Rachel Fixsen assesses recent trends in the asset allocation decisions of European pension funds

This autumn, a number of Europe's larger pension funds have been seen to tap the market for alternative investments. In France, the €33.4bn Fonds de Reserve pour les Retraites (FRR) announced it was looking for commodity managers.

After revising its strategic asset allocation, the fund aimed to invest an initial €2bn in a commodities mandate.

In the UK, the £30bn (€43bn) Universities Superannuation Scheme moved to bolster its alternatives team by hiring two new members for its private equity and infrastructure team. USS has committed to a target allocation of 5% to alternatives by next March, rising to 20% over the medium-term.

And in Germany, the €5.4bn pension fund for the German energy company E.ON is understood to have made its first foray into hedge funds in September, using both single and fund-of-fund vehicles.

Katharina Lichtner, head of research at Capital Dynamics, a private equity asset manager based in Switzerland, says the firm has seen a clear trend for pension funds to increase allocations to private equity from about 1% of assets now, to 3% and 5% in some instances.

She says pension fund managers have become more confident about their allocations to the asset class having gained experience with it.

Within private equity, she believes pension funds should focus on investments in buyouts.

"Buyouts have a risk return profile that typically fits well with pension funds," she says. But while private equity is still growing in popularity among pension funds, Du Toit, CEO of Investec Asset Management, is concerned that some investors may be buying into the asset class too late. "I fear there might be an after-the-event move into private equity," he says.

More generally, findings from the National Association of Pension Funds' (NAPF) annual survey of its members show that UK pension funds are making a slight shift away from equities and towards fixed income investments.

"Over the last calendar year, pension funds have been focusing on reviewing risk," explains Mark Brooks, spokesman for the association.

"Managing and mitigating risk have been the key strategies for managing pensions, and that includes looking at LDI (liability-driven investment) as well." LDI strategies tend to involve the use of long-dated bonds and indexation, but the shortage of long government bonds has been a stumbling block for the much-promoted investment method.

"We have been asking the government to issue more index-linked gilts, because they are an ideal way of mitigating risk" says Brooks. Cutting risk in this area frees pension funds up to take risk in other investment areas, he points out.

The NAPF report shows that there has been a shift into investment in hedge funds, private equity and other "alternatives" such as property; Brooks says the association has seen no sign that this trend has halted.

In its survey of global alternative assets earlier this year, consultancy Watson Wyatt noted that pension funds around the world were now prepared to increase the number of different alternative asset classes in their portfolios.

The data showed that top 30 pension fund managers in the areas of real estate, fund of hedge funds and private equity fund of funds managed $380bn (€258bn), $105bn and $80bn respectively at the end of 2006. Commodities remained a smaller alternatives play among pension funds, it said.

In Scandinavia, Jan Berhard Waage, managing director of Wassum Investment Consulting in Stockholm, sees the trend for pension funds to replace parts of their badly performing bond portfolios for better performing alternatives portfolios.

Within alternatives, pension funds are largely going for hedge funds, he says, though Wassum's larger pension fund clients are investing in infrastructure and private equity.

Although it is part bond holdings, rather than equities, that pension funds are sacrificing to provide the resources for alternatives, by and large, bond allocations are static in Scandinavia, says Waage. However in other countries within Europe, he notes, fixed income allocations are swelling because of liability-driven investment strategies.

"In some places, bond weightings are increasing as they move to longer durations," he says. "But generally, there is not much of a move away from bonds."

A small proportion of equity portfolios are being switched to hedge fund investments, he says. And within equities, there is a slight shift towards international holdings and away from the domestic market, he adds.

Though it is by no means a big trend, some pension funds are taking portable alpha strategies on board, mostly within bond portfolios, says Waage. "They are picking up alpha on international bonds and using that alpha to add to their Swedish bonds," he explains. Earlier this year, Swedish buffer fund AP7 awarded a pure alpha mandate to Danske Bank, as part of a new approach outlined last year to which the fund is allocating SEK2bn. (€216m). This particular mandate is not for a certain amount of assets, but rather involves a risk budget.

Danske Capital Sweden has explained that it is selling short in the market for around SEK1bn, and buying long for the same amount, so that the maximum exposure is SEK2bn.

Waage says some of the bigger players in Swedish pensions would opt for portable alpha strategies.

"There has been a lot of talk, and to some extent it's starting to happen," he finds, predicting these strategies will play a bigger part for pension funds in the future.

