The 2015 European Investor Roundtable: Taking the Long View

Amid market volatility and record-low interest rates, can pensions invest for the long term? Europe’s top managers discuss the challenge.


For European pension fund managers, there is no dearth of serious economic and financial issues to confront. That was the common theme on May 28, when nine investors from across Europe gathered for breakfast and a roundtable discussion at London’s Park Lane Hotel.

It isn’t often that investors from countries as diverse as Sweden, Poland, Italy and France — to say nothing of Switzerland, Austria and the U.K. — have the opportunity to share their ideas on coping with low interest rates and investing in “govvies,” or government bonds; the prospects for economic recovery; the risks of a Greek exit from the euro zone; and the pressure to produce short-term results. Throw in hedge fund fees and the benefits — or not — of portfolio hedging, and you have the ingredients that made up Institutional Investor’s first European Investor Roundtable, held in conjunction with the magazine’s first annual European Investment Management Awards, bestowed on May 27.

Most pensions have very long-term liabilities, but regulations and worries about volatility can pressure them to focus on short-term results, says Philippe Desfossés, CEO of ERAFP, a collective defined contribution plan for France’s civil servants.

Among the roundtable participants were Henrik Gade Jepsen, CIO of Denmark’s ATP pension fund and winner of the Lifetime Achievement Award, and Magnus Eriksson, CIO of Sweden’s AP4 buffer, or backstop, pension fund. Elena Manola-Bonthond, deputy CEO of the defined benefit pension fund at Switzerland’s CERN, the European Organization for Nuclear Research, joined the group, as did Geraldine Leegwater, CEO and former CIO of ABN AMRO Pensioenfonds.

Also participating were Günther Schiendl, CIO of VBV-Pensionskasse, Austria’s largest multiemployer plan; Mike Jensen, CIO of Lancashire County Pension Fund, one of 98 local government schemes in the U.K.; Wojciech Rostworowski, deputy CEO at PKO BP Bankowy OFE in Warsaw; and Alfredo Granata, CIO of Inarcassa, a Rome-based retirement fund for self-employed engineers and architects.

An edited version of the 90-minute conversation follows.

Institutional Investor: When you look at the macro environment in Europe, do you feel positive or negative?

Alfredo Granata: Coming from Italy, we have to be positive whenever we talk about Europe, because from the Italian point of view, we have only to gain from a united Europe and solidarity from Europe. I think [European Central Bank president Mario] Draghi’s policies are able to maintain stability in the euro countries, apart from the Greek situation. But I am even quite optimistic about the Greece situation. The buying by the ECB of government bonds around Europe will go on for the next one-and-a-half, two years. The problem is we are in a very low-yield environment, and we have to face this environment.

Günther Schiendl: I would agree. We have to be optimistic about Europe. We have been in our portfolio for the past three years. We are massively deviating from a typical European weighting in the MSCI World Index. We have a more than 50 percent weighting in Europe at the moment, which is partially tactical reasoning. I agree that Mario Draghi has changed the game. Perceptions are about to change, then flows will change. I would say that the big story is investing in Europe today, not necessarily in emerging markets.

Geraldine Leegwater: I’m not too optimistic, because from an investor perspective you would argue that with the quantitative easing, money is rapidly flying into the equity markets. I really doubt whether this money will end up in the real economy. Otherwise it’s just a bubble, the next bubble, and we will not be better off in Europe.

Schiendl: I think that the money will end up in the real economy, but through new channels. I don’t know who is aware of the change in the German regulators’ view last week, that credit funds will be allowed under German law. That means direct investing in corporates, in loans, will be possible in Germany and German law through dedicated investment funds. I think that is a sea change; it is telling us what will happen in the future. So the financing of the European economy will change in the next years dramatically.

Granata: I just started investing in direct private lending in Italy. I don’t know if you heard of the so-called minibond in Italy that can directly invest in lending to small and medium enterprises. It’s going to develop a great market for these kind of assets.

Philippe Desfossés: I would like to be very optimistic, but unfortunately if you really try to maintain a cool head, we see that the debt overhang is still there. We have just moved the burden from households to banks, from banks to states, and states to central banks. And after that, to whom? Mars? Venus?

Two or three years ago, there was a European agreement, and in this agreement it is written that all the countries having a debt-to-GDP ratio above 60 percent will bring that ratio back to 60 percent in 20 years. Look at most of the countries — what’s the primary surplus that you will need to have in order to reach that? Is there a primary surplus in France? No. Is there a primary surplus in Greece? Obviously not. So the question is, What will happen with that debt?

