Pension Funds Building Illiquidity Risks

Terry Flanagan

Andrew Parry, chief executive of Hermes Sourcecap, warned that pension funds are investing in too many illiquid assets in their search for yield.

Parry spoke on a panel at Lipper’s ninth annual Lipper Expert Forum in London on November 12.

He said that pension funds are trying to match higher return expectations in a low-yield environment. “They are adding risks that, in a non-QE world, they would normally run a mile from in an attempt to match their discount rate.I am seeing esoteric asset allocation for a 5% return and illiquidity is building up in institutional portfolios.”

Neil Dwane, European chief investment officer at Allianz Global Investors, was also on the panel and warned that investors are leveraging sovereign and corporate bond holdings at 8 times to earn an 8% to 10% return. He said that if market conditions normalise these investors will have to pay huge margin calls.

“The hunt for yield is already at worrying levels and can be seen in the credit and bond markets, “ Dwane added.

Dwane also warned that the insurance sector in the UK and Europe is putting too much money into illiquid assets.

“Allianz believes in preparing for a nuclear winter so we have a solvent ratio of 200%,” Dwane said. “Other insurers have piled into real assets such as infrastructure and real estate which used to yield 18%, but spreads have fallen to 6% as a wall of money has appeared. The behaviour of insurers in UK and Europe is structurally flawed.”

In 2015 Dwane expects assets to continue to be mispriced as financial repression continues. “Our job is maybe to fund the least misplaced asset rather than the one that is necessarily cheap,” he added.

Next year the riskiest asset will be cash as investors need income said Dwane. He recommended stocks that pay dividend and growth equities in Europe.

Keith Wade, chief economist at Schroders, was the third speaker on the panel and said equities remain attractive as even if interest rates go up, they are only likely to peak at 2.5%.

“The US dollar is strengthening but that has not halted the increase in the S+P 500 even though corporate margins are being squeezed,” Wade added. “We are starting to think about the time to rotate away from the US and Europe could be the next destination.”

Dwane said the US dollar will continue to strengthen next year as the US economy diverges from the rest of the world.

“Investors need to be aware that the yen could down further,” Dwane added. “The euro could also do the same as that appears to be what Draghi has in mind and that could be the catalyst for investors to move into European companies.”

Mario Draghi, president of the European Central Bank, said in a speech in Frankfurt today: “We will use all means available to us, within our mandate, to return inflation towards our objective, and without any undue delay.”

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