Taking the bull by the horns

For many Spanish pension funds and their clients, who by European standards are new to the world of investing, the only experience of risk taking ended in disaster when the recent stock market crash wiped billions of euros off the value of their investments.
The last thing you need when you’re just starting out as a serious investor is a massive blow to your self-confidence. But as in life generally, the only thing you can do is dust yourself down and carry on.
If only it were that simple.
Spanish pension funds have traditionally been very conservative in terms of asset allocation. “From the beginning of the 1990s until Spain joined the Euro it was almost impossible to find a pension fund in Spain that had been working with an average equity exposure of 10-20%,” says Gustavo Trillo, client portfolio manager at JP Morgan Fleming’s Madrid office.
He adds: “Funds were invested almost fully in domestic fixed income securities and the money market. Fixed income investments and even cash were very profitable; even if the real return was not very high the nominal return was very good.”
But there was another reason for the traditional Spanish affection for fixed income. “Most of the pension funds were invested in fixed income not because it was an asset allocation decision but because they didn’t know how to do anything else,” says Trillo.
Lynette Murad, investment consultant at Watson Wyatt in Madrid explains that: “Spanish people, and Spanish trustees more than others, do not like to see their capital decrease in value.”
But at the end of the 1990s, Spanish pension funds and their corporate and private clients were growing increasingly impressed with the performance of equities.
Additionally, joining the euro and the decline in interest rates generally forced pension fund managers to take more risk. The survival instinct took over.
How do people feel today? “If you ask the average Spanish client if he wants to increase the level of risk in his portfolio he will say no,” says Trillo. Once bitten twice shy, in other words.
Furthermore there is little education in financial matters among the fund managers’ clients in Spain. “We know that we will not get a 10% return investing in fixed income over the next five years but this has been difficult to explain to retail investors,” says Trillo. “So in today’s environment of low interest rates, fund managers have a difficult job to do in get returns with a risk averse population.”
Further evidence of their lack of sophistication can be seen in what motivates individuals to invest in a pension fund. “People in Spain chose what is fiscally advantageous rather than looking for the best investment opportunity,” says Trillo. “Investing in pension plans is very profitable from a tax point of view. So the investor is not necessarily looking for the best manager; he is just trying to avoid taxes.”
The lack of sophistication of trustees and individuals means that it is the fund managers, or gestora, who tend to drive the investment decision. “Unlike many other European markets the investment decision is completely top down,” says Trillo. “Trustees will assume that the gestora are expert and accept what they say.”
However, if a trustee wants to dictate the approach, for example a risk averse fund consisting mainly of fixed income, this is usually accommodated. But this is not always the case, as Trillo explains: “Sometimes if you ask for something that goes against the grain of the gestora’s approach there may be resistance.”
Murad of Watson Wyatt believes that small is beautiful: “In our experience, the larger gestoras tend to be a little less flexible in terms of setting ‘non-house’ benchmarks than smaller institutions who are often more adaptable to trustee requests.”
But the approach to asset allocation remains broadly conservative. For example, the trauma of the recent turmoil in the stock market and consequent focus on returns has made funds that offer a guaranteed rate of return very popular. Clearly this limits the scope for taking on any kind of volatility.
One factor that severely limits the level of risk which can be assumed by second pillar schemes is that only one investment portfolio is permitted per fund. This means that a fund cannot tailor its investment profile to the different age groups of its members and their respective levels of risk tolerance. “That is one of the reasons that corporate pension funds in Spain assume much less risk than others elsewhere in Europe,” says Juan Costales, head of investment at Caser.
“Trade unions lobbied for this saying it was discriminatory,” says Murad. “But there needs to be some education showing them that that is not discriminatory, otherwise everyone loses out.”
According to figures published by Inverco, the Investment and Pension Funds Association, the combined assets of the second and third pillar pension systems in Spain stood at E55.6bn at the end of December, an increase of 15% over the previous year. Total membership stood at 7.3m, an increase of 12.5%.
The second pillar accounts for E23.5bn but has barely 700,000 members, largely due to the extremely generous state pension system which currently guarantees up to 94% salary replacement for those earning up to the social security ceiling of E31,800. The new decree, introduced in February, aims to stimulate this sector (see April issue).
The Inverco data shows that second and third pillar schemes have seen a significant move to liquidity over the past two years. At the end of December, cash, which includes short term placements up to six months including money market and public debt, represented 20% of total assets compared with 18% a year earlier and 12% in 2001.
Managers have been keeping their assets liquid rather than invested so as to be ready for a market upturn,” says Inverco director general Angel Martinez Aldama.
Trillo agrees: “The high level of liquidity is partly due to the expectation among managers that interest rates will increase. But the truth is that they do not know which way interest rates will go.”
The move to liquidity is also a result of risk aversion, as Murad explains: “Fund managers say they’re trying to be defensive with their portfolios. They are concerned with the big fluctuations that have taken place during the year in bond and equity markets even though the year ended positive.”
The move to liquidity seems to have come directly from fixed income investments whose share of total assets has decreased from 55% to 47% between December 2001 and December 2003.
Within the fixed income part, the proportion of public debt decreased from 25% to 16% over the same period. At the same time corporate debt increased from 12% to 18%. This latter development is due to declining yields from state bonds and the need to improve returns without the risk of equities.
The approach to corporate bonds is generally conservative. “If they do invest in corporate credit it’s usually high quality triple-A, double-A and a bit of single-A,” explains Murad. “They will not go into triple-B.”
Meanwhile, equities accounted for 19% of total assets at the end of 2003 with an approximately equal proportion of domestic and foreign stocks. This compared with 21% in 2001, although they did dip to 16% of total assets in 2002 in the wake of the turmoil on the stock market.

