Concentration risk in Switzerland's SPI index, the dominant domestic equity benchmark for Pensionskassen, has increased significantly over the last year as financial turmoil has wreaked havoc on two of the country's largest listed companies.
The share prices of UBS and Credit Suisse have dropped by more than 65% and 40% since November 2007. This has caused the percentage weighting of the top three stocks in the SPI, Nestlé, Novartis and Roche, to jump by more than 13% to 53%. Novartis and Roche - both pharmaceutical companies - account for 33% alone.
"This represents considerable sector and regional concentration," warns Sven Ebeling, Mercer's head of investment consulting in Switzerland. "Pensionskassen and asset managers have to act, but, so far, almost none have."
Cutting overall equity allocations is not the answer, he believes, as rebuilding coverage ratios would otherwise be costly and take significantly longer. "This is not about reducing overall equity exposure, but schemes should reconsider their domestic bias," he says.
According to Swisscanto's latest Schweizer Pensionskassen report, schemes' average local equity allocation was 10-12%. So a 30% fall in the SPI since November 2007 has taken 3% off schemes' assets.
Despite this, Peter Bänziger, head of asset management and institutional clients at Swisscanto, doubts whether pension funds' allocation targets would decrease. "In the past, Pensionskassen have maintained stable allocations through market cycles," he says. "Relatively, Swiss equities are doing OK so there is no pressure for further diversification."
"Based on historical data, it is hard to convince schemes to diversify internationally," concedes Ebeling, "but the data is misleading and doesn't give the full picture. Concentration in the SPI is a problem that has intensified recently."
Currency risk has also discouraged some schemes from diversifying abroad, according to Thomas Buri, head of Swiss equities at Vontobel Asset Management. "Their liabilities are paid in Swiss francs. Given that Nestlé, Novartis and Roche are all international companies, there is already an inherent foreign exchange risk in these stocks," suggests Buri.
Sector risk also remains an issue, suggests Pictet's head of Swiss equity, Lorenz Reinhard. "There have been some well-known pharmaceutical product accidents in recent history, which have affected share prices significantly. These are difficult to predict and tend to hit investors. Hedging out these risks would be too expensive though," warns Reinhard.
As well as the falls in banking shares, concentration has been driven by a flight to quality as Nestlé, Novartis and Roche are seen as safe havens.
"Once markets begin to normalise, these stocks could see relative underperformance," Reinhard warns.
"A lot of safe-haven money is currently parked there, but the picture could look very different in a year's time. While they offer security at the moment, there may be better opportunities going forward."
Udo von Werne, head of continental European business development at Pictet, says consultants, who are still heavily dominant in the Swiss market, have been pushing many schemes towards indexation. "We're fighting an uphill battle. The core/satellite approach is a dominant theme for consultants so, even if we believe active is the way to go, our hands are relatively tied," he says.
Schemes applying passive strategies could adopt other indices such as the SLI, which tracks the 30 most liquid stocks with a maximum individual weighting of 10%.
Ebeling said a move away from pure market-cap weighted indices was not an ideal solution though. "The beauty of this method is its objectivity," he suggests. "Other systems, such as fundamental indexation, are subjective, based on factors selected by active managers or index providers."
Von Werne says Pensionskassen have not been too worried so far about increased concentration in domestic equity indices because they have delivered superior relative performance compared with world equities.
"Though this is likely to change over the next twelve months," he believes.
"The revised BVV2 regulations have moved to a prudent man approach. Going forward, Pensionskassen will no longer just be able to tick boxes or stay within the regulatory limits. They will have to prove their strategic investment allocation is a suitable fit for their liabilities," adds von Werne.
Buri concludes: "Clearly from a conceptual point of view, investing 70% of your assets in seven stocks is not wise. Investors need to be aware of these risks and monitor them appropriately. Even though the top three stocks are safe havens now, we cannot rule out future events."