Pension funds and other institutions are focusing on absolute return strategies as part of the drive to match assets to liabilities. Alternative asset classes are being used alongside other strategies in this move.
Continental European institutions looking to generate higher returns are considering tactical asset allocation, hedge funds,
private equities and extended asset classes such as emerging market equity, according to New Sources of Return 2004,
a report from JPMorgan Fleming.
Some 193 institutional investors - excluding those in the UK but including France, Germany/Austria, Italy, the Netherlands, the Nordics and Switzerland, which collectively account for E1,074bn of institutional assets - were surveyed for an insight into Europe-wide trends and the attitudes and investment characteristics within individual markets.
The report finds that European institutional investors expect overall nominal investment returns to average an annual inflation-adjusted 6% over the next three-to-five years, within a range of Italian expectations of 5.2% and Dutch of 6.9%.
But it characterises the overall situation in which Europe’s pension funds and other institutional investors find themselves as a Catch-22. On the one hand, they need to generate higher investment returns in the face of longer-life expectancy and falling stock markets while on the other, they find growing corporate pressures to limit the balance-sheet volatility that can arise from a fluctuating asset/liability pension profile.
It also detects a sea change in what constitutes ‘successful’ investment management, with a decline in the prevalence of relative performance. And while the survey found little willingness to be panicked into delivering a high return potential at any price, institutions were clearly interested in the range of instruments and strategies to achieve required returns while controlling risk, and it examines the extent to which investors are embracing such new opportunities as portable alpha, absolute-return strategies and tactical asset allocation overlay.
More than 80% of institutions measure performance against a market-related index and just over one in three measure against peer group. But only one in four currently uses an absolute-return benchmark.
The report also highlighted regional differences. The Netherlands and Nordics, for example, are eager to adopt new instruments and strategies, while Switzerland and others stick to more conservative asset management approaches.
And while it identified a
tentative trend towards delineating between beta and alpha returns, with 43% of European institutions claiming to do so, only one in four German institutions claimed to and 60% said they had no plans to adopt such analysis compared with 80% or more of respondents in the Nordics and France saying that they are currently or are planning to apply alpha/beta decomposition.
But having identified who distinguishes alpha from beta, the report assesses which institutions are seeking ‘portable alpha’ strategies to allow alpha generation to be transferred from one asset class to another without being exposed to the associated risks of holding that asset class. Again, it found wide variations, with 91% of Nordic respondents claiming to be familiar with the term against only 27% of French institutions. And the Nordics were the only market to register enthusiasm to apply portable alpha strategies, 63% of institutions either applying them or planning to do so, while French institutions were generally uninterested and Switzerland had the least interest.
On asset allocation, the report notes that while fixed income is generally dominant, with no market’s average asset allocation assigning more to equities than to fixed income. And while 80% employ some form of active asset allocation, only one in four of these use an asset allocation overlay which allows asset allocation to be managed separately from the underlying assets. But it finds one-in-three saying they intend to change their approach, principally by adopting an active overlay strategy.
Asked to identify the non-traditional asset classes/strategies they were interested in using to help deliver higher returns, the institutions’ most popular response was tactical asset allocation, with 81% of European institutions looking to explore it further, reinforcing a strong interest institutional investors have in exploiting short-term valuation anomalies between asset classes.
It was followed by, in order of popularity, emerging market equity, at 72%, and long-only absolute return strategies, a very new concept targeted for future use, being chosen by 67%. Surprisingly given their recent media prominence, hedge funds came in only slightly lower at 65% but overall the figures suggest a broadly equal level of interest in using both long-only and long-short strategies. Further, corporate high-yield bonds were cited by 63%, private equity by 57% and currency as a source of alpha by 52%. Other options - including emerging market debt, forestry and structured credit - were of interest to 6%.
JPMorgan Fleming suggests that these findings indicate that European institutional investors are amenable to exploring non-traditional asset classes and strategies to achieve higher returns from their investment portfolio.
The report also correlates the institutions’ eagerness to apply these strategies with their willingness to use derivative products such as financial futures, options and swaps that are required to affect them. It finds that 70% already use derivatives in some form while a further 11% say that they are willing to use them in the future. Further, of those are using or willing to use derivatives, two-thirds are prepared to use them as an overlay across all or part of their portfolio and only 28% are only willing to use them as part of a strictly-defined hedge fund allocation.
Of those not willing to use derivatives 58% said it was due to guidelines set by their pension trustees or investment committee, 30% cited regulatory restrictions and 17% ascribed it to limited understanding of derivative products.
Meanwhile, examining how institutions are currently allocating assets, the survey finds that overall 49.6% of portfolios were in fixed income and 30.9% in equity at end-2003, while other asset classes, including real estate, private equity, hedge funds and commodities, accounted for only 19.5%. And while Switzerland and Italy were the highest at 35.1% and 31.4%, respectively, substantial levels of real estate skewed the picture on both. But exposure to alternative investments remains extremely low and despite private equity and managed currency being cited by more than half of the respondents as areas of interest, they were the least used.
Germany and Switzerland have the highest proportion in hedge funds, with 2.8% and 2.2%, respectively, while at 2% France was the deepest into private equity followed by the Nordics at 1.8%.

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