The durability of long-term investors' portfolios in terms of their resistance to crises is currently and has been for some time severely challenging. Swiss pension funds are coping surprisingly well with this period, as already the exogenous shocks of the recent past could be absorbed well by most of the portfolios. On average, Swiss pension funds lost 7% in the "first phase" of the pandemic in March 2020, but ultimately ended 2020 with a strong performance of around 4%. Two years later, markets again are suffering from shock losses, driven by the Ukraine-war and the build-up of problems for economic growth in a higher inflation environment. As a result, portfolios decreased in the most recent quarter by nearly 3.5%. However, most Swiss pension funds reacted calmly to this development. They continue to follow the long-term trend towards an increase in real assets in their portfolios and increase their share of equities and alternative investments. To be well equipped for the current inflationary environment, we observe investors reviewing their long-term investment strategy with respect to its crisis-resistance. Especially, they continue to review whether the size of nominal assets is appropriate, and if necessary, to tactically underweight them or to shorten their duration. As high inflation rates can also harm real assets at some point, we have a neutral stance regarding equities and real estate and rather support investors reviewing their long-term direction paths. This means further optimization of risk premiums, support for the sustainable alignment of the portfolio, and increasing risk assessment.
Pension fund assets under management have grown very strongly globally over the past 10 years. According to the Global Pension Assets Study 2022 conducted by the Thinking Ahead Institute (a global not-for-profit research and innovation hub), pension assets have doubled from USD 666 billion in 2011 to USD 1,271 billion in 2021 which is an impressive annual growth rate of 6.7%. This growth rate can also be observed in Australia, the Netherlands, and the USA.
With increasing growth and low interest rates environment, the asset allocation also changed over the past decade. In 2011, Swiss pension funds invested roughly 47% of their assets in fixed-income related investments such as bonds and cash. This share decreased to 35% by the end of 2020.1 The search for returns led to a clear shift away from safe, partly negative-yielding (government) bonds toward more real assets such as equities, real estate and alternative investments. Swiss pension funds have reduced the share of domestic bonds drastically by one third, from roughly 28% to 18.7% at the end of 2020. By contrast, the share of equities has risen from 26% to 32.6% over the same time period. Investments in real estate have also increased by 3.7 percentage points to 24.4%. This shift from nominal to real assets amounted to almost 13% of the assets at the end of 2020.
As investors were searching for more returns and diversification the share of alternative investments increased by 10% from 2010 to 2020. Integrating infrastructure investments, which must be classified as alternative assets until 2019 it was even an 25% increase. Thanks to this change in classification and a (non-obligatory) limit of 10%, demand for this asset class has risen sharply. The share of private market investments also increased significantly, e.g. private equity and private debt. For comparison, the proportion of assets invested in insurance-linked securities, commodities and hedge funds was reduced by pension funds. This is especially true for hedge funds, their share in alternative assets fell by 50% as many hedge fund managers failed to deliver on their promise of returns.
If we compare Switzerland with the average of the seven largest pension fund markets in the world1 (USA, Canada, UK, Netherlands, Japan, Australia, Switzerland), a different picture emerges. In aggregate, the proportion of equities in the asset allocations of these countries has reduced from 60% to 45%, and this entirely in favour of alternative investments (including real estate). The share of bonds, on the other hand, remained the same.
Are portfolios and the current trend to increase real values assets equipped to deal with the interest rate turnaround and high inflation environment?
For several months now, after 15 years of expansive monetary policy bringing real rates below 0%, the inflation rate has been climbing upward, even if, compared to the U.S. and Europe with up to 8%, Switzerland is holding up much lower at only 2.5% thanks to the strength of the Swiss franc.
The conventional wisdom is, that high inflation rates might be somewhat transitory, and that levels will settle below the upper bandwidth of Swiss National Bank’s defined target range of 0-2% annual price increases in the medium term.
Since rising inflation is associated with a loss of purchasing power as well as losses on many investments, we see pension funds re-examining their investment strategy and its implementation.
As investments with nominally fixed cash flows record the greatest losses in the event of an increase in inflation, we recommend reducing the duration of the nominal values such as bonds and scrutinizing their overall share in the portfolio. Higher interest rates only hurt bonds in the short to medium term, as the rise in interest rates causes a shock drop in market value due to a higher discounting of future cash flows. In the long-term rising interest rates are making bonds attractive again, as re-investment can be done at higher rates. The effect inflation might have on real assets is somewhat trickier as depending on the level of inflation real assets might rise in price or fall and Inflation protection is only limited, as rising values are also accompanied by significantly higher volatility.
Therefore, we remain neutral on equities and real estate and focus more on the long-term, sustainable orientation of the investment strategy. This includes parameters such as diversification of risk premiums, consideration of sustainable investment principles and enhanced risk management and governance.
1 Global Pension Study 2022, Thinking Ahead Institute. Die
Q1 2022 saw Swiss pension liabilities on company balance sheets realise their largest reduction in any quarter since this index began.