The financial markets are still assessing the extent and impact of the sub-prime crisis, and the outcome could be far-reaching for pension funds and other large investors. So far, the main effect for pension funds has been heightened sensitivity to the dangers of being involved with a shaky investment partner, Waage suggests.

"There is an awareness of risk that was not there prior to this - of counterparty risk," he says. Funds are now more likely to look at the quality of the counterparty before getting involved in some of these seemingly attractive deals.

"There are a lot of new structures out there, including OTC swaps, for example," he says,

"They might also be unlikely to do this type of structure," he says. Even some of the big names in finance will be under scrutiny from the pension fund sector, he points out.

And the knock-on effect in the equities market has worried many.

In September, Fidelity International's survey of local authority finance heads showed that almost one in four respondents, "had been influenced into making asset allocation changes by recent equity market movement" and two-thirds said they would decrease their exposure to equities over the next 12 months.

But how much flexibility do pension funds have to respond to major market events, given that asset allocation is set so infrequently? David McCourt, policy adviser for investment and governance at the NAPF, says UK pension funds
tend to set their strategic asset allocation every three years, and there is no sign that this is becoming any more frequent. The actuarial valuation is three-yearly, and this is the point at which trustees tend to look at asset allocation he says. Whether pension funds have much, or any, room for shorter-term tactical asset moves depends on their mandates, McCourt says.

"But it's fair to say one of the ways to mitigate risk is to appoint a global tactical asset allocation manager,"
he says.

However, some of Europe's larger pension funds are able to invest much more flexibly. Sweden's second biggest pension fund, AMF Pension, which has SEK264bn under management, does not work with a strategic benchmark and has a great deal of room for manoeuvre, according to Sarah McPhee, AMF Pension's chief investment officer.

"We have an extensive mandate to work tactically between asset classes, and are never tied to any allocation," she says. However, McCourt adds that pension funds in the UK may see some degree of pressure from sponsors to look at asset allocation more often, as the corporates remain conscious of the pension deficits coming onto their balance sheets.

Ahold pension fund

In the Netherlands, the pension fund of international supermarket operator Ahold raised its allocation to alternatives at this year's strategic review, and trimmed its equities investments in order to do so.

The fund's asset mix is set every three years, and the latest asset allocation review took place in June this year.

"On the strategic asset allocation, we only made one change - we increased alternatives and decreased equities," explains Eric Huizing, director of investments at the €1.8bn Dutch pension fund. Equities dipped to 45% from 47.5%, bonds remained at 40%, real estate at 10% while alternatives swelled to 5% of the total portfolio from 2.5%.

The move was simply the outcome of an optimisation programme, says Huizing. Putting more assets into alternatives produced the best outcome for all three stakeholders involved in the ALM study upon which the strategic asset allocation was based - pensioners, active scheme members and the sponsor.

"We want to have an attractive pension premium, which is not too high and not too low; the chances of underfunding should be low and the pension should keep up with CPI to maintain purchasing power," he says. "So taking all those factors into account, we decided to increase alternatives."

The alternatives slice of the fund's assets consists mainly of private equity, but includes some infrastructure investment. "This is a long-term investment vehicle which has links with inflation, and also brings an element of diversification," Huizing notes.

The sub-prime crisis has not affected the Ahold pension fund, he says, as it is not invested in risky assets. "But generally we do see some risk in the market," he adds. "We are cautious about the near future."

PFA Pension

Denmark's mighty PFA corporate pension fund resets its strategic asset allocation every year, and is now in the process of finalising its 2008 investment mix.

For 2007, the strategic allocation allows for 22.6% in equities, 68.2% in bonds, 7.3% in property, 1.4% in interest-rate hedging instruments and 0.3% in infrastructure. Within equities, the fund has 6.6% in Danish equities, 14.24% in global equities and 1.75% in alternatives. Alternatives consist of hedge funds and private equity.

In 2007, the DKK213bn (€28bn) fund took on more risk, increasing its equity share, explains Henrik Franck, the fund's chief investment officer since April 2007. The move turned out to be fortunate given the lift in share prices since then, he says, while stressing that as with any strategic asset allocation decision, it was determined by the fund's liability profile rather than any view on the stock market.

However, between one strategic asset allocation review and the next, the pension fund does have scope to make tactical asset allocations, ie deviations from the strategic benchmark.

"We have ample room for this," says Franck. It is very important to be able to manoeuvre in this way, he says, adding that in the turbulent second half of this year, PFA made full use of this flexibility.

Franck says the effect of the sub-prime crisis on the fund has been minimal. "We have no exposure to CDOs or sub-prime or some of the other asset classes hit," he states. And while equities were affected, PFA benefited from this by taking an opportunistic approach, he adds.

