With an apparent pause in bad news from southern Europe, Swiss institutional investors might be forgiven for thinking the euro-zone crisis has abated, especially since their own economy is so strong. But the very strength of the Swiss franc makes pension funds wary, especially about Switzerland’s own economic growth – since every second franc earned comes from abroad.
And the general mood is one of scepticism. “The consensus is that the euro-zone crisis is not over,” says Eddie Stucki, senior investment consultant at Towers Watson in Zurich. “There are major structural labour market problems, which in some cases have been there for 20 years. Furthermore, the consequences of reining in excess liquidity after the period of quantitative easing by the European Central Bank (ECB) are completely unknown. What will happen when the ECB starts tightening interest rates, or investors sell off their assets in Mediterranean countries?”
However, Anja Hochberg, CIO for Switzerland and Europe at Credit Suisse, is more upbeat. “While we haven’t reached the point where no adjustment is needed in terms of debt, there has been visible structural improvement in euro-zone countries,” she says. “And in peripheral countries, 2014 will, for instance, see current account and primary balance surpluses. This is reflected in the narrowing of spreads between peripheral country bonds and German Bunds.”
Nevertheless, she says that Swiss institutions have been cautious about investing in the euro-zone periphery since 2010.
“However, if you want to add yield to your core bond investment, you might – from a risk-return perspective – also invest in high yield or corporate bonds, rather than peripheral [country bonds],” she says, although she adds that for benchmark investors it might be appropriate to look towards countries such as Italy and Spain, because of their market weighting and improved fundamentals.
But while Credit Suisse has reduced its US dollar exposure in equities, it is now overweight in European equities: “There’s still a level of under-representation of the European market in general.”
Ironically, the euro crisis has also fed into returns from Switzerland’s domestic assets.
The Swiss National Bank’s (SNB) ceiling of CHF1.20 to the euro, imposed in autumn 2011 partly to secure exports, has been accompanied by record low yields and results in an asymmetrical positive outlook for the euro and currencies linked to it.
“Low yields mean investors in domestic fixed income are getting less return because of the European environment,” says Rainer Ender, co-head of investment management at the private equity house Adveq. “Despite that, the currency is still strong because of the economy, which enjoys a balance of payments surplus.”
Over the years, overall asset allocation by pension funds has remained fairly stable. According to the Swisscanto Pension Fund Survey 2013 – which included over 300 pension schemes – just under 36% of portfolios was invested in bonds, 28% in equities, and 20% in real estate.
Swiss pension funds are traditionally biased towards domestic investments, particularly bonds and real estate.
However, according to the Aon Hewitt Swiss Pension Fund Survey 2013-14, 38% of assets were invested abroad by the end of 2012.
“Typically, they invest in global bond and equities funds,” says Beat Zaugg, senior investment consultant, Aon Hewitt Zurich. “Most of them do not take a specific euro allocation but invest according to the weightings of a global bond and equity index.”
According to the Credit Suisse Pension Fund index, the effective euro exposure of Swiss pension funds was on average only 4.5% of their total currency allocation as at 30 September 2013, partly because foreign currency bonds are normally hedged against the Swiss franc.
Hochberg says Credit Suisse clients had not taken off currency hedges on bond holdings as at end-September.
Credit Suisse recommends strategic foreign currency hedges in the bond universe, as foreign exchange risk (or volatility) is not yet compensated for by the low yield level in the developed world. In equities, however, their studies show that investors will not get rewarded strategically by taking foreign exchange risk. So here, only tactical hedging would make sense.
“For most of our clients, the euro allocation is still hedged, as part of the global bond hedging,” says Zaugg. “But a euro hedge is rarely seen for the euro equity allocation. Some pension funds have removed the hedge for as long as the SNB is defending the exchange rate, although we advise clients to maintain the hedge from a strategic asset allocation and risk management point of view.”
“Swiss pension funds typically are running a foreign currency exposure of about 20% by having a higher exposure to global asset markets,” says Christoph Müller, chair of the investment committee, NEST Sammelstiftung. “We temporarily increased the currency exposure, because the investment committee adopted the view that the Swiss franc will undergo a period of devaluation. But as time goes by and the Swiss franc devalues in real terms due to inflation, the upper limit could be abolished by the SNB. In consequence, we have reinstated the currency exposure to the strategic level.”