Mike Jensen: It’s exactly the same situation in the U.S. and Japan.

Desfossés: My feeling is that it’s a question of intergenerational equity on sustainability. The debt of someone is always a financial asset of someone else. And the young people are the ones who are paying the taxes, who are used to paying the coupons on the bonds that we own — when I say “we,” I mean people above 55, 60. It’s a problem whether at some point those people will accept that burden. I’m not sure. Frankly, do you feel comfortable to buy govvies right now?

Schiendl: It’s an oversimplistic answer. If you get less than 1 percent nominal yield on good-quality government bonds, don’t buy them. Buy something else. That’s the issue. I feel more confident giving a European small and medium-size company a loan for five years, for seven years, paying 6 percent or 7 percent. Of course, it’s a question of scalability.

Henrik Gade Jepsen: We’re hearing both optimistic and pessimistic views on the economy. I personally lean toward the slightly more pessimistic. For me the robust conclusion is that uncertainty regarding the world economy is unusually high. I think the important point about this is how that uncertainty is reflected in your portfolio. How do you build your portfolio so it can handle that things turn out differently from what you expected?

Desfossés: Are you totally free to invest in whatever you want?

Jepsen: Yes. We’re basically unconstrained. The board doesn’t give us any benchmarks. They give us a return target.

Desfossés: Regulation makes it possible for you to invest in whatever you want?

Jepsen: Yes. As long as we are prudent and operate within our risk management framework.

Desfossés: That’s good. But regulation is important. It’s one of the messages we convey to Brussels. When I say “we,” I mean [the Investor Group on Climate Change]. When we go to meet with the new commissioner, for example, we say: “You are saying that you want to encourage long-term investors to finance infrastructure. That’s good. But how can you justify having so many regulations that are totally orthogonal with that goal, like Solvency II?”

Schiendl: The wish of the politicians is understandable — having somebody else financing infrastructure. The point is how to implement this. And if one of you ever tried to implement infrastructure investments, you have to spend an awful lot of time considering the legal format of the structure, the domicile, the valuation, the risk management. Very often you find yourself unable to implement this investment. Something has to change; otherwise it’s just nice talk.

Leegwater: If markets would work very well, then we wouldn’t have all those issues. It’s a pity we tried to find other complicated channels; if the normal markets would function, then we would not have to do that.

Schiendl: But they don’t. The normal markets have interest rates that are rock-bottom.

Magnus Eriksson: But it also creates opportunities. We’ve done direct lending for a couple of years, but the problem is scaling it. You can scale it deploying capital, but when the problem comes around, do you have the right team to sort things out? You have to be very picky whom you deploy capital with.

Jensen: We got rid of our 30 percent allocation to traditional, investment-grade fixed income two years ago and now allocate 30, 35 percent to noninvestment-grade direct lending. The only piece that’s proved difficult to scale has been the European direct lending. U.S. direct lending and U.K. direct lending are reasonably straightforward.

Schiendl: I wonder how you get board approval for a long-term investment strategy. Because we have to do the valuation annually. I suppose everybody will make an annual balance sheet. How do you make a place for a true long-term strategy? It’s a valuation issue, isn’t it?

Eriksson: For us that’s not the big issue. Those type of strategies are kept at cost. And the duration is fairly short in those type of credits. It’s usually five years. So that has not been a big issue. But we do not have any solvency issues. That makes us able to be long-term. Because I think all this mark-to-market creates more problems than it solves.

Leegwater: If we all face this issue that it’s difficult to come up with good structures for all these types of investments, why don’t we as an industry manage to set up structures? That could be very helpful. There are many pension funds that don’t have the capacity to do all the work that you mentioned. Why isn’t it possible to come up with structures that would facilitate that, without ending up with the investment banks who do that for their own profit?

Eriksson: Aren’t we more different than we think? We like to see ourselves as the same type of investors. We should get together and do club deals like the Canadian model. I’m a bit skeptical on that model.

Desfossés: About infrastructure, I think there are issues that could be addressed in the first step: Governments should stop changing the rules of the game once the game has started. The fact that even if you are a big pension fund managing a billion euros, it’s very difficult to go on a stand-alone basis. If you’re alone in front of your government, they will twist your arm.

