The findings from the first review of the Finnish pension system, commissioned by the Finnish Centre for Pensions, were handed down by Nicholas Barr from the London School of Economics and Keith Ambachtsheer from the Rotman International Centre for Pension Management last month.

Although Helsinki in January is far from a party Ambachtsheer and Barr reached celebrity status in presenting the findings, with their photos on the front page of the newspaper and more than 250 people showing up for a workshop.

The purpose of the evaluation was to get a forward-looking external view of the Finnish pension system from an international perspective, and to specifically get recommendations on improvement.

According to Ambachtsheer and Barr the Finnish pension system is comprehensive and robust. However, the population structure and an increasingly global economy call for further development of the system. Retirement needs to be postponed, and pension asset investments need to seek higher returns.

The first recommendation relates directly to efficiency and cost, and Ambachtsheer is of the opinion that larger pension providers, or stronger co-operation between providers, would facilitate a drop in administrative and investment costs.

 

Value creation

The system costs about €1.1 billion a year to operate, (with total benefit administration of about €440 million) which is roughly €107 per member and is significantly higher than the average €60 per member of an international peer group assessed by CEM Benchmarking.

However it is worth pointing out that the pension administration costs cover both pension pillar one, the universal old age pension, and pillar two, employment based pensions. This is unusual compared to other countries.

Nevertheless, Ambachtsheer says that a value creation/cost reduction target of €400 million a year is not out of the question.

Further he says if €150 billion in Finnish pension assets were moved into long-horizon return-seeking investment strategies there is a potential €1.5 billion a year incremental return potential.

These two actions combined are equivalent to a potential 1 per cent gain in Finland’s GDP, the report says.

About a third of the system’s assets are invested in Finland, and Ambachtsheer says the system, and its beneficiaries, would benefit from being more global.

One way to do this is to be more cooperative with other funds around the world and syndicate investments.

“They need to think about Finland’s funds as part of a cooperative of international funds that invest all over the world,” he says.

Interestingly the Finnish pension organisations outsource a significantly smaller proportion of asset management than their international peers – around 35 per cent, compared with an average 88 per cent in the CEM database.

The report also found that the Finnish pension organisations currently spend less money on the internal investment oversight function than their international peers, and also have lower levels of compensation of senior pension executives.

 

What makes a sustainable system?

More broadly Ambachtsheer believes there are three tenets to a sustainable pension system.

The first is that you need as many instruments as there are goals. So for example affordability and payment certainty are two goals and so need two instruments.

Secondly, is what he calls the John Nash principle. (Nash is the Nobel Prize winning mathematician who was the subject of the movie “A Beautiful Mind”. He specialises in game theory). Ambachtsheer says that a situation has to be win/win all of the time, even in the bad times, which means if situation changes the solutions need to be dynamic.

And the third aspect is borrowed from Einstein, keep things as simple as possible but no simpler.

With regards to the pension industry, Ambachtsheer says there is a tendency to add a layer of complexity to solve the problems.

In the South African city of Pretoria, 50km outside Johannesburg, the sense of history is pervasive. The city was the capital of the apartheid regime and the site of Nelson Mandela’s presidential inauguration. It’s also home to Africa’s biggest asset manager the R1.17 trillion ($0.12 trillion) Public Investment Corporation, a state-owned body founded in 1911 which invests on behalf of the country’s biggest pension fund the Government Employees Pension Fund (GEPF), a defined benefit fund underwritten by the government. Fittingly, the PIC is also making history with the biggest shake-up in its investment strategy since it was founded 100 years ago. After a century of confining investment within South Africa it has begun a foray offshore in search of bigger returns in the wider continent and outside Africa altogether.

“I believe we are entering our golden age,” enthuses 49-year old chief executive, Elias Masilela, a trained economist who joined the PIC from private sector insurer Sanlam where he was head of pension policy, and whose youth and responsibility at the helm speak of the new South Africa.