Meanwhile, according to Werner Rutsch, head of institutional business Switzerland, AXA Investment Management, low interest rates mean that new asset classes have to be considered within the fixed income category. “Our view is that the euro-zone is coming out of recession, so yields will rise,” he says. “But this will happen quite slowly, as central banks will not move for a couple of years. Assets such as emerging market debt and high yield bonds are further up the risk curve but offer a yield pick-up. Pension funds will, however, hedge all these additions against the Swiss franc.”
Insurance-linked bonds are also growing in terms of demand, says Rutsch. “The yield pick-up with only moderate volatility makes them attractive, as does the fact they have little correlation with equities and bonds.” Other ways of diversifying are to go into lower-rated bonds or into corporate credit, or from liquid bonds into loans to small and medium-sized companies.
However, only the big pension funds have the internal resources for selecting alternative assets. Even then, they may get advice from consultants, for governance reasons.
Smaller funds rely more on global investment consultants for manager selection.
Stucki says: “Moving into alternatives costs money and small pension funds understand all too well that they are paying too much for an extra return which will be eaten up by fees.”
He says that hedge funds in particular are under-allocated.
“They are considered very expensive, especially funds of hedge funds,” he says. “And they have also disappointed in terms of performance. There is marginally more interest in private equity.”
Ender agrees that bigger pension plans are clearly building up their exposure to private equity, sometimes at the expense of their hedge fund holdings.
The bigger funds now have approximately 3-4% allocated to private equity, often with investment partners.
“Pension funds that can afford illiquidity because they have a lower proportion of pensioners or a good coverage ratio will increase their private equity allocation to 5% or even higher,” says Ender. “Investors are expecting an outperformance over public equity of about 300bps.” Allocations are spread across Europe, the US and most of Asia; Switzerland itself has few private equity offerings.
Ender expects the trend to continue, although it could be slowed by any rise in interest rates. “If that happened, bonds and equities could both suffer in the short term, leading to lower coverage ratios,” he says. “That could reduce risk capacity, with pension funds being forced to go to the perceived safe haven of government bonds.”
If some of the larger Swiss pension funds are backing sophisticated asset classes, they are equally interested in sophisticated investment styles. Smart beta is assuming increasing importance with Aon Hewitt clients, according to Zaugg; in practice, it is implemented as a satellite mandate within a more traditional equity allocation.
“It’s a good way to think about investment, specifically fixed income,” says Rutsch. “The financial crisis means the historic benchmarks are being challenged. So there are particular opportunities for a smart-beta approach.”
Müller adds: “The experience of the financial crisis showed how important it is to improve the stability and reliability of portfolios. But while new rules such as equally-weighted indices have potential, are they always ‘smart’? Robustness has to be improved.”
He says new indices such as the equal weighted concept should be regarded as an active approach. “Nonetheless, the development of rule-based investing seems to be promising, as I consider markets are inefficient enough to be exploited by active management,” he says. “Furthermore, rule-based approaches and the introduction of risk regimes in asset allocation have potential.”
Approaches similar to risk factor-based asset allocation are indeed finding interest, says Stucki. “Those pension funds that really get the importance of risk factor-based asset allocation will understand that in this low-yield environment, the solution isn’t to increase exposure to equities above 30%. The solution is to find other types of assets that add diversification and add a better share of risk in the portfolio.”
Meanwhile, the expectation that yields will rise is universal. “The large increase in long-term yields should be seen as a first significant step towards a yield level reflecting long-term inflation expectations,” says Müller. “We expect yields to be even higher on a 12-month horizon, but bond portfolio losses to be limited. NEST has reduced the duration of its fixed income portfolio to the limits allowed by our strategy, and we have allocated part of the global fixed income portfolio to high-yield assets. We are also overweight in corporate debt.”
Credit Suisse believes the short-term three-month rate on Swiss bonds will go above 1.2%: in 12 months’ time, it predicts a rate between 1.3% and 1.5%, because of GDP growth (estimated at 2% for 2014) and a 70bps jump in inflation, from -0.1% this year to 0.6% next.
In view of this, it favours corporate bonds, especially high yield bonds, which perform well even when interest rates are initially hiked.
“However, given current levels of emerging market debt, we prefer hard currency debt,” says Hochberg.
“But emerging market debt can act as a strategic inflation-linked investment. We are also using duration management to reduce risk – at present, we are short duration.”