EMU is likely to have the most drastic affect on the asset allocation of pensions funds since the abolition of exchange controls in 1989. The consensus among Irish managers is that once the definition of "domestoc assets" changes (and currency risk among EMU members disappears), the level of Irish equity investment in a typical Irish pension fund will fall from a current level of about 30 per cent to somewhere between 15 and 20 per cent by D-day. Ultimately, some feel that the level of Irish equities may fall to the market cap weighting of a euro index which would be 1-2 per cent of the euro group, or less than 1 per cent of the total fund Any manager who is evaluated against a euro index and who continues to hold any more than 1-2 per cent of domestic assets in Irish equities will effectively be taking potentially huge "bets" against the index. This is something that many Irish managers have been slow to do in the past.
Will this "sell-off" of Irish Equities be sharp or gradual? Could, at least, some of the reduction be handled by diverting on-going cash flow into Europe (ex Ireland) exclusively - to gradually shift relative weightings? These are questions investment mangers must be prepared to consider.
In the past, Irish "peer group" comparisons (ie CPMS or the Pooled Fund Average) have been the traditional method of manager evaluation. This has worked well because Irish Pension Fund Trustees and Consultants have tended to view a small, finite group of managers as the pool of potential providers of investment services.
In addition, the vast majority of funds in Ireland are managed to a balanced, fully discretionary mandate. However, post EMU the pool of investment managers capable of managing `domestic (EMU) equities" will expand geometrically overnight. In this new environment, how will we compare the performance of an Irish manager to that of, say, a German manager?
When Irish managers have completed the re-structuring of their domestic holdings, the resulting portfolios will look very different from the domestic portfolios of today. For example, banks make up a huge percentage of the existing Irish index, while in the new euro indices, banks account for only 15 per cent. Construction and forestry are also extremely overweight in the Irish indices relative to the new euro indices. Similarly, exposure to sectors Ireland does not currently have, like oil, utilities, and autos, will allow greater diversification within the domestic equity sector.
Any sell-off of Irish equities relating to the asset allocation shift mentioned should be somewhat offset as managers from other EMU countries look to broaden their "domestic" portfolios. This may not happen perfectly "in sync" and may cause short-term volatility in the share prices of many Irish equities.
As a result of the anticipated convergence of total equity/bond weightings across Europe, an expected £200 billion should be injected into Euroland equities, with Ireland's share estimated at close to £6 billion. Managers from other EMU countries will begin to market themselves as domestic managers in Ireland, while Irish managers will begin to market themselves in other EMU countries. In the scramble to claim expertise and business, there is huge potential for mergers and liaisons between complementary managers in order to cover the new domestic markets quickly. Investment managers are likely to change their decision making process (if they have not done so already) within Euroland from one that chooses countries first, and then stocks, to one that looks at all stocks (regardless of their country of domicile) according to industry classifications. This has implications for the way in which many investment management firms are organised.
Companies with several pension plans in different countries may begin to look at the feasibility of one domestic investment manager and one custodian, despite the continuation of several legal-entity pension plans. Plans could then leverage those close relationships with regard to fees.
Alternatively, the idea of a "Golden Circle" of providers has emerged. Under this scenario, a company or plan sponsor will approve a group of investment managers and custodians from which regional decision-makers can choose. In addition, despite existing tax and legislative obstacles, the idea of a true pan-European pension plan is being researched by several large multinationals.
The new euro environment may set in motion another more "evolutionary" change in the way pension funds are managed in Europe. Currently, pension funds are most often managed by one manager who handles all asset classes, with each region showing a bias toward the "national" asset class. With the advent of the euro, member country pension funds will move toward having a bias toward the euro asset class. Therefore, it is possible that funds will shift the focus of the management of their funds from a single manager/balanced mandate to a combination of specialist mandates.
Under this scenario, funds will hire a domestic (EMU) equity manager, a global ex-euro manager, a bond manager, etc.. This new environment will make the need for performance standards even more critical. Previously unknown managers will be arriving in many countries, highlighting the need for standards.
In addition, accounting and performance practices can differ from country to country. In this expanded market, standards like the AIMR Performance Presentation Standards or the Global Investment Performaqnce Standards (GIPS) will become a necessity.
Overall, the effects of EMU on asset allocation are imminent, and will ultimately be dramatic, for member countries. There are implications for the viability of national performance surveys. Indices will change. Comparing investment managers across borders will be challenging, requiring separate comparisons against local and European managers for some time.
Ms Deborah Reidy is an investment manager at CPMS. The above article is an extract from Ms Reidy's presentation to the recent Montgomery Oppenheim Investment Managers' Annual Conference on the theme "Euro Capital Markets - Considerations for Irish Investors".)