“We’re venturing outside South Africa opening up to new challenges and expectations.”

GEPF’s mandate allows the PIC to allocate 10 per cent of its assets outside South Africa, split between a 5 per cent allocation to other African economies and a 5 per cent global portion outside the continent.

So far the PIC has only placed 1 per cent of its African allocation. Masilela says they are “still exploring” the best options in an investment strategy that aims to capture Africa’s economic growth and emerging middle class. It will be managed in-house with the PIC “going it alone” building its own, specialist African team. It has snapped up a $250 million, 20 per cent stake in Africa’s biggest banking group EcoBank in an “investment that optimizes our footprint across the continent in one fail swoop” and also made a private equity investment into an expanding Tanzanian cement group, Simba Cement.

Given the lack of liquidity in many sub-Saharan markets much of the investment will be via private equity.

“We won’t prioritise or rank countries though – we’ll invest according to opportunities that avail themselves,” he says.

The PIC has outsourced management of its 5 per cent global allocation in passive equity and bond mandates. It tends to manage most assets itself with an in-house team of 80 but does use private sector managers where needed. Masilela says this global allocation will switch to active management; then his team will “start to have more involvement.”

 

Africa calling

Although the PIC’s off-shore incursion is still tentative, Masilela believes the GEPF will ultimately portion much more Africa’s way.

“I believe there is at least another 20 per cent to go – the ceiling will be relaxed if we do well.”

South Africa’s Regulation 28 of the Pension Funds Act governs funds’ asset allocation, stipulating that funds can’t invest more than 25 per cent of their assets outside South Africa. “Although it does use Section 28 as a reference point, GEPF is not bound by the same regulation,” he says. South Africa still uses exchange controls to stem capital flight but Masilela is adamant the PIC, which targets returns of 3 per cent above inflation in rand terms, would struggle to grow more confined to South Africa “You need to go outside for returns; it’s one of the reasons to go offshore.”  .

It’s a point underscored by the PIC’s dominance across South Africa’s investment landscape. Its assets comprise a 50 per cent allocation to listed South African equities, a weighting that accounts for 13 per cent of the capitalisation of the Johannesburg Stock Exchange. The inability to invest elsewhere left the fund limited in its ability to shelter from the global downturn that buffeted South African stocks.

“South African companies have seen their trade and exports hit; imported inflation and the general slowdown in economic activity have been a problem. We’re not isolated from the rest of the world.”

 

Internal management

Around 75 per cent of the equity portfolio is managed internally on a passive basis allowing “significant savings” in management fees. In keeping with its hybrid structure the remainder is externally managed in active mandates by local asset managers.

“External mangers are important for us in generating alpha. Internally it’s just beta,” says Masilela. “We’ve found that over time the cost of asset management is high compared to in-house management yet the returns are comparable. Externally managed funds don’t deliver as well as we want them to.”

It’s this “low-cost operation” that he believes makes it unlikely the PIC will be challenged by private asset managers bidding to run GEPF assets, or the other public sector funds it invests. The GEPF accounts for 90 per cent of PIC assets with the balance made up from other South African funds like the Unemployment Insurance Fund and the Guardian Fund.

A 30 per cent allocation to the local debt market includes government bonds, state-owned companies and corporate entities, all managed in-house. It’s an allocation that has shrunk back in recent years with a shift to diversify and not just “fund the government deficit.” The PIC uses the All Bond Index (ALBI) and the STeFI (short-term fixed interest) index to benchmark performance. “Our goal is to outperform these indices and we always have.”

A 5 per cent property allocation is managed through spin-off PIC Properties and spread across diversified assets from commercial office, retail and industrial space to low-income housing. In some cases the properties are held on GEPF’s balance sheet, others are owned indirectly with GEPF a shareholder in unlisted property companies. It also partners with other private sector entities, including black empowerment developers, the South African government’s initiative to address the inequalities of apartheid by giving disadvantaged groups economic advantages.

