Return of the absolute
The beginning of this year saw two major regulatory changes in Sweden: the introduction of the traffic light system and the implementation of the EU pensions directive. And experts are seeing a clear trend towards a demand for absolute return products.
“The traffic light system has certainly had an impact on pension funds,” Mats Langensjö, managing director at Aon Consulting in Sweden, says. “It has taken on a very interesting role because, even if it is only a checkpoint for the regulator, it has become a very visible benchmark for pension fund boards and trustees to measure how they are doing. That means that we see a very risk-averse attitude, more risk management, more understanding of risk. What you find is that it is getting less relevant in this risk-averse environment if the risk is defined as mismatch of asset duration and liability duration. That means that some of the fundamental active long-only managers have a hard time selling their products.
Instead, there are a lot of innovative ways to create absolute return products. I think some of the hedge funds are having a good time.”
“The absolute return focus is much more pronounced these days due to the traffic light system, which is the Swedish regulator’s response to the introduction of the EU pensions directive, and due to the downturn in the equity market,” PO Öst, head of marketing and sales at Carlson Investment Management, says. “This absolute return drive points towards unconstrained mandates both in equity and fixed income and it also points to hedge funds and private equity. It points to diversification.”
“Absolute return has not necessarily to come from hedge funds or other currently available alternative investments, but for example from products with a multiple alpha approach,” Christer Wachtmeister, managing director at ABN AMRO Sweden, stresses. “We will see a stretching of what is an absolute return product from discussions with clients.”
However, the introduction of the traffic light system did not trigger immediate changes in pension fund portfolios as some had expected. “The introduction of the traffic light system in Sweden has been an interesting experience and it has changed behaviour somewhat,” Torgny Krook, head of institutions at Nordea Bank, says. “However, the reserves of Swedish insurance companies and pension funds are considerable so that, except for in a few cases, the traffic light system does not really have an immediate and large effect on asset allocation. It is something you consider, you watch it, but it is not constraining you in your investment activities.”
“Since the liability situation has been so markedly and rapidly improved by rising interest rates there has been less pressure than expected towards a shift to long-dated bonds,” Peter Agardh, managing director of independent adviser Agenta, explains. “There was a lot of noise prior to the legislation taking place both from investment banks and asset managers in terms of putting solutions together. I think to a lesser extent than expected have the pension funds actually implemented bespoke solutions or changed their asset allocation.”
However, not all pension funds have yet made use of all the opportunities under the new regulations. “A couple of funds have been active and modern and have already adapted to the new prudent person principle introduced under the EU pensions directive,” says Langensjö. “But some are trying to hide from the change. And we have a big group in the middle that is still struggling with the internal process to decide how they are going to deal with this.” He adds: “So it is very early days to assess the full impact of the changes.”
“There are quite a few pension funds that do not have the resources or knowledge to actually exploit the opportunities,” agrees Agardh. “But Swedes are fairly quick in adapting, compared with Germany, for example.”
Pension funds are looking at a wider range of investments such as alternatives, including hedge funds, commodities and private equity, as well as the use of derivatives.
“However, by and large pension funds are still cautious about using these instruments and they are still very much in the embryonic stage,” Åsa Norrie, investment director for Scandinavia at Standard Life Investments, says. “But I am very encouraged by the developments that we have seen. The big investors will lead a trend towards a behaviour similar to the UK and the US in this field. We have the leading big pension schemes taking the most bold movements initially and they are being followed by others.”
The new regulations will also have an impact on demand and supply at the bond end of the asset management sector. “There has been more focus on ALM now and the last year than before,” Wachtmeister says. “So I think there is a certain trend to lengthen the duration of assets and that will be done by everyone.”
“The traffic light system treats foreign bonds less favourably than Swedish bonds and I think that with the arrival of our new government, this is going to cause serious problems,” Sarah McPhee, CIO of AMF Pensions says. “There is a lack of material at the long-duration end to start with and if the government is able to sell off all companies, the Swedish debt will disappear completely.”
“There is also a lot more innovation on the fixed income side as we have a limited local market on the long duration side. In this area the competition between asset managers in Sweden is very tough,” Langensjö notes. “In other areas there is much more cross-border co-operation between different parties in the market. In some fields foreign asset managers are better than domestic ones and vice versa.”
“I think a number of companies have recognised that, for example, asset classes such as real estate, private equity and some of the more advanced structures of bond vehicles are areas where foreign players can add value,” Norrie agrees. Similarly, in fields like non-domestic equities a number of organisations in the Nordic region feel that they are too removed to be able to manage these assets successfully themselves therefore they are very susceptible for opportunities for co-operation with foreign players”.
“The winner is the manager who does not only want to sell a product but who has know-how, ability to implement and ability to communicate,” Langensjö says. “It has been a very important competitive factor to not only sell a solution but to offer know-how. And that might be a problem for mid-sized to small domestic managers. They have to decide if they want to service pension funds. Some might not because it requires too much in terms of know-how, investments and infrastructure. At the same time, you will have a growing DC market that does not require managers to invest in pension capital advisory departments or ALM systems. DC is going to be the future.”
“Because of diversification there will be more international players and domestic ones will see fewer and fewer of their asset classes being used which is a challenge for domestic ones to match the internationalisation,” Wachtmeister thinks. “That is our advantage over domestic competitors that we are part of an international group.”
“Pension funds will look more towards multi-manager firms because of a lack of resources for hiring and firing, because of the purchasing power multi-manager firms can offer and because of the fact that they can offer solutions at lower rate than any institutions can on their own,” Agardh says.