Schiendl: There has been in the press the story of a gas pipeline in Norway. Big Canadian pension funds and others have been invested. The government changed the prices. It’s legal risk now that we’re facing.

Eriksson: I agree. And where is the risk? I think that in general we are underestimating the legal risk toward governments. I would much rather have that risk on a well-run corporate than on government officials that have to be reelected every four years.

Elena Manola-Bonthond: Typically, for infrastructure, one option would be to do it directly or in a club deal. We were concerned of possible legal issues. Another option was investing through a fund, but there you are not protected from legal issues and the returns that we could get are a bit below what one would expect for the type of risk that you are taking. So for the time being, we are not considering infrastructure.

Has that been the general experience around the table? Is it more talk than action in terms of infrastructure?

Jensen: We’ve done small-scale direct investing with — touch wood — extreme success so far. There’s certainly plenty of opportunities to pick up those schemes that have returned to banks’ balance sheets because of defaults and they do not have the capital base or do not have the regulatory freedom to deal with those things.

Making that next step into the scalable issue seems to be more difficult but doesn’t seem to be — certainly in the U.K. — something that one can’t overcome as long as you have proper governance structures inside your own fund and understand exactly how these things need to go, how your engagement with government needs to work.

Our issue in the U.K. is that the Canadian guys have huge checkbooks. They have well-funded extant teams that can do an awful lot of work in advance, and it’s very difficult for the smaller U.K. guy. Much as we try and persuade government that keeping U.K. infrastructure within the U.K. tax base is a good idea for U.K. PLC, in the end it’s the size of the check that they care about rather than anything else. Which I suppose as a taxpayer one ought to have a slightly ambivalent view about.

How do you solve the size issue as an infrastructure investor?

Jepsen: Historically, we have done quite a lot of infrastructure investment, but if you look over the past couple of years, we have two deals. We’ve done much more in real estate. I think there are two issues. You talked about the changing aspect of risk in these regulated assets. But another thing is that price inflation also shows up in the illiquid, complex assets. It may turn up in ways that are less obvious than in a government bond or a listed equity, where you can see the price. It could be in the assumptions that you accept when you’re buying a windmill. If the deal is that you expect to achieve an internal rate of return of 6 percent because the wind is going to blow more than it used to, it’s probably stretching the imagination a bit. We have preferred simpler, more transparent assets in the real asset space over the past couple of years.

Eriksson: Our experience is just the same. There was a big transaction in Sweden just recently and the price went through the roof, with the Canadians coming in with a big check and teaming up with some locals. I can’t see how that’s going to be a good deal for the pensioner.

We’re investing much more in real estate, in residential, to capture the urbanization trend that seems to be ongoing. We’re doing it in social housing and elderly housing. And that has some of the same characteristics as infrastructure. We now get paid for short-term finance — 15 basis points when we finance our residential company. We put 70 percent leverage on that. There’s no vacancies whatsoever. The rents are way too low because of regulations in Sweden. We think that’s a much better asset to own long-term, where you can control it, than picking up infrastructure around the world.

Granata: You can imagine that as architects, engineers, we are very linked to these worlds, both real estate and infrastructure. Historically, we had a big share of our portfolio invested in real estate, and now we are trying to diversify abroad. On infrastructure we set up a company last year, together with two other private retirement funds, that invests mainly in social infrastructure like schools or residential housing for older people.

The limitation of the government rules in this kind of environment is very hard. What the government initially is trying to do is to push us to invest in infrastructure but with their rules, with their governance. That’s the main friction between us as an institutional investor and the government. They want the money, but they want to rule. It’s not so easy.

Could you expand on that?

Granata: We invest in some closed-end funds that are matched by Cassa Depositi e Prestiti, a government agency. We will see in the next 15 years what’s going on. It’s €200 million [$221 million] just to begin the process. We have in the past few months done two investments in private schools in Bologna and in Milano, and two retirement buildings in Torino and in Milano.

Eriksson: We’re doing the same. In some of the municipalities around Stockholm, we’ve bought the schools and the elderly housing. We find that the politicians are much easier to make a deal with; we can say that we are long-term. As Swedes, we’re selling to ourselves, so we get advantage getting in, getting access to the deals, in pricing and then on finance.