 

Favouring co-investment

The Corporation also has a 5 per cent allocation to Isibaya, its return-seeking fund that seeks a developmental impact. Investments range from R2 million to R2 billion including affordable housing and healthcare, transport initiatives, telecoms and renewable energy, plus lending to small and micro businesses via private equity.

“We tend to co-finance deals and not be the single largest investor. Investments are made either through third-party managed funds, joint ventures or retail intermediaries,” says Masilela who can’t hide his enthusiasm for “the real change” private equity reaps in these areas in a way listed equity investments can’t. “Every rand you spend in a small business generates higher returns in jobs than a big business; it is the key to unemployment.” PIC impact investment also draws others to new asset classes; investment flocking into low-income housing with returns of between 8-10 per cent is a case in point, he says.

Masilela says the philosophy and energy behind Isibaya is pervasive throughout the fund with the entire portfolio considered from an ESG point of view, and investment strategy honed to benefit “workers in their retirement but also in their productive years.” It will be the same principles that guide much of the PIC’s investment in the wider continent where it hopes to use its size and strategic position to find ways to make a difference. “We are a leader in sustainability and won’t compromise or change our standards just because we are operating outside South Africa.”

2012 was a year of battles for European pension funds. An ongoing war was waged against a severe regulatory challenge from the European Commission in the shape of Solvency II-style legislation. Aside from the uncertain struggle of that campaign, major European investors gained plenty of credit from standing up to corporate boards in the “shareholder spring”.

The prolonged offensive against perilous funding states also saw some notable success with pleasing, if not spectacular, returns.

Top1000funds.com spoke to Matti Leppala who, as secretary general of Pensions Europe, is effectively European pension investors’ commander-in-chief, to hear some tales of a momentous year. Pensions Europe is an umbrella organisation of national pension fund associations in 20 European countries.

Beware the IORP!

The threat facing European pension funds from the European Commission’s Pension Directive review remains “very serious” says Leppala. Proposed changes to the Institutions for Occupational Retirement Provision (IORP) directive could lumber pension funds with similar new solvency restrictions as insurers, and place a premium on holding equities and other traditionally “risky” assets.

Leppala criticises the “false sense of security” behind the framework of the review, which assumes that pension funds can boost their solvency by becoming more reliant on government bonds.

While Leppala adds that the days of pension funds in the UK or Netherlands having most of their assets in equity markets are over due to the de-risking of schemes, the proposed IORP directive review threatens an unwelcome jolt to the investing landscape. “We think pension funds should be able to take risk in the long term and provide capital for growth and employment”, says Leppala.

He argues that at a time when banks and insurance companies can’t invest in riskier assets, denying pension funds the right to step into their place would both close the door on a valid investment opportunity and threaten the struggling European economy. A healthy European economy is in turn vital for any investing strategy, he points out.

A final lobbying push is in store over the next few months, with the European Commission set to outline a final proposal for the review in June or July 2013.

What’s wrong with the directive

Leppala regrets that a “political exercise not based on facts” could transform the well-established European institutional investing landscape.

An apparent failure to appreciate the differences in pension markets across Europe or between pension fund models is another point that irks him in the proposals. “It’s a very diverse landscape in the way investments are run and the needs differ wildly between huge Dutch funds and small Irish defined-contribution schemes, for instance,” he says.

The experienced Finn rejects a view, however, that politicians have turned against investors en masse since the crisis. Plenty of support for investors’ priorities can be found in the opposition from the European parliament to the likely nature of the changed IORP directive, as well as a unanimous front against this from British politicians, employer groups and unions.

It remains to be seen whether this support has any impact where it counts – at the European Commission.

Leppala sees some positive political influence away from the IORP debate, with attempts by governments to encourage pension funds to invest in long-term projects, such as the UK’s infrastructure fund that began to take shape in 2012.

