Portugal’s pension funds are cautious on Europe after recent events, writes Gail Moss

At a glance

• Portuguese investors are looking to global assets for diversification. 
• Brexit is affecting some allocations with some investors less positive on Europe.
• Pension funds are likely to turn to non-traditional assets to provide more yield.

Against a backdrop of a steadily recovering domestic economy, private pension funds in Portugal have maintained stable asset allocations over the past year. But this does not mean there have not been noticeable shifts between and within asset classes.

Last year’s economic challenges centred on complying with the terms of the European Union bail-out in providing fiscal stability, plus continued fall-out from the Banco Espirito Santo collapse. Since then, potential causes of concern have arisen in other parts of Europe.

“Brexit has affected our conviction on European equities,” says José Luís Borges, head of institutional client portfolios at BPI Gestão de Activos (BPIGA). “We still prefer them to their US counterparts, but have less conviction since the Brexit vote, and recently shifted part of our European allocation to global assets because of the increased uncertainty in Europe.” 

“The way the EU addresses Brexit and the danger of political turmoil – further enhanced by the outbreak of terrorism – will play a major role in the way we move risk within portfolios going forward,” says João Eufrásio, head of institutional portfolio management at BMO Global Asset Management Portugal (BMO GAM). 

Another cloud on the horizon affecting allocation decisions is the Italian banking crisis. Willis Towers Watson (WTW) has noted some decrease in exposure to the Italian market, mainly in government issues which it says is the most relevant asset class for the region. However, Eufrásio says the dimension of the Italian banking problem has created not only risks, but also opportunities. 

“We have become more cautious on the sector and also on the country,” he says. “The opportunities arise from the fact that the news flow will create distortions and misreading of reality. As with the political crisis in Spain [at end-August the country was still without a functioning government since inconclusive elections last December], we tend to be more dynamic in managing the exposure to the country and sector.” 

According to the Portuguese Association of Investment Funds, Pension Funds and Asset Management (APFIPP), investment in non-domestic assets by Portuguese pension funds is as high as 80%, excluding real estate and deposits, where investment is virtually 100% domestic.

Gaudêncio Guedes, investment consultant, at WTW, says: “Europe continues to be the most desired region for Portuguese pension funds. We estimate a relatively small fraction of the total assets – around 10% – are invested outside Europe. This probably has to do with the fact that most are fixed-income-type assets, and to avoid foreign currency exposures.”

APFIPP estimates based on official figures from the pension fund regulator and information collected by APFIPP itself show that at 31 March 2016, debt still dominated portfolios, with 54.9% invested in the asset class. Of this, there was 29.4% in public and 18.4% in private debt (both invested direct), with a further 7.1% in bond funds. Total equity holdings were 20.3%, with 8.6% held directly and 11.7% through funds. Direct real estate made up 8.8% of portfolios, with a further 5% through funds.

“Government issues have been picked up with more frequency compared with corporate debt,” says Guedes. “However, overall we have noticed an increase in corporate debt exposures, and a significant decrease in money market and long-term deposits (about 2.5% and 5.5%, respectively).”

“There is an overwhelming preference for Portuguese sovereign debt at present,” says Ramón Pereira, general manager, Spain, Franklin Templeton Investments. “Specifically, this is towards the shorter and medium-term maturities, as it continues to deliver strong yields now, and has done over the past few years. Other secondary areas would be emerging market debt and floating rate debt, but strictly towards risk-adjusted alpha-generating-type strategies.”

But all is not rosy within the domestic economy, says Guedes. “The Portuguese banking sector, as well as the public finances, are a bit out of shape, which has been sending some less positive signals to the markets,” he says. “We have noticed a substantial decrease in the exposure to Portuguese financial markets, mainly in the equities market.”

Eufrásio says that since the inconclusive outcome of last year’s elections in Portugal, BMO GAM has assumed that Portuguese government bond yields would become more volatile, potentially interrupting the spread compression observed in the past few years. 

“However, fundamental choices of allocation to Portuguese government bonds have not changed,” he says. “We have slightly reduced our exposure to reflect an increase in risk.”

And, as ever, the search for yield continues. Eufrásio emphasises that with most of the investable universe of a classic fixed-income portfolio carrying zero or negative yield, investors have been forced to look for other sources of income. 

“Markets are now open to issuers who were not able to access the bond market before, due to size or credit quality,” he says. “These types of issuers are now able to extend the maturity of their debt, given a renewed appetite from market participants to take more risk. We have to cope with these conditions, aiming to diversify away from government bonds using a mix of private placement issues, securitisations and stretching the maturity on a variety of issuers where we are more in touch with their risk levels and activity.” Other options, he says, have been to look at selected emerging markets for higher returns on a combination of yield and currency play. 

APFIPP says that Portuguese pension funds returned 2.4% over 2015, according to estimates from consultants. The best-performing asset class was equities, with 4%, while European equities returned 5.5%.

But there is consensus that euro-zone fixed-income also played its part. Borges says: “In terms of risk-adjusted returns, euro-zone government bonds have been contributing the most. Nevertheless, looking ahead, our outlook for this asset class is not positive. We are markedly underweight fixed-income assets, both government and corporate bonds, because we consider that there is an asymmetry of return/risk in fixed-income assets, that is, not enough return potential for the risk incurred.”

The million-euro question is, of course, will interest rates go up or down? And when?    

“Pension funds have been waiting for many months for interest rates to pick up,” says José Veiga Sarmento, chairman, APFIPP. “But the opposite has been happening. It is a very difficult situation for defined benefit schemes, where sponsors are currently trapped with no solution in sight.”

Pereira says: “Pension funds in Portugal are generally preparing for an eventual rise in interest rates, but there is a wide variety in views on the exact timing and rate of increase. However, the expectation of a potential rate rise is leading pension funds to look at the lower to medium ends of the yield curve.”

Turning to the outlook for the next year or so, diversification seems to be a priority. Sarmento says investors are looking for opportunities outside Europe, especially in emerging countries. “Safe harbours like gold can be of some interest,” he adds.

Borges notes that some pension fund sponsors are shifting part of their euro-zone bond allocation to international bonds.

Likewise, Guedes says: “Given current low interest rates, which we believe are here to stay for a long period, we are advising our clients about moving to a more global diversified approach, to dilute their overall concentrated risk position in the euro-zone markets.”

He adds: “It would not come as a surprise if an appetite for sources of return other than the ones available in the traditional investment toolbox arose in the near future. This could mean non-European credit and, eventually, alternative assets.”

According to Pereira, Portuguese investors are currently very focused on risk mitigation and drawdown profiles: “There is a focus on strategies with a risk/return profile for low (1-2%) and medium (3-6%) volatilities,” he says.

Pereira adds: “A number of players are also looking to the liquid alternatives space, as they search for yield in this low-growth environment, but with controlled volatility and daily liquidity.” 

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