Pension fund allocations to alternatives increase as European investors, rattled by the volatility created by the Eurozone crisis, continue to turn their back on the equity markets, according to Mercer’s annual European Asset Allocation Survey. The survey of more than 1,200 European pension funds with assets of over €650bn found that an increasingly broad range of alternative asset classes are being considered by pension plans, with 50% of schemes now holding an allocation to alternatives, up from 40% last year.
Mercer’s research reveals that schemes in traditionally equity-heavy markets such as the UK and Ireland still have the largest equity weightings although they have witnessed the largest falls in equity allocations, mainly driven by a move away from domestic equities. In the UK, average allocations to domestic and non domestic equities fell by 4% (from 47% to 43%) over the last 12 months. In Ireland the current average allocation to equities is 44%, down 6% from last year and down over 20% since 2008.
Nick Sykes, European Director of Consulting within Mercer’s Investments business, said: “As the Eurozone crisis continues unabated, pension funds are faced with the dual challenge of managing portfolio risk brought on by market volatility, while at the same time identifying opportunities that will generate returns to support future liabilities. In their quest to control volatility without sacrificing long-term returns investors have turned their attention to alternative asset classes.
“In addition to their relative attractiveness compared to low-yielding bonds, alternative asset classes also offer appealing diversification characteristics. Indeed, schemes are looking to asset classes that are less exposed to the sovereign debt crisis, with a particular focus on emerging markets, both for equities and bonds. Investors are also looking globally for yield in bond markets, since the crisis has pushed core yields in Europe to very low levels. Liquid asset classes are also favoured, as investors value access to their assets in such turbulent times.”
Trends in alternatives
In the alternatives category, hedge funds, emerging markets debt and high yield bonds were the most popular categories across Europe (ex-UK), with almost 20% of schemes having an allocation to one or more of these areas. This trend is even more pronounced for larger schemes, with over €2.5bn in assets, where around 60% have allocations to one or more of these asset classes. This is up from 40% in 2011. In the UK, the most popular alternative asset classes were diversified growth funds, macro hedge funds, also known as GTAA strategies, and funds of hedge funds, with 23.2%, 13.6% and 10% of schemes having allocations respectively (See Charts 1 and 2).
The size of allocations to alternative asset classes is also on the increase but remains relatively small compared to traditional asset classes. Allocations of around 3-5% to individual alternative asset classes are currently fairly common. However, as investors diversify and increase the number of alternative asset classes held, total alternatives allocations continue to move higher. This year the total allocation to alternative asset classes reached an average of 8.5% for all surveyed schemes.
Sovereign bond yields remained extremely low over the last year leading many schemes to halt further allocations to bonds. Across Europe, bond allocations remained broadly stable although the UK witnessed a 1% drop in allocations, from 43% in 2011 to 42%. However, many schemes have implemented trigger-based policies that prompt an increase in bond allocations as yields rise and funding levels improve. Of the schemes surveyed, around 15% have LDI strategies in place to address funding risks and 57% of this group have some form of trigger mechanism in place.
Trends for the future
Over the next 12 months, the trend away from equities looks set to continue, mostly through reductions in domestic equity allocations. For example, in the UK, 38.8% of schemes are planning to reduce their exposure to UK equities, with only 1.4% expecting to move in the opposite direction. Nearly 24% of UK schemes intend to reduce their overseas equity allocation; a similar pattern can be seen across Europe, with around 20% of schemes planning to reduce their domestic or overseas equity allocation.
The picture for domestic real estate is quite bleak across continental Europe, with 13.2% of schemes planning to reduce their allocations and only 1.6% expecting an increase. In the UK, however, sentiment is mixed with 5.3% of schemes planning a reduction in the size of their allocation and 6.6% planning an increase.
Phil Edwards, Principal in Mercer’s Investments business and co-author of the report, said: “The forecast reductions in domestic equity and real estate allocations might be seen as a reflection of how schemes see the Eurozone crisis unfolding. Confidence in local markets remains low and many investors are broadening their search for return. Pension schemes are increasingly seeing the benefits of global diversification as the economic outlook and investment environment in different parts of the world diverge.”
“Investors are right to remain cognisant of risk in today’s environment. However, it is important to recognise the attractive return opportunities that will inevitably arise from the market turmoil and the behaviour of a capital-constrained financial sector,” Mr Edwards added.
The popularity of alternative asset classes is likely to persist over the next year and beyond with 27.2% of UK schemes and 12.9% of European schemes expecting to increase their allocations. Diversified growth funds (DGFs) are expected to see continued interest in the UK with 25.7% of schemes planning an increase in allocation. For now, the popularity of DGFs is very much a UK marketplace phenomenon – only 2.6% of European schemes plan to increase allocations in this area. What might be termed ‘growth bonds’ is also an area where schemes plan to increase exposure over the next 12 months, with 9.5% and 11% of European schemes and 8.4% and 5.8% of UK schemes looking to increase their allocations to emerging markets debt and high yield debt respectively.
Interestingly, inflation concerns are also evident, with 15.1% of European schemes and 24.8% of UK schemes planning to increase allocations to inflation-linked bonds over the next year.
“Given the extent of central bank monetary easing in the developed world in response to the financial crisis, many investors remain concerned about the potential for inflation to emerge in the years ahead. In addition, our view remains that the weight of pension scheme demand is likely to be a support for the inflation-linked market going forward,” added Mr Edwards.
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