The short-term attraction of European governments struggling with sovereign debt to pension-capital concerns remains an additional threat to investors across the continent, explains Leppala. The nationalisation of Hungarian pension funds and redirecting of pension capital from investors to the state in Poland, Slovakia and Ireland are all cited as instances of this.

Pensions Europe’s Brussels secretariat is undoubtedly a great location to check the pulse of efforts to revive Europe’s debt-laden peripheral sovereign debt issuers.

A return to some normality in bond yields towards the end of 2012 has of course relieved many investors faced with difficult choices on their holdings of troubled high-yield bonds and low-yielding core bonds.

The possibility of a further calming of the European sovereign-debt waters in 2013 opens the door for pension funds to profit from their government bond holdings, while playing a positive part as investors in the healing process, says Leppala.

Shareholder spring and renewed market health

Leppala perceives 2012’s “shareholder spring” as a definite sign that Europe’s institutional investors are beginning to throw their weight around as shareholders. A number of companies in Europe and the US saw their executive pay plans rejected by institutional investor-led shareholder rebellions, while heads rolled at the top of other firms. He sees major pension funds in the Netherlands, Scandinavia and the UK as driving forces behind European investors’ new taste for shareholder activism, and also cited the UK’s Stewardship Code and the participation of European investors in US class-action suits as underlying signs of a shareholder awakening.

In Europe, he stresses that “many countries are very undeveloped” on shareholder activism, particularly in countries without very large investors lead the way. Being a large investor brings increased public scrutiny along with capabilities for activism, Leppala says.

Differences in the definition of investors’ fiduciary duty explain why many European investors still appear to take a back seat on activism, compared to their North American or Australian counterparts, Leppala reckons.

A healthy year for European equity markets has relieved the pressure on several pension funds that had faced funding difficulties in the aftermath of the financial crisis. “I think there is a breathing space now, there is confidence, which is very good,” said Leppala. He spoke on the same day that the Austrian pension fund association, one of Pensions Europe’s member groups, revealed that the country’s funds returned 8.39 per cent on average in 2012, as opposed to minus 3 per cent in 2011.

Crisis in the global economy may be knocking the value of most UK pension funds off course, but it is actually helping swell assets at the £12-billion ($19-billion) Pension Protection Fund (PPF). Established in 2005 along similar lines to America’s giant Pension Benefit Guaranty Corporation, the PPF absorbs the assets of defined-benefit private sector schemes when sponsoring companies go bust and honours their pension liabilities. As the recession continues to claim corporate scalps, PPF assets are steadily growing by around $3.2 billion a year, with some 120 schemes transferring assets to the lifeboat fund last year. To date, the fund manages assets and liabilities from over 500 schemes.

“The current rate of insolvencies and the number of schemes we are assuming responsibility for is linked to banks tidying up their balance sheets and bringing companies to the wall,” says Martin Clarke, executive director of financial risk at the fund. And even when the recession abates, PPF assets will still accrue from investment growth and new claims for years to come. “We estimate we’ll have $95 billion worth of assets under management by 2030,” says Clarke. “This will take us to end of our active period. There are only a finite number of defined-benefit pension schemes that can come onto our balance sheet. After this our liability profile will decline as our member population ages.”

 The advantages of scale

For now, the fund’s growth is encouraging diversity and an ability to tap a wider range of assets for the first time. The conservative strategy hasn’t changed – it only targets returns of 1.8 per cent above liabilities with a relatively tiny risk budget – but the PPF is venturing in new directions nonetheless. “We are growing bigger and increasingly able to take investment decisions with all the advantages of scale,” says Clarke. “As we get larger, we are seeing more opportunity to diversify and secure first-mover advantage.”

