Quick march to diversification
Our inaugural study of the continental European institutional asset management industry indicates that pension funds are now forging ahead with international diversification and outsourcing a larger proportion of assets to external investment managers – particularly specialist managers.
Although pension funds are increasingly favouring equities – especially non-domestic equities, as is the case in countries such as the Netherlands and Germany – there is little evidence of a wholesale switch from bonds to equities on the Continent, as some had anticipated. As a consequence of the asset allocation shifts and outsourcing trend, demand for new managers is very robust and is focused on managers with specialist regional and global investment capabilities.
We interviewed 178 large pension funds in 11 countries – The Netherlands, Switzerland, France, Germany, Belgium, Sweden, Denmark, Norway, Finland, Spain, and Italy – in April and May 1999, as part of a broader study comprising 258 interviews in person and including insurance companies, corporate treasury funds and foundations. As with pension funds, the insurance companies we interviewed plan to diversify internationally and to increase marginally their non-domestic equity holdings, but are not inclined to outsource a greater share of their assets to external investment managers.
Pension funds’ penchant for international diversification – and equities, to a lesser extent – is apparent in the table below, which shows the expected shift in the asset allocation of funds over the next three years. The continental European data indicate that pension funds expect that their holdings of domestic bonds will fall from 38% to 29% by 2001, while their allocation to non-domestic European bonds and other international bonds is expected to rise from 14% to 19%. Domestic equities are expected to decline from 16% to 14% by 2001 and non-domestic European equities, North American equities, and other international equities are expected to increase from 19% to 24% as a proportion of total assets.
Pension funds in most of the large institutional investment management markets on the Continent, except Switzerland, plan to increase the international diversification of their investment portfolios over the next three years.
In the Netherlands, for instance, over the next three years, pension funds expect that their portfolio holdings of domestic bonds will fall from 38% to 25%, while their allocations to non-domestic European bonds and other international bonds are expected to rise from 15% to 19%. Domestic equities are expected to remain unchanged, while non-domestic European equities, North American equities, and other international equities are projected to rise from 22% to 28% by 2001.
In both the Netherlands and Germany, the projected shifts in asset allocation point to both international diversification and a move into equities – particularly European equities, North American equities, and other international equities.
In the Nordic markets, although pension funds’ overall allocation to equities is expected to remain unchanged, the geographical composition of equity portfolios will shift substantially: domestic equities as a proportion of total assets are expected to fall dramatically from 25% to 14%, while the allocation to non-domestic European equities, North American equities, and other international equities is expected to rise precipitously from 14% to 23% by 2001.
Similarly, in France, while the overall asset allocation to bonds and equities is expected to remain stable, there is a clear trend to increase the international diversification of portfolios.
Switzerland stands alone among the major pension fund markets as the one country seemingly impervious to asset allocation shifts. International diversification by Swiss pension funds is expected to be confined to a small shift in favour of non-domestic equities.
The anticipated shifts in asset allocation are reflected in the hiring demand for managers on the Continent, which is clearly very robust: 48% of pension funds have hired a new manager in the past year and 42% expect to hire a new manager in the coming 12 months.
The strongest product demand in the past year among all the institutions in the study has been for European equities, US equities, and international bonds; however, in the coming year, US equities, European equities and emerging markets are expected to have the highest anticipated hiring demand. It is significant that hiring demand is almost exclusively for specialist managers as opposed to balanced managers. This is true for all the institutions included in the study: 32% of pension funds expect to hire a specialist manager in the coming year compared to just 3% that expect to hire a balanced manager; similarly, for insurance companies, 42% expect to hire a specialist manager in the coming year while none expect to hire a balanced one.
When interpreting the demand for specialist managers it should be noted, however, that our study focuses on the largest institutions on the Continent. The picture is somewhat different for smaller pension funds where balanced management features more prominently.
It is, at this juncture, also worthwhile considering the results of our twelfth annual study of the investment practices of large pension funds in the UK, where the use of specialist management has literally soared: the proportion of funds using specialist managers is up from 40% in 1998 to 59% in 1999, and their share of total assets under management is up from 19% to 27%. This dramatic shift in the UK pension fund market is expected to continue with 18% of funds expecting to start using a new specialist manager, compared to less than 1% that expects to start using a new balanced manager over the next 12 months.
It is a fair conclusion that, as the larger continental European institutions shift their asset allocation to take account of international diversification and the concomitant move into non-domestic equities, demand is being generated for investment managers with specialist regional and global investment capabilities.
Pension funds on the Continent currently manage 73% of their assets internally. The 27% under external management is either held in commingled or pooled vehicles (7%) or via discretionary mandates with external investment managers (20%). By 2001, the expectation among pension funds is that they will manage 58% of their assets internally and outsource 42% of their assets to investment managers. Among the larger funds in the study, it is anticipated that this will be fairly evenly distributed between pooled vehicles (19%) and discretionary mandates (23%). Unlike pension funds, insurance companies do not expect to increase the current proportion of assets managed by external investment managers – 15% – in the next three years.
The research confirms the view that the continental European pension fund markets are undergoing rapid transformation and offer significant opportunities for managers with specialist regional and global investment capabilities.
Linda Nockler is a consultant at Greenwich Associates in Greenwich, Connecticut