Elan and AIB put spotlight on pension fund weightings

Recent woes have focused attention once again on the high exposure to Irish equities of domestic pension funds.

Revelations concerning dubious accounting practices continue to negatively affect share prices around the world. Various regulatory bodies and special investigations are set to ensure that the spotlight will remain on this issue for some considerable time.

In the market environment post-Enron internationally, and post-Elan domestically, investors will be quick to punish companies that are found wanting in terms of the robustness and transparency of their respective accounting practices.

The collapse in the Elan share price has hit Irish investors hard and this is reflected in the year-to-date decline of 23.7 per cent in the ISEQ general index.

The damage to the ISEQ financial index subsequent to the AIB rogue trader bombshell has been far less severe. In fact, the ISEQ financial index is still providing a positive return of 3 per cent so far this year. Nevertheless, investor confidence in the Irish market has been severely dented by recent events.

A critical issue that has resurfaced is the high exposure to Irish equities of domestic pension funds in particular. Approximately 18 per cent of the portfolios managed by Irish fund managers are invested in the Irish market. This is well below the 35 per cent weighting that was common prior to the emergence of the euro.

By international standards this is not an unusually high exposure to what is the home market of Irish fund managers. For example, many UK pension fund managers would hold up to 50 per cent of their assets in the UK equity market. The problem for Irish managers arises due to the fact that the bulk of the ISEQ's market capitalisation is accounted for by a relatively small number of companies. At its peak price Elan accounted for 25 per cent of the overall market capitalisation of the ISEQ.

The upshot of this was that the average Irish pension fund would have had 4.5 per cent of its total assets invested in Elan if it maintained a portfolio weighting equivalent to Elan's weighting in the overall index. The majority of institutional fund managers would consider such a large investment in any one company as being far too risky.

Indeed it does seem that most Irish fund managers ensured that their investment in Elan was far less than 4.5 per cent of portfolio assets. Nevertheless, recent events have served to reopen the debate among pension consultants and investment advisers as to what is the appropriate amount of funds that Irish fund managers should invest in the Irish market on behalf of their clients.

The extreme view is that Irish fund managers should invest with reference to Ireland's weighting in the euro zone. This would imply that Irish fund managers should hold no more than 1 per cent of their assets in the Irish market given that the Irish market forms such a tiny proportion of total European equity market capitalisation.

Although such an extreme shift in portfolio weightings is unlikely, it seems a foregone conclusion that Irish fund managers will reduce further their exposure to the Irish equity market. This may cause some short-term share price weakness in Irish equities.

During 1999, when Irish institutions were actively reducing their Irish equity exposure, the Irish market did under-perform other European markets. However, in 2000 and again in 2001 Irish equities outperformed and over the three-year period to 2001 the Irish market has fared much better than equity markets in the UK, Europe and US.

Over this three-year period Irish companies in general produced above average growth in profits, so that buyers emerged for Irish shares to take up the slack created by selling from Irish institutions. The overall strength in the Irish economy over this period was clearly a factor in bolstering the case for investing in the Irish equity market.

The recent slowdown in the Celtic Tiger may lower the profile of the Irish economy among international investors somewhat.

However, the medium-term prospects for the economy remain healthy and therefore corporate profits generated by Irish business should maintain above-average growth.

Despite international diversification by Irish quoted companies, the Irish operations of Irish-quoted companies remain important. For the overall market approximately 35 per cent of profits are generated in Ireland, whilst for financial companies the equivalent figure jumps to just under 55 per cent.

Therefore, as long as Irish companies can continue to grow their profits, any share price weakness caused by Irish institutions reducing their Irish equity exposure should prove to be short-lived.