Alpha searches vary on the two sides of the Atlantic

NEW YORK — U.S. and European pension funds are seeking alpha — but from different places.

A new report from JPMorgan Asset Management finds 76% of European pension executives are using or are considering using absolute-return strategies, compared with only 56% of their U.S. brethren.

Yet 52% of American pension funds are using or are considering portable alpha strategies vs. only 37% of their continental European counterparts.

Many of the differences are rooted in varying regulations, accounting rules and risk tolerances, Eve Guernsey, chief executive officer, JPMorgan Asset Management Americas, New York, said in an interview.

"Europe isn't the United States of Europe. Pension funds are still regulated and monitored within each country's borders. Regulations are different, and cultures are different in terms of their risk tolerance," Ms. Guernsey said.

For example, U.S. investors have a much higher average allocation to stocks than Europeans — 63% vs. 31%. The typical U.S. fund had 27% invested in fixed income and 10% spread across a variety of alternatives. European pension funds' asset allocation varied greatly by country, but overall, they had 50% in fixed income and 19% in alternatives.

Client demand for alpha sources is leading JPMorgan officials to test an array of new strategies. The manager may launch 25 to 27 vehicles representing 14 sources of alpha next year, Ms. Guernsey said. Under development are strategies involving long-short value equity, high-yield bonds, emerging-market debt and a global real estate investment trust, she said.

The JPMorgan report is based on separate surveys of U.S. and continental European pension executives. The U.S. survey is based on interviews last February with executives at 120 of the largest 350 U.S. pension funds with a combined $1.2 trillion in assets. Results of that survey were published in Pensions & Investments last spring (P&I, May 16). The European survey last May and June covered 193 institutions with a total of $1.3 trillion across Germany, the Nordic countries, the Netherlands, Switzerland, Italy and France.

Absolute-return strategies, which include market-neutral and many hedge fund strategies, are designed to produce a positive return in all market conditions and tend to have to low correlations to public securities.

"Most European clients haven't fully embraced benchmarks" for measuring performance, making them more comfortable with absolute-return strategies, Ms. Guernsey said.

While 99% of U.S. plans measure their performance against market indexes and 78% against peer groups, only 82% of European plans measure against market indexes and 37% against peer groups, the report said.

In a portable-alpha strategy, a plan invests in one strategy, such as a hedge fund of funds or small-cap equity portfolio, and shorts that strategy's market exposure, or beta. That leaves only the added value, or alpha. The fund or its manager then ports the alpha onto a different market exposure, often in an asset class that is viewed as very efficient, such as U.S. large-cap stocks or core fixed income.

The contrasting paths to alpha reflect different levels of sophistication and the availability of derivatives in various markets, JPMorgan officials said.

U.S. pension executives are more likely to use portable alpha because, for one thing, it's easy to transport alpha on to a Standard & Poor's 500 futures index. Such liquid derivatives contracts are not as available for European indexes, the report said.

For another, European investors tend to be less sophisticated, Ms. Guernsey said. One in three European investors were unfamiliar with the term "alpha transport," compared with only 6% of U.S. investors.

Also, many European pension executives are not as comfortable with derivatives, which are required to transport alpha, or don%A0;#x2019;t have systems in place to monitor them closely, Ms. Guernsey said.

European and U.S. pension executives also diverge in their willingness to make short-term strategic bets, the study found.

More than 75% of U.S. pension executives said they rely on passive rebalancing — primarily range-based triggers — to get their allocations back in line. In contrast, only 40% of European pension executives use a passive approach. What's more, 81% of European executives made active tactical bets to take advantage of mispricing among different asset classes, JP Morgan found.

Europeans' willingness to make short-term bets also is played out in their greater interest in tactical asset allocation strategies: 81% of Europeans said they'd consider using TAA to generate higher returns, compared with only 46% of U.S. pension executives. Europeans' interest in TAA also may reflect their greater focus on currency issues and more internally diversified portfolios, the report said.

Both U.S. and European pension executives expressed strong interest in other alpha-generating strategies, including emerging market equities, long-only absolute return, hedge funds, high-yield bonds, private equities and currency.

In most categories, interest by Europeans led, with the notable exception of private equities, where 75% of U.S. investors said they like the asset class, compared with 57% of Europeans. That reflects U.S. pension executives' greater experience with private equities.

The structure of U.S. and European pension funds' equity portfolios is likely to change. In equities, both Americans and Europeans use about 30% passive and 60% actively managed constrained portfolios, and 10% actively managed unconstrained portfolios. Constrained portfolios typically are tied to a benchmark, often measured in terms of tracking error, while unconstrained portfolios can take on much greater risk.

In the future, however, European investors said they expect to adopt a barbell-type structure: 18% said they plan to increase their passive investments while 13% plan to cut passive exposure; 21% expect to decrease constrained active mandates vs. 8% increasing; and 27% plan to increase unconstrained mandates while only 5% expect to reduce them.

In contrast, 25% of U.S. pension executives said they plan to cut passive investing while 7% plan to increase. In constrained active investments, 18% of the Americans said they plan to increase such strategies while 10% said they plan to reduce. Meanwhile, 13% plan to boost unconstrained active investments, while only 2% plan to trim these allocations, the study found.