Officially, Swiss pension funds must observe investment limitations set out in a law which details how much they are allowed to invest in certain asset classes. There is, for example, a 30% ceiling on foreign exposure across a portfolio.

However, an increasing number of pension funds want to gain benefits through diversification. So, while the restrictions on investments are detailed in articles 53 to 57 of the so-called BVV2 law, they are making use of article 59. This allows them to exceed the investment limits if their financial situation allows it and they submit the reasons for it in writing.

The Swiss pension fund for employees of the Canton of Zürich (BVK), for instance, exceeded the foreign exposure criteria by nearly 9% at the end of 2006. It usually takes advantage of article 59.

"The investment limits give false security and some of the new instruments or products, such as commodities, are completely ignored by the law," says Daniel Gloor, head of asset management at BVK. "That is why we apply the prudent man rule rather than stick to the prescribed limits. To achieve our return - targeted to be 5.9% for 2007 - and in accordance with our risk ability, we have to diversify and invest more abroad. We cannot invest our entire CHF21bn (€12.7bn) in assets under management in Switzerland alone."

Gloor says that submitting written reasons for a relaxation of the limits is a straightforward process. "But when more and more pension funds make use of the exemption rule, the question arises whether the limits are still justified," he adds.

The validity of the 20-year-old limits has been discussed by politicians over several years, but unlike the minimum investment return it no longer seems to be a priority, Gloor says.

Nevertheless, the limits may still give guidance to small pension funds.

Rolf Banz, chief investment architect at Pictet Asset Management, says that the application of the rules has always been pragmatic. "I still see a great deal of resistance towards the prudent man rule because there is the feeling that some of the smaller funds might be tempted to do things that they should not," he says. "But the bigger funds find it very easy to apply article 59 without significant time or cost factors."

René Raths, client relationship manager at Zürcher Kantonalbank (ZKB), puts the increased use of article 59 of the Swiss pension fund law down to the importance of asset liability studies. "Asset allocation strategies are based on asset liability studies, which should reflect the market conditions and new asset classes as well as the specific structure of the pension fund," he says. "Consequently, asset allocation strategies aim at the prudent man rule. And nowadays it is possible to monitor asset allocation strategies via risk parameters such as volatility, value-at-risk and tracking errors so the limits are out-of-date.

"However, it is mainly the large pension funds that invest according to the prudent man rule. For small, traditional pension funds, a simple law often works better than the prudent man rule, as they tend to employ external specialists, which makes investment limits important."

Serge Ledermann, head of investment and strategy at private bankers Lombard, Odier, Darier, Hentsch & Cie (LODH), says that if a pension fund is a professional organisation and looking for better returns, there is no other option but to diversify, with the risk being mitigated through the portfolio's diversity.

"The Swiss are generally quite prudent," he says. "Because they have to deliver guaranteed minimum interest rates, pension funds are unwilling to take undue risks. And new products take time. So those that move away from the guidelines do so only in small steps."

Like the rest of the market players, Andreas Schlatter, responsible for Switzerland at UBS global asset management, opposed investment limits but favours their simplification rather than complete abolition. He says that, since article 59 started to allow pension funds to deviate from the limits in 2000, alternatives have become more popular in the search for diversification.Gloor believes that diversification in alternative asset classes reduces the overall risk and has a stabilising effect with regards to the traditional asset classes.

As part of its strategic asset allocation 2007-2011, BVK recently started directly investing in foreign real estate and aims to increase that exposure to a fifth of
the portfolio's total 20% real estate investment. The pension fund also started investing in fund of hedge funds in 2007 following its move to commodities in the previous year and a renewed uptake of private equity exposure in 2002. In total, alternatives form 11% of BVK's four-year strategic asset allocation, on top of a 30% exposure to both equities and fixed income and a 9% exposure to short-term investments.

But BVV2 regulates only second pillar pension funds. AVS, the first pillar state fund for disability, social security and old age, is regulated by internal guidelines drawn up by its own board.

"Because we pay Swiss old age pensions and have only Swiss franc liabilities, our equity distribution is atypical for Swiss pension funds," says AVS managing director Eric Breval. "Swiss equities only make up approximately 4% of total equity exposure. A typical home market bias for Swiss pension funds is more like 40-60%."

AVS' liability structure requires the fund be highly liquid and to earn as high a return as possible as it feels the pressure of increasing net outflows. (See How We Run Our Money, p30.) It currently invests 50% of its CHF28bn assets under management - with an additional average of CHF2bn in treasury - in fixed income, 35% in equity and 10% in listed real estate. For decorrelation and diversification reasons rather than for additional expected returns, the fund also started to invest 5% in commodities at the beginning of 2007.

Although it is Geneva-based and reports in Swiss franc terms, the pension fund at the European Centre for Nuclear Research (CERN) counts as an international organisation and is therefore exempt from the rules of Swiss authorities.

"As we are not single-country bound, we have no home-bias and have no Swiss bonds at all in our bond allocation," says Christian Cuénoud, pension fund administrator at CERN. "Swiss exposure also forms a minority in equities."

The fund, which has CHF4.5bn in assets, is influenced by the Swiss pensions industry but compares itself more to pension funds in other countries such as the Netherlands and the UK. The CERN pension fund currently invests 36% in bonds and convertibles, 40% in equity, 10% in real estate, 7% in alternatives and currently has 6% in cash.

The pension fund's alternatives currently consist of a 4% absolute return allocation, 2% commodities exposure and just over 1% in private equity. But, to improve the risk-return ratio, a new strategic asset allocation is looming, based on the last three-yearly asset liability management study. According to the new asset allocation - which should be implemented when the new board is set up - the absolute return component will be higher than the current 4%, with the extra percentages set to be taken from equities.

CERN's pension fund also differs from Swiss pension funds in that it directly invests more in foreign than in Swiss real estate. But it does not invest in hedge funds because, according to Cuénoud, hedge funds are not yet a clearly defined asset class but a new and costly one that lacks transparency and has no proven better returns over the last couple of years than those of more liquid corporate bond portfolios.

CERN pension fund has invested in private equity since 1993. Cuénoud says the fund used to be slightly biased towards venture capital due to its own scientific nature but recently reduced that exposure in favour of other forms of private equity.

Its guidelines and asset allocation are set by its board based on asset liability models, expected returns on the passive side and returns overall.

"We use the prudent man rule as we try to optimise our return by keeping things simple," Cuénoud says. "We passively invest in some of the most efficient market areas, for example in US large caps. In other markets such as Far East or small caps, we invest actively. In total for bonds and equities, 60% is managed actively and 40% passively. We do not invest in liability-driven solutions because we need more return than they can give. Nevertheless, we might look at it in the future to better match our liabilities."