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Impact Investing

IPE special report May 2018


Why asset allocation looks more attractive

The asset allocation of a pension fund is a very important matter. Furthermore, it is widely accepted that the asset allocation is the most decisive factor in determining the level of the return and the associated level of risk assumed in a portfolio.

However, we would like to make the point that one should not undervalue the quality of the ‘asset manager'. Not paying sufficient attention to the quality of management takes us into a market in which the services of asset management are considered as ‘commodities'.

In this case the main factor in the selection of the asset manager is the cost leading to the withdrawal or restriction of entry of new asset managers into the market. Taking this further, the impact of this approach could potentially reduce the quality of active management of investments, reducing the profitability obtained and/or increasing the volatility and the risk.

Employer qualified pensions plans (EQPP) first appeared in Spain in 1990. Since then they have undergone rapid growth as can be observed in Table 1.

In summary, during the early years (1990-1992), the promoters of pension plans were mainly former state-owned companies (eg Telefonica, Repsol) and large domestic public service companies (Endesa, Iberdrola, Gas Natural). Between 1998-2002, pension plans were introduced by subsidiaries of European and North American multinational companies. Since then it has been the public administration that has led the process of establishment of EQPPs.

Spain has active population of around 16m people but it is important to realise that although there is still space for growth in EQPPs, most of the leading companies (large domestic companies, subsidiaries of multinationals and the public administration) have already established pension plans.

In Spain, pension plans are compulsorily integrated in a pension fund administered by an ‘entidad gestora' (similar to an asset manager) and a custodian. This arrangement is supervised by a pensions fund control commission (similat to a board of trustees. This commission is made up of the members of the control commissions of the pension plans, which are integrated in the fund.

The employer qualified pension plan control commission is made up of representatives of the workers and representatives of the company. Among its various functions it has responsibility for the selection of the pension fund in which the pension plan will be integrated. If a pension fund holds a single pension plan, the plan control commission also exercises the functions of the fund control commission.

It is important to point out that the majority of pension plans in Spain are defined contribution (DC) schemes in which the risk of the investment is borne by the employees who participate in the plan.

Spanish legislation sets out a general framework with regard to the asset allocation of the pension funds and the main points are:

❑ At least 70% of the assets of the pension fund must be invested in financial assets accepted for negotiation in regulated markets, in bank deposits, in credits with a mortgage guarantee and in real estate. Also, holdings in unit trusts may be included under Directive 85/611/CEE.

❑ The following guidelines apply more generally:

- investment in securities of any particular company may not exceed 5% of the assets of the pension fund;

- investment in a single unit trust may not exceed 20% of the assets of the fund; and

- investment in real estate may not exceed 20% of the assets of the fund. No more than 5% of the assets may be invested in a single piece of real estate.

❑ It is important to emphasise that no limits are set with respect to investment in equities nor on the geographical distribution of assets other than those set out in the previous points.

Asset allocation is generally defined as the allocation of an investor's portfolio among a number of asset classes. Traditionally, the main classes of assets that the control commissions have considered have been: fixed income and equities.

Therefore it is the control commission for the plan that must define the strategic asset allocation and its observance by the asset manager. In general terms, the decisions in this respect that are taken are: the maximum exposure in equities; the minimum concentration of investments in euros; the average duration of the fixed income portfolio; the minimum percentage of fixed income securities classified as investment grade; and the maximum percentage to be invested in emerging markets.

However, of the 1,787 pension plans which existed on 31 December 1995, the majority was integrated in multi-plan pension funds, in such a manner that the strategic asset allocation of the pension fund is decided between all the plans which make up the fund. If the plan integrated in a multi-plan fund decides to change its strategic asset allocation, the simplest solution is to integrate into another fund that is in accordance with the new investment policy.


From 1990 until around 1996, asset allocation was extremely conservative, as the pension funds were investing primarily in fixed income from the Spanish government. This might have been because the majority of sponsors were companies which, although they were later privatised, were then part of the public sector.

From 1997 onwards when subsidiaries of multinational companies were establishing EQPPs, asset allocation began to be diversified between fixed income and equity, although until 1999 there was a strong concentration of investment in Spanish securities.