The portfolio is split with 70 per cent in bonds and cash, 10 per cent global equity and 20 per cent alternatives. The cash and bonds allocation is divided between a collateral pool, which supports a derivatives program to hedge against interest rate and inflation risks, and return-seeking bonds. Here the allocation is in global sovereign and corporate debt, emerging markets and UK fixed income. The alternatives bucket includes what Clarke calls global tactics, comprising real estate (both UK and overseas), private equity, infrastructure and “alternative” credit. In this case, the strategy is to take advantage of the deleveraging of investment bank-balance sheets, including distressed debt. Similarly, the alternatives mandate now includes investing in assets from distressed sellers of private equity funds. In another departure, the PPF recently set an allocation to farmland and timber, with $100 million about to be invested in Australia and Brazil. It has appointed seven managers for these new mandates, including Brookfield Asset Management and Macquarie. “Some managers will be funded immediately, while others are appointed for deferred investment. All were appointed for four years, with the flexibility for two extensions of up to two years,” says Clarke.

In total the PPF uses 25 fund managers, which Clarke plans to increase to 30 throughout 2013, and strategy is managed by an inhouse team of 12. “Around 70 managers sit in a pool, we pull them off the bench, drawing upon them as and when,” he says. “Although we have a low tolerance to risk, not every mandate is low risk. Some of our mandates in the global tactics pool are positively volatile – we hold volatile and less volatile assets and the aggregate meets our tolerance for risk,” says Clarke, who confesses to having “spent a lifetime in insurance,” joining the PPF six years ago from the Co-operative Insurance Society.

Most allocations are active, although there are some passive mandates. “Our passive mandates tend to be in risk-adjusted benchmark funds. When we think the opportunity needs a particular skill, like private equity, we use an active strategy. Our allocations to alternatives also tend to be active.” Moulding the investment strategies of funds that come under its management is a gradual migration. “They don’t immediately transfer to the PPF; we do due diligence on the new scheme first.” This includes engaging with trustees to align strategies, introducing measures to hedge liabilities and reduce equity allocations.

 Managing risk in the lifeboat

Within PPF’s modest 10-per-cent equity allocation, UK exposure is minimal so as not to double up on the fund’s existing exposure to UK economic risk. “If you look at the things that damage us as a business, it’s the insolvency of companies registered in the UK,” he says. “Hitching our investment strategy to the UK economy, when we are already exposed to UK corporate insolvencies on our balance sheet, would be a concentration of risk.”

It’s the flip side to the steady stream of stricken schemes’ assets landing in the PPF’s lap. Any sudden spike in offloaded pension liabilities, or the arrival of a particularly large corporate scheme, has the potential to sink the lifeboat fund. The PPF is also operating against a backdrop of deteriorating deficits in many of the 6000-odd schemes it potentially has to protect. The average UK scheme is only 80 per cent funded thanks to low interest rates at home hitting funding levels; recent PPF research puts the aggregate deficit of the schemes it could potentially have to cover at $386 billion. “Because of long bond yields, funding levels are now a lot worse than what they would have been three years ago,” says Clarke.

 Fuelled by levies for now

The PPF charges the 6000 UK schemes eligible for its compensation should they go under premiums or levies in a process that nets around $950 million a year. So far it’s been enough to cover most – but not all – payouts, although it was frozen this year in response to corporate concerns during the recession. “The levy is still a large part of what is coming in,” admits Clarke. However, the PPF ultimately wants to be self-sufficient, drop the levy and rely solely on its own investment strategy for income.

The levy charged is particular to each scheme and set to reflect the risk that scheme represents to the PPF, gauging factors including the size of the scheme and the strength of the sponsor. “If the sponsor isn’t strong or the pension scheme is badly funded and our exposure is high, there will be a larger levy,” he says. The cost of the levy schemes have to pay the PPF is also set according to their own investment strategies. Schemes with large equity allocations and aggressive growth strategies pay a higher premium than those with more conservative strategies, with premiums oscillating to reflect different strategies by as much as 10 per cent. “We take a view like any insurer would. We don’t tell you what car to buy, but we will charge a higher premium if it’s a Ferrari,” says Clarke. It’s a cautionary mantra, skewed against risk, that the PPF will now apply to its ever-increasing asset base and investment clout.

