic reform, harmonisation, efficiency improvements and corporate restructuring. The merits of these benefits will have to be judged against the likely short-term pain and cost increases, and the corresponding risks of EMU failure.
Whatever the relative strengths of these competing flows, the one assured result will be an increase in cross border (vanishing borders in some instances) fund flows. What we can also be certain of is that portfolio rebalancing will not happen overnight, but will be slow and measured against the changing liability profile of participants.
Whatever the speed of rebalancing, it is certain that the ability to manage large asset flows will be an essential one for fund managers to possess. In attempting such an efficient movement of money, it will be the large managers who can add most value, both because they have the greater systems capacity and because of the importance of crossing in cost savings. A very large manager can often cross securities instead of buying and selling them in the open market, and thus save large amounts of money on dealing spreads, stamp duties and brokers fees. Such activity demands a coincidence of buyers and sellers unavailable in any but the largest managers. The need for matching orders also means that index houses are most likely to be able to cross large amounts, as their holdings resemble each other more than they would do in a traditional active environment, where the profiles of each fund for separate clients vary significantly. Thus it is the leviathans of the investment management industry, firms like Barclays Global Investors, who are best able to cross securities for their clients. A vast asset base and corresponding trading volume gives the large managers the ability to seek the very best trade executions.
In the prelude to EMU, clients may have to become more searching in questioning their managers about their trading capabilities. With the need for large amounts of rebalancing, it will become more apparent which managers have the ability to save money for their clients through crossings. After all, the ability to cross eventually bolsters, or rather avoids the reduction of, the returns that clients eventually receive on their portfolios. In what seems to be an era of fairly efficient markets, particularly in the US and UK, it is hard enough to add value above an index - a fact clearly demonstrated by the recent underperformance of most active managers - without throwing away returns on costs. Both clients and thus fund managers need to look very closely into transitioning techniques in the light of the approach of European monetary union.
John Minderides is head of asset allocation and derivative strategies at Barclays Global Investors in London"