Pensions hit by failure to diversify

The reluctance of some Irish fund managers to diversify away from Irish equities is now costing the average Irish pension fund holder, writes Fiona Reddan

AS IRISH-managed pension funds experienced another torrid month in October, should Irish pension fund managers be blamed for their reluctance to diversify away from Irish equities?

While markets have fallen significantly around the world, causing pension funds to fall everywhere over the past 12 months, the Iseq has been one of the worst performing markets - down more than 55 per cent in the year to October.

Having been advised to diversify away from Irish equities for some time, the stubbornness of fund managers is now costing the average Irish pension fund holder.

In October, Irish pension funds recorded a 9.2 per cent decline, on average, bringing losses over the past 12 months to about 33 per cent. This latest decrease has effectively wiped out the impact of the boom years, with funds returning just 1.9 per cent annually over the past 10 years. Over the same period, inflation has averaged 3.8 per cent per annum.

In comparison, while members of British pension funds have also suffered from market volatility, the average pooled pension fund there declined by just 15.6 per cent in the year to September.

Much of the disproportionate losses incurred by Irish pension funds can be explained by their overdependence on Irish equities.

Investment consultants argue that, as the Irish market represents only about 0.3 per cent of the global equity market, pension funds should allocate, at most, 1 per cent of their stock market funds to the constituents of the comparatively tiny Irish stock market. However, the average Irish-managed balanced fund remains overweight in Irish equities to the tune of about 9 per cent.

But what's so wrong about that?

Pension fund managers in other countries also show a preference for domestic equities on the grounds that they know these companies best.

However, Michael Curtin, a senior investment consultant with Mercer, says this home bias is more understandable in larger, deeper markets, unlike in Ireland where the market is highly concentrated. This concentration is two-fold. Firstly, the Irish market has traditionally been made up of just five stocks, which accounted for 50 per cent of the Irish market by value, while the top 10 stocks represented 80 per cent of the market.

For a pension fund with a 20 per cent allocation to Irish equities, this would have meant that it had a 10 per cent concentration in just five stocks - an unacceptable level of stock-specific risk by international standards.

Secondly, there is a marked concentration in the Irish market on just two sectors - financials and construction. Irish financial stocks typically represent about 40 per cent of the value of the index. If a fund allocates 20 per cent to Irish equities, then 8 per cent would have been in Irish financials.

In October alone, Irish financial stocks fell by almost 35 per cent, their worst ever monthly performance, and this decline came on the back of a 30.6 per cent decline in September. In the year to October, Irish financials fell by a staggering 75.3 per cent.

The Irish market is also heavily weighted towards construction stocks, and with the property market floundering, these stocks have dropped off, compounding consumers' exposure to Irish residential property.

So what has stopped pension fund managers from diversifying appropriately?

Curtin attributes part of the reluctance to slow decision-making by investment managers as well as the desire by managers to keep performance in line with their peer group. In addition, while the recent downturn has hit us harder relative to European peers, the Irish market was, for the three years before 2007, among the best performing worldwide - acting as a disincentive to diversification.

As pensions ombudsman Paul Kenny says, as long as Irish share prices were going up there was a tendency on the part of pension fund trustees to "leave well enough alone".

Another factor in the lack of diversification is down to legacy issues. Up until the early 1990s, exchange controls constrained investment in international equities, and although these were removed pension fund managers continued to favour Irish equities as it enabled them to match the currency of the assets in the fund with those of the liabilities.

For example, in 1998 Irish pension funds had a greater exposure to Irish equities than they did to international stocks, and AIB alone accounted for more than 5 per cent of a fund's exposure.

Although the advent of the euro zone did see fund managers actively moving to reduce their Irish holdings, concern about the impact on the Dublin market of a precipitous sell-off alongside the outperformance of the Irish exchange meant the dilution has been painfully slow.

Now, with the Irish market in freefall, it is too costly for pension fund managers to diversify.

However, the collapse of the Irish market this year, and in particular financial stocks, means that pension funds' exposure to Irish equities has been significantly reduced - with little effort from the fund managers.

In the year to September 2008, the average allocation to Irish equities dropped by 44 per cent, from 15.9 per cent of the total fund to 8.9 per cent, while individual funds also saw the proportion of their funds invested in Irish stocks decline dramatically.

Moreover, by the end of October, Irish financial stocks accounted for only 22 per cent of the Irish market - down from 40 per cent 12 months ago when the capitalisation was higher than the entire market is now.

Last September, 25.3 per cent of Davy's managed fund was invested in Irish companies, but within 12 months this had dropped to 7.1 per cent.

Similarly, Bank of Ireland's allocation to Irish equities in its balanced fund last autumn was about 19.5 per cent - which was actually greater than its investment in European equities. Since then this has dropped back to 8.3 per cent and now lags the fund's investment in European stocks.

Rather than managers actively selling out of Irish equities, however, Curtin estimates that about 70 per cent of this declining exposure is simply due to falling values on the Irish market.

But it isn't just Irish pension funds' allocation to domestic equities that should cause concern for pension fund holders. In a survey conducted by Mercer this year, Ireland was shown to have one of the greatest asset allocations in Europe to equities in general, at 67 per cent, ahead of the European average of 50 per cent, and more than 10 per cent greater than the average investment by British funds in equities.

Moreover, Ireland had one of the lowest exposures to bonds, at just 27 per cent, far below the European average of 43 per cent.

Curtin argues that, in continuing the move away from Irish equities, pension funds need to consider diversifying into other areas, such as commodities and infrastructure funds, and increasing their exposure to fixed income assets. And any such diversification needs to have a "meaningful" impact on the fund, he says.