Sir Henry Wellcome, the early twentieth century pharmaceuticals magnate (pictured below), would be pleased with how well the London-based charitable foundation that bears his name has weathered the global downturn. The Wellcome Trust (WT), which supports medical research in Britain and around the world, reported a total return of 12 per cent for the year to the end of September 2012, boosting its portfolio value to £14.5 billion ($23.2 billion). Since 2009 the WT – based on London’s traffic-clogged Euston Road – has returned a total of 27 per cent, while continuing to reduce its previous overexposure to UK and eurozone assets.

Peter Pereira Gray, the investment division’s managing director, says his team starts with the advantage in volatile markets of having no strategic asset allocation. “It allows us to operate a little differently from typical financial markets-led funds,” observes Pereira Gray. The WT has also benefited from the decision in 2006 by its new chief investment officer Danny Truell – with the investment committee’s support – to rectify what his deputy Pereira Gray calls a “distinct home-market bias”. Today, just 6 per cent of the WT’s assets are in the UK, compared with 33 per cent in 2006. Over the same period, the portfolio’s exposure to Europe as a whole has shrunk from 48 per cent to 13 per cent. In contrast, global investments outside North America, Europe and Japan account for 41 per cent of the portfolio, more than triple the proportion in 2006, with an emphasis on faster growing developing markets such as Brazil and India.

The way to illiquidity

The WT’s strategic shift out of Europe, however, has been carefully paced to negotiate the shocks and aftershocks of the 2008 market crash. “We didn’t see the full extent of the financial crisis that was coming, but we did see the risk, and hence we built up our cash position going into 2008,” recalls Pereira Gray. Between September 2007 and 2008 the WT’s holdings of cash and bonds grew from 5.4 per cent to 9.3 per cent of the portfolio, with a further rise to 13 per cent over the following year. Since then, the WT has become steadily more illiquid, with cash and bonds only accounting in September 2012 for 3.9 per cent of all assets. Pereira Gray declines to specify the amount of liquidity his team is required to hold, but the investment committee endorses Truell’s focus – reiterated in December – to seek long-term “premium returns from illiquid assets”.

Those assets cover three broad asset classes: property, private equity and hedge funds. Real estate, representing 10.6 per cent of the portfolio, typifies the WT’s general move to “a fewer number of larger positions,” says Pereira Gray, who before joining the Wellcome in 2001 was director of property fund management at the Prudential. Since 2006 the WT has sold off almost all its commercial real estate, while 90 per cent of its residential portfolio is invested in just four assets: about 1600 freeholds in the affluent southwest London district of Kensington; some 1500 freeholds spread across southeast England, the UK’s richest region; a UK student housing joint venture with property management firm Quintain; and investments in German residential real estate.

Like other UK property funds, the WT has capitalised in recent years on the continuing rise in upmarket residential real estate prices across London and southeast England. Since 2009, the directly owned residential portfolio has achieved an average annualised return of 15.2 per cent, rising to 17.8 per cent in the year to September 2012. At the same time, the WT continues to wind down its stakes in external property funds, which have performed less well in the same period, due in part to excessive bank lending.

Private equity, which amounts to 27.5 per cent of the total portfolio, is another illiquid asset class in which the Wellcome WT is a strong believer. Both Truell and Pereira Gray argue that the best funds in this sector will continue to produce superior long-term returns to public equities. So far, they have largely been vindicated, despite the improved performance of equities in 2012. In the three years to September 2012, the WT’s private equity portfolio achieved an average annualised return of between 10.3 per cent for distressed private equity and 13.3 per cent for large management buyout funds, compared with a return of 7.7 per cent over the same period by the MSCI World equities index. To sharpen its expertise in this sector, the WT last September appointed Damon Buffini, former chairman of UK private equity firm Permira, as a governor.

