Most Spanish pension funds increased exposure to equities in 2009, finds Gail Moss. What will they do next?

As with institutional investors in other countries, Spanish pension funds have seen a flight to safety after last year's market crash. "The great majority of pension funds in Spain suffered from the bear market of the second part of 2008," says senior associate, investment department, Hewitt, Madrid . "The managers were not prepared; the risk measures they used were relative to the market, such as the Sharpe ratio, volatility against benchmark, and tracking error. And target returns were based on the benchmark - for pension fund managers to achieve 100-150 basis points above the benchmark was a very good result."

Of course, this strategy became practically useless after the market falls in the last quarter of 2008, producing returns of between -5% and -20%, depending on the investment policy of the funds.

Since then, fund managers and investment advisers have begun to analyse new types of risk measure, based not only on the relative behaviour of a fund against the market, but also on performance in absolute terms.

"Typical measures introduced were stop losses, maximum drawdown or value-at-risk (VaR) ranges," says Corral. "However, the most important consequence of the credit crisis in terms of risk management was asset reallocation. Every fund, independently of its investment policy, began to reduce its positions in equities."

But this itself has its problems, he says: "The great majority of these funds have continued to underweight equities throughout 2009. This passive strategy has meant that the equity funds missed part of the 2009 bull market - furthermore, it is not a guarantee of protection against a new bearish rally."

Every company pension fund in Spain must have a mandate (ie asset allocation) determined by its pension control committee, which is generally made up 50:50 of representatives of the employers and members. The most common allocation before the crisis was around 30% equities and 70% fixed income, with the ability to change allocations within a margin.

"However, at the end of last year, many control committees allowed their pension funds to reduce the equity allocation close to zero, but have increased it again this year so it is back to the neutral exposure on equities," says Juan Marina, director, investment consultancy, Aon. " But if there is another crisis, the fund manager could reduce their exposure to zero. That has been an important change."

But he says that at individual stock level, Spanish pension funds now investing in equities are flying in the face of conventional wisdom.

"What we're seeing is decreasing diversification in equities," he says. "If they are using advisory management and not funds of funds, they are reducing the universe of shares and investing just in very high quality companies. They want to invest in very big companies with strong balance sheets."

Within the fixed income portfolios, Marina says that allocations to corporate bonds are being reduced, with a reduction in the number of issuing corporates in fund portfolios, while exposure to government bonds has increased; for some pension funds, government paper now makes up 75% of fixed income portfolios.

Marina also says that pension funds generally are reducing the duration of their fixed income securities to relatively short periods. And holdings in the financial sector in both the equity and fixed income portfolios have been reduced.

Some funds have implemented other policies for reducing risk. Gerokoa EPSV, the defined contribution pension fund which covers employees in Gipuzkoa, a province in the Basque Country region, has decided not to invest in mutual funds, an asset class it used before the crisis.

"But it has never invested in asset classes such as high yield or mortgage-backed securities, a principle which has proved to be extremely important," says Javier Hoyos, chief investment director, Bankoa, which manages the pension fund. "The fund's high-quality portfolio has allowed it to perform quite satisfactorily throughout
the crisis."

"All the management companies have reinforced their system of risk control - for instance with VaR, shortening the period for taking the moving average sample, so it is more frequent," says Valentin Fernandez, director, strategy and external communications director, Fonditel, the pension fund for employees of telecoms operator Telefonica. "This means the updating of statistical data in order to get an amount for the expected loss can be done more frequently as well."

For many pension funds, liquidity is now a major issue, says Angel Martinez-Aldama, director general, INVERCO, the Investment and Pension Funds Association.

"The financial crisis has reduced the liquidity of many fixed income assets," says Martinez-Aldama. "Last year, we saw the crisis affecting equity markets, but although there was a big fall in prices, they were still very liquid. But it has not been the same with some bond assets and CDOs. The market has shrunk, and has made things more difficult for the smaller pension funds in particular."

This is important because while second pillar company pension funds normally have a long-term investment horizon - since they can predict when an employee is likely to retire - third pillar individual plans do not offer the same comfort to the management companies that run them, as members can transfer from one plan to another at will, and without penalty.

"There have been a large number of these transfers, and this has led to a structural change in the pension fund industry," says Martinez-Aldama. "We have seen fund portfolios increasing their weightings of liquid assets at the expense of long-term assets."

However, pension funds have taken measures to control risk. "From the point of view of pure risk measures, some management firms are implementing several risk control techniques," says Corral. "The most common are the use of VaR, tracking error ex-ante and weekly volatility limits. But these measures are currently internal controls applied by the risk department of management firms and they are not included in the investment policy of the funds yet."

Corral says that in the case of alternative investments, management firms are developing plans to make the due diligence process more efficient when investing in hedge funds and private equity funds.

"However, this process is at a preliminary stage, because of the relatively low percentage invested in this type of product," he says.

But there is one further cloud hanging over the pensions industry landscape - the advent of Solvency II, which could significantly increase buffer requirements for pension management companies, or pension gestoras.

"Solvency II will affect the small and medium-sized companies in the industry because they have less money to manage, and make less profit," says Fernandez. "So there may be some mergers and acquisitions. But the big managers like BBVA and Santander will remain, although pensions management may become a less attractive business for them."

He says Fonditel - which not only runs the pension scheme for employees of the Spanish telecommunications giant Telefonica, but also offers pension management services to other schemes - has the financial strength to be largely unaffected by Solvency II, because of Telefonica's financial solidity.

Similarly, Hoyos notes that Gerokoa's investment manager, Bankoa, as a bank regulated by the Bank of Spain, has to comply with solvency requirements which are more extensive than those of a pension management company.

Martinez-Aldama says: "Only a very small percentage of pension schemes in Spain are DB schemes, so the importance of Solvency II is reduced."

In fact, the great majority of Spanish pension plans are DC plans - with over 90% of assets under management - and so it is the members who have to shoulder the investment risk. Only third pillar pension schemes allow individuals to decide their risk options, depending on their risk profile. For qualified plans, the average 2008 return was -8.05%, according to INVERCO.

"The 2008 credit crisis and financial crash have clearly changed the risk tolerance of the average investor, with a clear increase for the very conservative risk profile, ie short-term fixed income funds," says Corral.

But the concept of lifestyling is not a feature of Spanish company schemes. Instead, they offer one investment strategy to members whatever their age. Since December 2007, however, company schemes have been allowed to offer two different types of investment strategy for employees either side of a specific age to be decided by each plan's pension control committee.

"Although there is the opportunity, no plan has done it yet," says Marina. "It is difficult enough for schemes to establish one investment policy, so it would be doubly difficult to establish two." Martinez says this issue reflects a wider concern: "Many young people are investing in the more conservative fund options. But if they are investing for the long term, it would be the wrong decision, and that could well cause problems in the future."