05.30.2012
By Terry Flanagan

Euro Fears Drive Pension Funds Into Alternatives

The eurozone debt crisis is forcing big European buy-side institutions to flee the region’s equity markets and tap alternative asset classes in a search for alpha.

Spurred by minimal equity returns over the past few years, pension funds are pulling back from equities and increasing their asset allocations in alternatives such as hedge funds as investors seek to diversify their portfolios, according to new research from consultant Mercer.

“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,” said Nick Sykes, European director of consulting within Mercer’s Investments business.

“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 favored, as investors value access to their assets in such turbulent times.”

Mercer surveyed 1,200 European pension funds with assets of over €650bn and found that of the alternatives hedge funds, emerging markets debt and high-yield bonds were the most popular alternatives categories. Half of the schemes surveyed now hold an allocation to alternatives, up from 40% last year. In the U.K., average allocations to domestic and non-domestic equities fell by 4%, from 47% to 43%, over the last 12 months.

“When I speak to my clients, because of the issues with equities right now and people aren’t making any money and the spreads are where they are with equities, many are looking for alternatives,” Tanuja Randery, chief executive of London-based MarketPrizm, a trading technology company, told Markets Media. “So I think to diversify and use strategies with new asset classes is absolutely where people are going.”

The picture for domestic real estate is also quite bleak across continental Europe, according to Mercer, with 13.2% of schemes planning to reduce their allocations and only 1.6% expecting an increase.

“The forecast reductions in domestic equity and real estate allocations might be seen as a reflection of how schemes see the eurozone crisis unfolding,” said Phil Edwards, principal in Mercer’s Investments business.

“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 cognizant of risk in today’s environment. However, it is important to recognize the attractive return opportunities that will inevitably arise from the market turmoil and the behavior of a capital-constrained financial sector.”

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