Hanging on to hedge funds

The WT has also kept faith with its hedge fund investments, accounting for 16.1 per cent of the total portfolio and total exposure of about $4 billion. Yet like other investors, the WT is wary of backing the many hedge fund duds. Since September 2007, the WT has more than halved the number of its invested hedge funds from 56 to 24, in line with its strategy of consolidating assets. Pereira Gray argues that the remaining hedge fund assets are worth holding in the long term for three reasons.

For a start, he says, the best hedge funds are very well run and offer excellent returns. Again, the WT’s own balance sheet supports Pereira Gray’s thesis. In the year to September 2012, four of the WT’s long/short equity funds produced annualised returns of 30 per cent by deftly exploiting the uneven recovery in global stock markets. Overall, the WT’s hedge fund assets delivered a 9.5-per-cent return for the year, with only managed futures funds (minus 1.3 per cent) a disappointment.

In second place, Pereira Gray says the WT’s long-term hedge fund investments dampen volatility in the portfolio as a whole, which would otherwise be more vulnerable to swings in equity markets. Lastly, Truell and Pereira Gray see hedge funds as an additional source of liquidity. “When you have a mature portfolio of hedge funds, it is effectively a liquidity pool, because you can typically get your money back on three months’ notice,” says Pereira Gray.

Long-term absolute return investor

Meanwhile, the fund has another potential source of liquidity in the form of about $10.5 billion invested in public equities. Equities today represent 42 per cent of the portfolio, compared with 62.5 per cent in 2006. The WT also now directly manages about 40 per cent of all equity investments, up from 35 per cent in 2009 – although not in markets like Brazil, India and sub-Saharan Africa, where it employs external managers with local knowledge. These markets, called “faster growth” by the WT, have in fact held back the overall performance of the stocks portfolio over the past three years, with the Wellcome WT scoring an annualised return for the period of 7.2 per cent, slightly less than the MSCI World equity index. Pereira Gray is not unduly disturbed, pointing out that all the fund’s equity investments are driven by a focus on underlying earnings rather than the share price. “We are not driven by relative returns,” he says.

As he emphasises, the WT does not regard its investment strategy as marking it apart from other endowments and charitable foundations. “We are not a bunch of mavericks,” says Pereira Gray, but a “long-term absolute return investor”. What is plain, though, is that the WT has been more nimble than many institutional investors in sidestepping the storms that have buffeted global financial markets since 2008.

Its agility has allowed the WT to meet the only benchmark that matters – delivering ever-greater sums to finance increasingly expensive medical research. Between 2012 and 2017, the WT forecasts that it will be able to spend about $5.6 billion on charitable activities, a 25-per-cent increase over the previous five years. Such a figure was beyond the dreams of the Wellcome’s original trustees, who began work in 1936 (the year of Sir Henry’s death) with no offices, no staff and just £74,000 in the bank.

A company pension fund might not be the first place you would think of applying for a mortgage.

According to Matthias Weber, a partner at Zurich consultancy ifund services, the issuance of mortgages by investors is likely to deepen as Swiss pension funds continue on their quest to find good alternative assets.

Weber has just helped to complete a survey of 200 Swiss pension funds’ investment priorities and reckons that the hunt for alternatives is at the top of the list. He expects major Swiss investors to grapple with this in 2013 as they look to reduce bond holdings. Yields of Swiss government bonds dated five years or less have hovered around zero in 2012, placing great strain on their return potential and necessitating a search for new ideas, in Weber’s view.

The typical major Swiss pension funds hold a rather chunky 30 to 50 per cent of their assets in domestic bonds. Government issues are a significant proportion of this, says Weber, as domestic corporate debt offers only a “limited” market.

Alternative ideas

Weber simply does not think that conventional asset classes can soak up all the money that Swiss pension investors will take out of domestic bonds in the next few years. As many pension investors are also looking to de-risk due to the closure of defined benefit schemes, alternatives generating dependable return streams will be the name of the game.

Weber identifies commodities and insurance-linked investments as two asset classes in the alternatives space attracting the attention of major Swiss pension investors.