Also included in Inverco’s figures are a significant proportion of other assets which stood at 12% at the end of last year.
The largest part of this is due to the process of externalisation of pension obligations. In 1995 the externalisation law was approved but the decree was not published until 1999. The decree set November 2002 as the deadline to externalise pension assets. The figure represents promises which have been recognised but where funds have not yet been transferred. Inverco believes that these will be settled within five to 10 years.
Inverco also compiles investment performance statistics for second and third pillar funds. Last year the combined return was 5.4% in total which compares with a three-year average of loss of just under 0.3%. This is due to the upturn in the equity markets. Second pillar schemes drove the recovery returning 6.7%.
Of the third pillar schemes, the two most representative groups that comprise over 66% of individual plan assets are fixed income funds and mixed funds that invest between 15-30% in equities, the rest in bonds and cash.
Fixed income funds returned just under 2% last year compared with a three-year average of just under 3%, reflecting the fall in interest rates. Meanwhile the corresponding figures for the mixed fund are a return of 4% and a loss of 1%.
Funds are an increasingly popular investment choice. “There is a trend towards investing by means of funds instead of selecting specific shares or bonds,” says Diego Valero, president of Ocopen, the association of Spanish pension fund consultants. “The relative size of the Spanish pension funds is small, and therefore, when they decide to invest in equities, especially outside the Spanish Ibex, they prefer these instruments.”
Recently, and particularly in last twelve months, there has been a focus on alternative investments from dynamic money market to hedge funds of high volatility and high returns. “Average allocation to alternative investments, while very low compared with other European countries, is growing very fast,” says Trillo.
Here too the issue is one of sophistication, as Murad explains: “Trustees are starting to see that there are some hedge funds that are risky but that there are also hedge fund strategies that remove market risk and just seek to add value. It’s a question of education.”
She adds: “There is a lot of inertia in terms of alternative investments: trustees just can’t handle the volatility.”
With interest rates unlikely to increase significantly the acceptance of risk as a way of life will be unavoidable.

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