A proactive approach to maximising returns

The third annual survey of European institutional investors, organised in conjunction with Pyramis Global Advisors, reveals pension funds across Europe are still adapting their strategy to come to terms with the low-return investment climate and above-average market volatility.

More than 30 per cent of 160 professionals surveyed, who together account for E880bn in managed assets, identified the big investment theme for institutions in 2011 as ‘dynamic asset allocation strategies’. This revelation was followed by 21 per cent who cited ‘risk-on versus risk-off decisions’, while 20 per cent went for ‘portfolio diversification’, and 17 per cent chose ‘managing volatility’.

“Their proactive approach is refreshing,” says Young Chin, chief investment officer at Pyramis Global Advisors. “The general view is we are in a low investment return environment and this climate could have further to run. Second, there is an overarching concern about risk. The responses were all about how you can get greater return and how you canreduce downside risk, and dynamic asset allocation is one play to address both sides of the coin.”

A clear message

The respondents, of which more than half were in corporate management or overall fund management, had a clear message to convey in relation to how they might improve their solutions for excessive volatility in the capital markets. Nearly half (49 per cent) cited the need for greater education for trustees and the investment committee – a response that was far from tongue in cheek – and eclipsed increasing allocations to global tactical asset allocation (GTAA), which was ticked by 38 per cent.

“We’ve experienced this with a number of our large clients,” says Mr Chin. “Pension schemes take a long-term view but they have struggled to explain their approaches to investment committees and trustees, who sometimes respond to short-term results and recent market impacts on portfolios. When there is a sharp market downturn, some trustees query what is happening. Responses to our survey show a commitment to helping trustees better understand that investment is not about quarter- to-quarter decisions.

“In instances where schemes shifted from actively managed strategies to passive management, due to short-term performance issues, education may have helped trustees maintain a longer-term view and allowed the scheme to benefit from the recent outperformance of active strategies.”

Enhance returns

The survey revealed growing comfort in investing more heavily in riskier asset classes such as emerging markets, which was cited as an area where around half expect a modest increase in their exposure, even though 46 per cent believe emerging market equities are the most volatile asset class. Schemes are also diversifying into real estate and commodities, as they attempt to enhance returns in the face of volatility. Some 64 per cent are comfortable with derivatives as a risk management tool, and 8 per cent plan to review their use of them in 2011, while 4 per cent say they are too expensive.

Volatility, last year’s top concern, remains something to be minimised, rather than explicitly harnessed to generate returns. More than 80 per cent implement investment strategies to minimise portfolio volatility, while the others said they opportunistically take advantage of volatility to generate alpha.

“Long-term, most of our focus is on trying to ensure the portfolio has some tail-risk protection,” says Gustaf Hagerud, head of investments, alpha and beta, at Third Swedish National Pension Fund. “We mainly achieve this through diversification, using assets that are not highly correlated to global equity markets, and by dynamic asset allocation, by which we mean a formal investment process around changing the risk exposure of the fund. So when we see there is a big chance of a slowdown on a macro level, we move out of equities. [We also use] derivatives, although this is a costly way of achieving downside protection,” he says.

“The general advice before the crash of 2008 was always to stick to your benchmark and eventually you would be rewarded, but pension schemes learned that was not easy when they were losing so much money,” adds Mr Hagerud.

“Many were forced to reduce risk at a point when they should have bought equities, so now they are reducing risk on the way down, and not when the regulator or their board tells them to.”

Liquidity remains an issue, and 57 per cent said they are using cash as a lever to diminish overall risk, while around 30 per cent use swaps and other derivatives. Use of exchange traded funds is low, at 17 per cent. To boost returns during 2011, 26 per cent of the schemes said they will consider increased use of liquid alternatives such as long/short equity, market neutral, managed futures and global macro, while 16 per cent are likely to use them.

Similarly, 23 per cent will consider upping their use of more aggressive ‘sub asset’ classes such as high yield, bank loan, emerging markets equity, and 19 per cent are likely to incorporate them.

However, many pension funds drew the line at increased exposure to illiquid alternatives such as private equity, venture capital and distressed debt, with 33 per cent stressing they would not increase exposure to these assets, and 29 per cent saying it would be unlikely.

Rebalancing portfolios

Furthermore, over the next two years, 13 per cent expect to significantly reduce holdings in government bonds, while 6 per cent expect to significantly reduce their exposure to domestic equities and 7 per cent expect to decrease their fund-of-hedge funds allocations. The beneficiaries will be global equity, to which 6 per cent expected to significantly hike their exposure, while 13 per cent expect a similar boost to emerging market equities, 5 per cent to corporate bonds and 4 per cent to real estate.

“The real challenge is the low rates of interest on fixed income – the situation was at its most extreme last autumn but it is still challenging,” says Risto Murto, chief investment officer of Varma, the Finnish pension insurance company.

“Short-term interest rates are still near zero and real returns are still extremely low up to five years’ duration. Varma’s holdings in government bonds are at our lowest ever.”

Asked whether they thought interest rates will rise over the next two years, 89 per cent agreed, but perhaps more surprisingly 8 per cent thought they will take longer to rise, potentially over a five-year period.

There seems to be some consensus that while interest rates will rise in the early summer, it won’t be a cycle of massive interest rate hikes, but limited to two or three small rises. The fieldwork for the survey took place in January and February, at a time when 17 per cent thought the sovereign debt crisis in the European Union would cause those countries to abandon the euro.