The survey of Swiss pension funds by ifund services found that 61 per cent already hold commodity investments. The company also knows of seven pension funds looking to take on new external commodities managers in the next year. Commodities allocations rarely exceed 2 per cent of overall portfolios though, according to Weber, with investors wanting to keep their overall performance detached from the well-known volatility of commodity prices.

An even greater number pension funds are said by Weber to have an interest in appointing new insurance-linked investment managers. Some 21 per cent of Swiss funds responding to the survey already hold the relatively new asset class.

Catastrophe bonds in particular are interesting Swiss investors, Weber says.

More than a decade after their introduction he says they have performed well – with returns usually between 4 to 6 per cent – proved to be fairly liquid with low fees. “The market is tiny though, at around $15 billion, so you can only really allocate 2 to 3 per cent to catastrophe bonds” he says.

Hedge fund-style alpha and mortgages

Hedge funds might appear natural bedfellows of Swiss funds looking to diversify and find low-risk, steady returns. Weber explains that Swiss institutional investors were extremely enthusiastic about hedge funds from the late 90s, but there has been widespread disappointment since. Now, many of them feel hedge funds have been “expensive and have not performed well in the past few years”, says Weber, with the Swiss media frequently honing in on concern at hedge fund fees. The ifund services survey found that eight Swiss institutional investors are looking to drop their hedge fund managers in 2013.

Well-managed unconstrained bond funds and alternative UCITS are of interest to Swiss institutional investors looking for hedge fund-style alpha, says Weber (pictured left).

Another developing alternative asset class for the largest Swiss institutional investors is the issuance of credit to replace reduced bank lending in Europe.

Weber says that “some pension funds have begun issuing mortgages to their employees, and there is a feeling that direct lending can bring in good returns at low costs”.

The $15-billion Swiss Railways’ SBB Pension Fund last year acquired $686 million in mortgages while the $10.9-billion Basel City pension fund and $8.3-billion Aargauische Pensionskasse also offer mortgages.

On the whole, Weber reckons that Swiss institutional investors will look for holdings in alternative asset classes of around 8 to 10 per cent of their total portfolios.

Ultimately, with limited interest in existing alternatives and other asset classes just arriving on the scene, a lack of acceptable alternatives might lumber Swiss pension funds with the government bond holdings that many are looking to reduce.

Sticking to the well-trodden path of caution on alternatives and faith in large bond holdings might result in many funds needing to reduce liabilities with benefit cuts, Weber warns.

The established options

Given the scarce supply of alternatives, Weber expects real estate and less traditional bond holdings to prosper even more from a sustained move away from domestic bonds.

Global corporate bonds, high yield and emerging market debt as well as real estate investments offer established alternatives that Weber expects Swiss investors to utilise.

Weber cautions though that “a lot of pension funds might hesitate to swap the safety of Swiss government bonds to emerging markets or senior loans when they don’t know the issuers or the risk.”

The Swiss real estate sector is more of a trusted destination for pension capital, however. The sector has been a beacon of solid performance while its European counterparts have crashed recently.

Any fears that Swiss real estate is overvalued by this resilience are wide of the mark, reckons Weber.

He argues that property price increases have been more modest in Switzerland than elsewhere over the past two decades, offering 3 or 4 per cent net returns on average.

Taking the passive route

The ifund services survey found that around 50 per cent of assets at the Swiss funds responding are managed in passive external mandates. Some 56 per cent of assets in developed market equities are passively managed according to the survey, making this the most passive asset class.

A range of Swiss pension funds want to further increase their use of passive managers, according to Weber, but does not know a single pension investor looking to increase active management.

He thinks that reducing risk relative to benchmarks is the overriding reason why cautious Swiss pension funds have come to embrace passive investing, explaining that most pension fund boards in Switzerland are very conservative and “there is no reason to select active funds if you are not convinced”.

“Many funds feel that the search costs and monitoring of active managers – occasionally revealing big mistakes – are excessive”, says Weber.