Mercer European Survey: Alternative investments will continue to increase, focus on 'alpha' strategies like hedge funds rather than private equity

European pension funds are managing risk in their portfolios by diversifying and placing more money in alternative assets, according to a Mercer survey.

The new European survey by Mercer Investment Consulting (Mercer IC) covers 570 European pension funds with EUR 364 bn assets under management. The survey also found that, as well as reducing risk, pension funds are putting greater emphasis on active manager strategies ('alpha' strategies) to enhance returns.

Results showed that the UK and Ireland have the highest exposure to equities in Europe, at 62 per cent and 60 per cent respectively. UK pension funds have reduced their equity exposure from 68 per cent three years ago, at a rate of two percentage points a year.  At the other end of the spectrum, French pension funds invest just 28 per cent in equities on average while Germany, the Netherlands and Switzerland invest 31 per cent, 33 per cent and 33 per cent respectively.   Funds in these countries have correspondingly higher allocations to bond markets.

Andy Green, European Director of Consulting Policy at Mercer IC, commented: "UK and Irish pension funds have traditionally been more equity biased than funds in other European countries, although allocations are falling gradually year on year."

Equity investment in Europe is split broadly equally between domestic and international markets.

ALTERNATIVE ASSETS
As pension funds seek to diversify their risks, interest in alternative investments is growing. 

Property is the most popular alternative to equities and bonds, with 25 per cent of UK funds investing in this asset class compared to 62 per cent on average in Continental Europe and Ireland.  Virtually all Irish funds have exposure to property compared to 68 per cent in Switzerland and 41 per cent in the Netherlands.  "Property has been a long-standing alternative investment to equities and bonds for pension funds." commented Green.  "With prices having risen strongly in many domestic property markets, we are now seeing much greater interest in international investment as pension funds seek to enhance returns." 

In the UK, 7 per cent of funds invest in hedge funds, allocating 6.9 per cent of their assets on average.  Larger funds are more likely to invest in hedge funds, with around one in ten doing so.  In Continental Europe and Ireland, allocations are generally higher, with 13 per cent of funds on average investing in this asset class. 

Green said: "The proportion of funds investing in hedge funds has the potential to rise even further this year, by up to 5 percentage points across Europe, as pension funds become more comfortable with this asset class.  Pension funds are also showing more interest in hiring single manager hedge funds, typically equity market neutral and long/short funds, in addition to the more diversified fund of hedge funds. This is particularly true in Continental Europe."

Alongside hedge funds, active currency management is the most popular alternative to property in the UK, where 7 per cent of funds on average now employ an active currency manager.  In Continental Europe and Ireland, greater use is made of tactical asset allocation (TAA).  Use of both strategies is likely to increase this year, particularly in Ireland and Spain, as clients seek return-enhancing opportunities, although activity will depend on the availability of products. 

Interest in private equity remains strongest among larger funds, with 22 per cent of UK funds with over GBP 500m assets investing in private equity.  In Continental Europe and Ireland, 12 per cent of funds with over EUR 750m invest in private equity. 

Green said: "Exposure to private equity by pension funds is unlikely to increase substantially across Europe this year. It can be difficult to access the best funds and it takes a long time to build up the desired allocation.  While investors may find the investment rationale for this asset class appealing, they are generally opting for alternatives that are easier to implement and manage."

LIABILITY-BENCHMARKED INVESTMENT STRATEGIES
The survey identified that one in ten UK schemes (10 per cent) is expected to consider introducing some form of cash-flow matching or liability-benchmarked strategy in 2006, either through physical bonds, swaps or liability-driven mandates.  Use of swap overlays and liability-benchmarked mandates is also expected to grow significantly in Ireland and the Netherlands (up to around 40 per cent), where the regulatory and funding issues are similar to the UK.  Exposure elsewhere in Continental Europe is likely to be limited. 

"Liability-driven investment and interest rate hedging products are huge growth areas for asset managers and they are generating significant interest in the UK, Ireland and the Netherlands.  Plan sponsors and trustees have managed investment policy relative to their liabilities for many years, but these new products allow them to manage assets directly against liability benchmarks and mitigate some of the risks that are not expected to generate any additional return.  However, many schemes in the UK are finding the current price of long-dated bonds and their derivatives unattractive," said Green.

Copies of Mercer's European Asset Allocation Survey report are available at www.mercerIC.com/assetallocation

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