It’s a very good investment to invest within the local municipalities, getting people living there, getting them engaged, whether it’s help with homework or local clubs or just work over the summer. For every one that you give a summer job to, they’re going to be the local police in that area for the coming years, so it pays off very well, on top of doing good things. That’s an area that we would much rather invest in than infrastructure, where it feels like you just add risk instead of being able to control it.

What are you doing on the environmental, social responsibility and corporate governance front?

Schiendl: We are about to start a momentum ESG strategy, and the reason is simple. You can invest on the equity side in funds that invest only in approved green companies, or you can say, “No, it’s about becoming green, it’s about becoming sustainable, so it’s about the differential development.” That means we are about to invest in companies that are not necessarily green, that are not necessarily at the high standard, but they have the potential to become so. This is a long-term strategy, and it will pay off for long-term investors.

Jensen: Something we have regular arguments about: If we are going to be an ESG investor, what is the point of buying companies that are already substantially top quartile? Much better if we’re expecting to make a difference globally is to look for the failing — probably the wrong word — but certainly the underperforming firms in that space. Those that are willing to listen to engaged investors who can potentially make a difference. So I wholeheartedly agree with that approach. It’s surprisingly difficult to sell to trustees.

Schiendl: Yes, it is. That’s why we don’t talk about it much and try to do it and establish a track record.

Jensen: On another topic, do any of you invest synthetically in the equity market to change the symmetry of retirement profiles? We’re trying to get it through the trustees at the moment, effectively employing a deep-in-the-money call strategy for public equity.

Jepsen: We’re doing the same thing. As part of our tail-risk management, for example, in 2007 we bought deep-out-of-the-money put options on the entire equity portfolio because volatility was so low, it was very cheap. We didn’t anticipate what was going to happen, but fire insurance was very cheap at the time, so to speak. In that sense, we try to truncate the tails as much as we can.

Are you doing that now? Is this 2007 all over again?

Jepsen: Yes, I think we have done that consistently. We did the same thing in oil when prices reached $140 [a barrel] in 2008. Most of the tail-risk hedging we are employing right now is on rising inflation long-term. We’re providing nominal guarantees; rising inflation would have a very negative effect on the purchasing power of nominal pension guarantees.

Desfossés: One thing I learned being the CEO of a brokerage for two years is that every day when you are managing a portfolio, you are buying every stock you have in your portfolio. It means that every morning you say, ‘I’m a buyer of that stock.’ If you are not, it means that you should sell it. So why should you hedge a portfolio if you think that the valuations of the assets you are owning are right?

The second question is, Is the duration of your liabilities long enough, and do you have a liquid situation that will make it possible for you to hold your position? Maybe you are losing something or paying for something that you actually don’t need. I think we tend to equate volatility and risk. The problem is that most of our trustees are scared by volatility, and the regulation is pushing in the same direction. Does it make sense to stress-test a portfolio of pension funds with an average duration of 30 years as if they were a brokerage firm?

Manola-Bonthond: I couldn’t agree more with what you are saying. This focus on volatility and short-term-result measurement can push you in a direction where you definitely don’t want to go and compromise the results in the long term. Our annual return objective is 3 percent. The problem is that this is measured from the first of January to the 31st of December, so people get nervous around October and say, “Okay, where am I?” So there is volatility around October, November, and there is a risk of a decision to cut the exposure to block the results, and miss opportunities. In my view, the most important risk today is liquidity. It’s not volatility.

Granata: We use dynamic hedging management in terms of profit taking, so when things go really, really well, we take profit with the derivatives, not direct selling. We increase our derivative hedging the more things go better. The first three months of the year, every part of the portfolio reached 15 percent or 16 percent results because of investing mainly in Europe, so we cut the exposure to European equities by hedging derivatives. And we increase this hedging the more the markets go up.

Wojciech Rostworowski: We have the simple life because we are not allowed to use any derivatives, whether for hedging or restructuring. So we just buy and sell plain-vanilla things.

Granata: Of course, you have to have a lot of cash to manage derivatives, but we have a lot of cash now because we don’t know where to invest our cash. So we use this cash to manage derivatives.

Jepsen: Should we hedge? Should we be a contrarian investor? I think you have to balance these issues, at least when you provide guarantees. I think it’s our members’ right to know whether we are on track to provide those guarantees in a timely fashion. You can discuss whether you should use volatility or another measure for that, however imperfect that may be, but you need something to make sure and to demonstrate that you will be able to honor your future obligations.