The impact of the negative years for stock markets during 2000, 2001 and 2002, unlike what happened in the US and the UK, was limited in absolute terms due to the low exposure in equities of Spanish pension funds. It did, however, promote a great aversion to risk in the population as over those years the investment of pension plans was going for the first time into equities.

From 2000, the structure of the portfolio of the pension funds was diversified as can be seen in Table 2 which was published by Inverco, the pension fund association.

A strategic asset allocation aligned with market practice is defined in Table 3. The percentage of equities (set at 25% in the table example) in the general practice of the market oscillates between 20% and 45%. It is not common for EQPPs to invest more than 60% of their fund in equities.

There is a strong tendency to concentrate the investment in equities in the Euro-zone (not only in Spain), with the main reference index being the DJ EuroSTOXX50. The investments in the markets of the US (S&P500), UK (FTSE100) and Japan (Toppix225) are generally no greater than 5% in total of the strategic asset allocation. The investment in emerging markets is generally a tactical decision, not a strategic one.

With regard to the duration of the fixed income, it should be pointed out that in 2005 and in previous years a duration of between four and five years used to be set in a general manner. However, due to the foreseeable rise in interest rates and its effect on the value of bonds, the market modified the strategic average duration of the fixed income securities to between three and four years.

There is a strong aversion to exposure to currencies other than the euro.

Generally, investment in emerging markets is by means of specialist investment funds of international managers, while the investment in the Euro-zone is generally carried out directly in shares. The use of derivatives on indices is also common.

Historically, the profitability obtained by the EQPPs is very much correlated with the evolution of the fixed income and equity markets of the Euro-zone. This indicates that the management of the asset managers has been quite traditional, concentrating primarily on beating the reference benchmark.


Royal Decree 304/2004 (regulations which appeared in 2004) sets down the obligation on each pension fund, with the participation of the management company, to work out in writing a declaration which explains the investment policy of the fund. This document will define the methods of measurement of risks inherent in the fund's investments and the procedures for monitoring those risks. In addition, it includes the strategic placement of assets with regard to the nature and duration of the commitments taken on. This declaration must be available to any member of the plan.

The positive evolution of the stock markets and the average profitability obtained by employment-related pension plans during the past two years: of 5.52% in 2004 and 7.22% in 2005 has led to the consolidation of the strategic asset allocation carried out over the last few years.

In our experience, a significant increase in the exposure in equity of pension plans is not foreseeable in the short term. The coincidence in the establishment of new plans and/or the introduction of variable income in the strategic asset allocation of pension funds with the negative development of the stock markets in the years 2000-02 has contributed to the fact that control commissions are still very cautious when increasing the weight of variable income in the plan. Nor is a change in geographical distribution foreseeable, a high concentration in the Euro-zone will be maintained.

With regard to the duration of the fixed income, we believe that once there is an expectation that interest rates will stabilise, the average duration of the portfolio of fixed income will go back to being four to five years. As a function of the economic prospects and the spreads obtained, it is foreseeable that tactically a larger percentage should be assigned to corporate fixed income to the detriment of sovereign fixed interest. In the short term, we do not foresee an increase in the allocation to high yield bonds.

With regard to new classes of assets, direct investment in real estate sets out difficulties of valuation. The investment through real estate funds resolves these technical problems for the pension funds. However, the increase in prices over the past eight years in a variety of countries, particularly in Spain and in the UK mean that this is an investment decision which must be highly selective.

On the other hand, the fact that the DJ Eurostoxx 50 index has grown by more than 50% since December 2003 creates, as we understand it, a space which is encouraging for investment in other markets with better growth prospects and above all alternative asset classes which are less correlated with the evolution of traditional financial markets and which are looking for a consistent positive absolute return. With regard to this kind of asset, the increase in weight is foreseeable as a tactical decision although it is not expected that this increase will go beyond 5% in the short term.

Logically, if the evolution of financial markets in 2007 is negative, a reaction to this could be that the instruments of alternative investment management would become more attractive as part of the asset allocation of the pension funds, bringing us closer to the European average.

Jose-Luis Masferrer is head of investment consulting with Buck Heissmann in Madrid

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