"We have a portfolio of credit bonds, and this was affected, but we did not have a significant allocation," he continues.

And performance figures show no sign that any of the pension fund's hedge fund exposure has been significantly hit, he says.

Infrastructure is one asset class the pension fund expects to expand in future.

"We already have committed more to infrastructure than our allocation signals," he says. "We will watch the results of our current allocation, and then build this further."

Franck finds infrastructure a good asset for pension funds because it provides liability coverage, with the long-term cash flow and the inflation links that are built into contracts. On top of this, he sees another attraction in that the scale of infrastructure finance means it is often restricted to large pension funds and similar institutions.

Know your parameters

At a time when pension funds are being encouraged to broaden their investment horizons and allocate assets to new niches, it may seem strange to hear voices reminding them of their limits.

Not that anyone is saying pension funds should stop spreading their risk through diversification of assets. The cautionary note rather makes the point that not every fund should be trying to find reliable alpha, or outperformance through skill.

In research into best-practice investment management, which involved case studies of 10 institutional funds including six pension funds, Gordon Clark, academic and executive director of the Oxford University Centre for the Environment and Roger Urwin, global head of investment consulting at Watson Wyatt Worldwide, said investment funds should recognise their institutional limits.

Pension funds with fewer in-house investment resources - those with a trustee board and possibly an investment committee, but which make decisions based on calendar time rather than in real-time - should put their assets in beta (market returns), rather than seeking alpha, the authors said.

"Best practice should recognise the institutional limits of such entities against competing market players eschewing active management for passive management such (the core best-practice factors, such as mission clarity and effective focusing of time) are focused on beta not alpha activities," it said.

And others in the industry are quick to agree with the principle that better governance and in-house investment resources help pension funds make more of their own decisions. But in practice, this level of resources is not always easy for the funds to achieve.

"I think strengthening internal resources is beneficial to the plan but trustees should also be strong enough to take a devil's advocate position," says Chris Jones, chief investment officer at Key Asset Management. He adds that all but the biggest funds will be unable to attract and remunerate the best resources.

Steven Nicholls, senior vice president and account manager at PIMCO, says all schemes should be moving in the direction of good governance, though it is a resource issue, in terms of time and money. "To the extent that schemes adopt good governance principles, trustees can make their decisions better informed and reduce the risks associated with uncertainty," he says, adding: "This must be an advantage in a number of ways and never more so in the context of making good asset allocation decisions."

As pension funds are increasingly faced with the question of boosting their governance, Andrew Fraser, director of institutional business at Henderson Global Investors emphasises the smart funds are not those that outsource or those that strengthen the in-house resources. Instead, he maintains, they are those wise enough to understand which category they should move to, and execute this part of their strategy quickly.

"Other markets, such as the Dutch, have formed industry schemes to take some of this burden, while others are looking to the growing buy-out market," he says.

Increasingly, fiduciary mandates are seen by pension funds as a way of outsourcing a whole raft of functions - including asset allocation.

Jones says asset allocation has always been implicitly outsourced to a small degree, with consultants discussing proactive measures with trustees. "It was probably the consultants that introduced the trustees to alternatives rather than vice versa in many cases," he says.

Hendrik du Toit, chief executive of Investec Asset Management, which has $60bn (€40.8bn) of institutional money under management, notes yet more potential for fiduciary management in the pension fund industry.

"In the Netherlands, there are many fiduciary mandates where the manager is freer to do what he wants, to be faster and more active," he observes.

Some fiduciary mandates give a great deal of discretion to the manager, and he feels this type of arrangement can work well. "I would say the successful ones require adequate flexibility, but it depends on the fund."

But outsourcing is not all sweetness and light, warns Andrew Fraser of Henderson Global Investors.

"Implemented consulting and fiduciary management has the potential to improve governance of pension funds especially with regard to risk budgeting, asset allocation and manager selection," he says. "However, whether these new players have the skill to deliver strong risk-adjusted returns in the long term remains to be seen - there are bound to be winners and losers."

Though Europe cannot really be seen as one pensions investment market, Du Toit says change is afoot in investment habits across the continent. "The market is on the move; people are doing things," he says.

"While pension funds were very focused on their liabilities, investment is now getting a lot of attention. Funds are willing to target more risky assets, such as emerging markets, frontier assets and private equity."

"The trend is clearly towards more diversity - different exposures; many in small baskets," he says. "Make sure you can live with market cycles - that's the awareness that came out of 2000."