Will Swiss pension funds increase allocations to infrastructure?
A new rule to raise Swiss and non-Swiss infrastructure investments for pension funds looks set to boost alternative investments overall, giving investors greater headroom to increase allocations within the alternatives category. From 1 October 2020, article 55f of the BVV2 investment ordinance for pension funds increases the permitted allocation to infrastructure to 10% of total assets.
This long-debated change to BVV2, first proposed in 2015, now separates infrastructure from other alternatives assets, lifting the overall ceiling to 25%. A later amendment is set to permit direct investments in infrastructure of up to 1% of assets.
In practice, pension funds have always been able to exceed the permitted asset class ceilings using provisions in article 50 of BVV2.
Graziano Lusenti, founder and managing partner of Lusenti Partners, says that allocations to infrastructure could increase to up to 10%. However, given the size of Swiss pension assets, the overall excess of private and institutional savings and the relatively small pipeline of likely domestic infrastructure investment opportunities, most infrastructure investments are likely to be made abroad, he says.
“Infrastructure investments have potential, with some reservations, and provided their returns in Swiss francs are around 4-6% net,” Lusenti says.
Carl Hollitscher, head of institutional business for Switzerland at Franklin Templeton says the decision of the Federal Council is a step in the right direction: “It takes a stable asset class out of the alternatives corner and facilitates a larger allocation,” he says.
Christoph Ryter, CEO of the CHF26bn (€24.2bn) Migros Pensionskasse, points to the effort needed in selecting and monitoring investments in infrastructure or other alternative asset classes like private equity.
He says: “It is therefore difficult to foresee the development of these types of investments. If infrastructure no longer counts as an alternative, a slight reduction in alternative investments that do not fall under infrastructure can be expected.”
In the context of low interest rates, one structural change relating to how Pensionskassen construct their portfolios could be a shift from nominal to real investments. Ryter considers investments with a stable cash flow to be ideal for a pension scheme with fixed obligations: “For this reason, infrastructure or real estate investments are certainly interesting investment classes,” he says.
According to Dominik Irniger, head of asset management at the CHF18bn (€16.8bn) Pensionskasse SBB, infrastructure is “too leveraged and too expansive so we focus on private equity, which has higher returns”.
The fund has increased private equity asset allocations over time, with the goal to reach 5% exposure in the next 3-5 years from the current 2%. “We think that private equity is even more interesting now than it was in the past because valuation levels in private equity have gone down,” Irniger says, adding that distressed private equity could be of greater interest.
Pensionskasse SBB has primary programmes in the US and in Europe, and some secondary fund-of-funds investments have been made over the last three years. “These have helped to ramp up our private-equity allocation,” Inriger explains.
For Ueli Mettler, partner at the St Gallen-based consultancy C-alm, the classification of infrastructure as a separate asset class may reduce the hurdle for some Pensionskassen to invest in the segment. “However, I believe that for prudent investors the legal classification of an asset class should not decide if an investment is to be undertaken or not. Once again, the risk-return view of an asset is key,” he says.
As investors with a very-long-term allocation horizon, pension funds should not “over-emphasise the liquidity issue in their asset allocation decisions”, Mettler says. To be considered in an overall asset allocation, he adds, illiquid asset classes have to outperform liquid asset classes in terms of risk-return profile. This means that non-listed or private equity investments need to show at least comparable fundamental properties as in a listed, traditional equity portfolio, he explains.
“By the same token, illiquid or alternative fixed-income categories, such as senior loans, insurance linked securities, or private debt, have to outmatch their liquid-traditional fixed-income benchmark with regards to their return and risk properties,” Mettler says.
The investment vehicle must also offer transparency, and pension funds should know the portfolio of potential investments, Mettler adds: “The bottom line for illiquid asset classes is that illiquidity is not a problem, but a lack of transparency is not acceptable. We believe that only open-end single funds vehicles have the advantage that they offer potential investors insight into the portfolio to see if they match their investment criteria,” he says.
More emphasis on alternatives to counter low bond yields
Negative yields on bonds and regulatory changes look set to steer Swiss pension funds towards alternative investments. The share of allocations to alternatives has risen slowly – from 4.8% at the end of 2010 to just 6.52% in the second quarter of this year, the highest level recorded from 2015, according to the Credit Suisse Pension Fund Index.
Carl Hollitscher, head of institutional sales for Switzerland at Franklin Templeton, expects the trend towards allocation in alternatives to continue: “The search for yield and the further diversification of portfolios are the main drivers of this trend,” he says. Diversification and “much-needed” higher yields may structurally change how pension funds build up their portfolio, with an emphasis on alternatives, he adds. Franklin Templeton manages over €900m for Swiss institutional clients, according to IPE’s latest market survey.
Returns on alternative investments remain modest, from 0.10% in 2010 to 0.13% in 2015, and a negative 0.99% in Q2 this year, according to Credit Suisse.
Swiss bonds and most bond-like investments denominated in Swiss francs may be “dead wood”, but pension funds retain Swiss franc-denominated bonds – 10 to 15% of total allocations – as risk-free, low-volatility assets, says Graziano Lusenti, founder and managing partner of Lusenti Partners. “We have pressing issues of diversification, actually of replacing bond investments, which are still a significant part of total asset allocation,” he says.
On average, as Lusenti outlines, fixed-income remains a central pillar for allocations, with 25-35% invested in CHF bonds, foreign bonds, convertibles, and emerging market bonds. Other core investments are equities – 25-40% in actual, tactical allocation – and real estate at 15-25%. Only 5-15% is allocated to non-traditional or alternative investments, but this segment is expected to grow, Lusenti adds.
Apart from private equity and precious metals, alternative investments have not performed well over the past decade, Lusenti says: “People are very keen to find new investment opportunities and new sources of return.”
In Switzerland, the dominant type of vehicle in the real estate is the Immobilien Anlagestiftung, an open-end single fund vehicle. “This shows that the open-ended single fund is very well suited for illiquid investments from a Swiss pension fund’s perspective,” Mettler notes.
Costs, liquidity, choice of investment vehicle with respect to investor rights and taxes, and currency exposure, are other points to address for pension funds choosing investment vehicles.
Swiss Anlagestiftungen (investment foundations), for example, “will be fine” as an investment structure, as well as any fund – or fund of fund – located in a European domicile, according to Lusenti. “Costs may be very high in infrastructure, even if eventual returns are okay,” Then you have the liquidity issue: getting into the infrastructure investments is the easy part, going out is far more difficult, and investors might get stuck for many years in these investments,” Lusenti notes.
Lusenti also foresees a further hurdle: infrastructure investment in foreign currency will have a maximum limit of 30%, according to BVV2, alongside equities, bonds and real estate. “This implies that most foreign infrastructure investments will be hedged, which will reduce the performance in Swiss francs markedly,” Lusenti says.