In Denmark the regulators for 15 years have been very strict in enforcing this kind of thinking. I think it’s down to you to set up your fund in a way that ensures solvency and thereby retains the ability to be a contrarian investor. That’s why we hedge our liabilities and apply insurance strategies to the really bad tails in our portfolio, because that gives us the ability to be very aggressive when everybody else is very fearful.

Eriksson: Go back to what your biggest risk is. The movement we had in the interest rate market the past month shows that there is no liquidity when you need it. Being a long-term investor, having the ability to buy equities when everybody else is selling, you have to finance that. And if you don’t have any liquidity in your bond portfolio, how does that help you? So we’ve taken that step since the beginning of the year, making sure that we have liquidity in our bond portfolio to enable us to step in if things go bad.

On Philippe’s point on volatility, it depends so much on what your objectives are. We’re a buffer fund. We have a 40-year time horizon. We’ve pushed very hard that we don’t want people within the fund to sit and manage their career risk. We have long-term issues when you manage your portfolio on a yearly basis because of your career. We’re very careful to not give away money to outside managers that are very much driven by volatility, by value-at-risk measures, that are forced to sell when we want to step in. You have to treat volatility differently as a measure of risk, depending on the time horizon of your investments.

Look at things like private equity. In ’08, ’09, some of these funds were forced to sell when we just wanted to pick up and buy. Is that the type of investment that we want to finance? Our answer is no, that’s too short-term for us. ?

Desfossés: We are pension funds, and the risk appears on the liability side. The world we used to live in where you could have a discount rate in the 3, 4, 7.5 range, like [the California Public Employees’ Retirement System], it’s over. Should we not have a zero discount rate in order to make totally conditional what you will distribute to your beneficiaries?

When I joined ERAFP, the discount rate, the minimum rate of return we should get, was 1.44 percent in real terms, management fees included. At that time, the French OAT [ten-year government bond] was paying around 4.5 percent. This year I managed to convince my fund that we should lower that discount rate from 1.44 to 0.9 percent in real terms. But the French OAT at the minimum in nominal terms was paying 50 basis points. So every euro invested in the French OAT was destroying wealth and reducing the coverage ratio.

Leegwater: In the Netherlands they just change the rules and increase the discount rate again, and then you don’t have any problems.

What have you been doing to either drive down costs or reduce allocations?

Leegwater: As asset owners we should probably be much tougher on the ones who are investing for us. We’re still paying far too much for the mandates that we provide to them. I don’t have the illusion that we can immediately lower the salaries there, but that’s part of the problem. Why are they paid so much? I don’t see a reason.

Desfossés: Personally, I would not pay. We don’t pay 2-plus-20. We think this is totally silly, especially for bigger funds. The 20 percent, they don’t need it. If 2 percent is levied on funds that are managing billions of dollars, they can be a happy camper with 2 percent.

Leegwater: I don’t think hedge funds is a category.

Jepsen: It’s a way of organizing the business. We don’t have a hedge fund strategy as such.

Manola-Bonthond: We have a very significant allocation to hedge funds — beyond 15 percent — that we are looking to reduce because the returns were disappointing. It was returning 6, 7 percent, a bit better than our real estate portfolio. We compare the fees that we are paying and the risk, not necessarily the volatility. When you compare the fees, especially 2-and-20, and you take the return of 5, 6, 7 percent, then the significance of the fees compared with the return is enormous. If you have a return above 10 percent, then this ratio improves. It’s very simple mathematics. We are going to try to reduce the allocation to 10 percent and seek higher returns and see how that goes. You cannot go from one day to another from above 15 percent to zero. We will gradually reduce, change the objective and see what happens.

Jensen: While hedge funds have come in for the most visible opprobrium around the fee structures, personally I think private equity is the most pernicious model that we deal with. Not just on the fee structures, which are egregious, but the costs, the management fees, all those other hidden-agenda items that no matter how much we ask and how much we dig, it’s almost impossible to get any real understanding of what is happening. The only time we come across any understanding of how this works is if the fund closes early. Is anybody surprised that regulators don’t take a much harder look at these guys? If I was at [the U.K.’s Financial Conduct Authority], that would be my first port of call.

Granata: It was the hardest environment for hedge funds in the past five years because all the traditional assets performed so well. I am really interested in the next five years how the hedge funds will return, because in my opinion, from now on that is one of the few ways to get positive returns in declining markets. •