European institutional investors are taking strong measures to address solvency concerns and improve investment performance, as evidenced by their widespread adoption of new investment approaches and unprecedented levels of turnover of external asset managers.
Despite these newly aggressive tactics, however, Greenwich research suggests that many institutions are hesitating in adopting certain critical practices necessary to achieve their long-term goals.
The market recovery from mid-2003 to mid-2004 restored the total assets of continental institutions to the levels of late 2001. Despite this turnaround – and the fact that many plan sponsors bit the bullet and made hefty contributions to their pension plans – more than a third of continental pension funds still have funding ratios of less than 100%.
These ongoing solvency concerns, and the fact that plan sponsors on the Continent are much more dedicated to their final salary plans than their counterparts in other markets, suggest that European institutional investors will need to increase investment returns in order to keep up with their future obligations.
Recognising this need, many institutions have taken steps that would have seemed radical just a few years ago, including jettisoning balanced investment managers in favour of specialty managers and adopting core/satellite strategies that are in turn leading to revisions in asset allocation.
However, Greenwich’s 2004 research reveals that many institutions have failed to follow through with aggressive plans from past years, especially with regard to increasing allocations to equities and alternative asset classes. Last year’s predictions of significant increases to equity allocations did not pan out for the most part, as many institutions sold equities into the rising market to offset prior losses, restabilise portfolios, and shore-up solvency ratios.
The overall proportion of equities in the typical institution’s portfolio inched up from 20% at the end of 2002 to 22% at the beginning of 2004, despite the fact that most of the world’s sizeable stock markets rose 30% or so in 2003.
By all accounts, European institutions should be moving into equities with increasingly large investments in the next few years. Institutional rate-of-return expectations for active equities for the next five years stand at 8.1%. However, these relatively favourable expectations are not quite reflected in the fact that only 6% of continental institutions expect to hire a manager for core European equities within the next 12 months.
Given the international geo-political situation, the level of energy prices, and the prospect of rising interest rates, institutions are understandably skittish about increasing their use of equities. Nevertheless, the intended shift in medium-term asset allocation towards equities is on the right track, and Europe’s institutional investors would be well served by holding the course.

Shifting strategies
The continuing shift to a core/satellite investment strategy by many of Europe’s institutional investors suggests that they are committed to a relatively aggressive course of action. In general, the core/satellite approach consists of a substantial ‘core’ of low tracking error or passive equity and fixed-income mandates, and ‘satellites’ of very actively managed high-alpha equities, corporate or emerging markets bonds, and alternative investments. Investors using this strategy count on the passive components to provide market returns, and expect to improve on them by taking more risk with their satellite investments. As practised in the US, the mix can be as restrained as 70 core/30 satellite, or as aggressive as 50/50.
Although continental institutions have a long way to go to achieve these sorts of ratios, their intended shifts to their asset allocations suggest that they are on their way. Perhaps the most pronounced indication that a meaningful shift is taking place is the year-to-year decline in government bond allocations reflected in our 2004 research.
European government bonds shrunk to 25% of overall continental institutional assets at of the end of 2003 from 27% the prior year. In addition, more than 30% of continental institutions told us that they expect government bond allocations to fall further by 2006, while only 13% anticipated an increase. The main beneficiaries of the shift to ‘core’ to this point have been passive equities and bonds. A full 38% of continental institutions now use passive managers for equities, up from 34% last year. The use of passive bonds has increased even more rapidly, jumping from 12% to 20% over the past year. International (non-European) equities also have gained as ‘satellite’ investments. The proportion of institutions using an international (non-European) equities mandate rose from 58% in 2003 to 64% this year. While only 12% of institutions hired an international equity manager from 2002 to 2003, 27% of them hired managers for the asset class in the past 12 months. In addition, 18% expect to hire one in the next 12 months.
The trend in corporate/credit bonds is also toward higher usage and new manager hires. The proportion of continental institutions using corporate/credit bonds is up from 40% to 45%, with an additional 6% expecting to hire a manager for these bonds in the next 12 months. Usage of high yield bonds is up from 18% of these institutions in 2002 to 21% at the end of 2003, with 5% more expecting to hire in the future. The proportion of continental investors using emerging market bonds rose from 12% to 17% over the same period, and 5% expect to hire an emerging markets bond manager in coming months.
In another key satellite component – alternative investments – European institutions have consistently fallen short of their own expectations. In 2002, institutions expecting to increase their allocations to private equity by 2004 outnumbered by 11 to 1 those expecting to decrease, and institutions expecting to increase allocations to hedge funds outnumbered those expecting to decrease by over 40 to 1. In fact, however, European allocations to private equity, which amounted to 1% of total assets in 2003, were still 1% in 2004, and overall allocations to hedge funds also remained at 1%.
In hedge funds, moreover, current return expectations among continental institutions appear relatively modest, with reported annual rate of return expectations of 7.9% over the next five years – a level that lags expectations for equity markets.
European investors have also been hesitant to embrace private equity. The proportion of institutions using private equity actually fell from 34% to 27% during the past year. The trend has been similar in real estate where, despite heady expectations for increased investment last year, institutional allocations remained flat at 6% in 2004.
There is even less optimism looking forward, since continental institutions expect an annual rate of return of just 6.4% from real estate over the next five years.
Despite their hesitancy in moving assets into these higher-yielding alternatives, continental plan sponsors deserve to be complimented for the responsible steps they have taken to stabilise their situation after the market debacles of 2000 to 2002, and for the flexibility they have since shown in shifting to new investment strategies and diversifying their line-up of external investment managers. But Europe’s institutional investors should not be lulled into a false sense of security.
Many pension funds remain under-funded. To meet their needs in coming years, higher investment returns will be required, and too much conservatism now could be counter-productive, or lead to sustained levels of high contributions later.
Berndt Perl is a managing partner at Greenwich Associates, a research-based consulting firm in Connecticut