Adoption of the euro might lead European pension funds to a fundamental reassessment of their asset allocation practices and to radical changes in their investment management strategies.
In the process, European pension funds would have to reallocate billions of dollars of securities to meet new benchmarks spurred by the adoption of a single European currency Jan. 1, 1999.
Under one scenario, Dutch pension funds would have to sell off some $27 billion in domestic stocks -- 6.6% of the value of the Amsterdam Stock Exchange as of Jan. 31 -- buying stocks from Germany, France, Belgium and elsewhere, according to a study by Merrill Lynch, Pierce, Fenner & Smith Ltd., London.
And if the United Kingdom were to participate in the first round -- although government officials have rejected this option -- some $248 billion in U.K. stocks would be sold as British pension funds rebalance their portfolios, the Merrill study said.
Adoption of the euro obviously will have the biggest effect on pension funds in countries that participate in the new single currency.
But European economic and monetary union also will have dramatic implications for correlations between stocks in different countries and investments in all European stocks, thus affecting global investors from the United States to Japan.
Asset/liability models hit
This change will have dramatic implications for asset/liability modeling, which is based in part on historic performance.
"It's going to be tough to do any ALM work in the next two or so years because you will have to use certain assumptions," said Johan Cras, director with Frank Russell Co., Utrecht, The Netherlands.
The effect on U.K. pension funds, however, will be small until Britain decides to join EMU, said Andrew Dyson, head of U.K. pension funds at William M. Mercer Investment Consulting, London.
The impact will be felt both in terms of how assets are allocated by country or region, and by industry sector.
For example, a Dutch pension fund might have 35% of domestic equities in oil stocks, mainly Royal Dutch Petroleum, reflecting the energy sector's weighting in domestic indexes.
But a pan-European benchmark (including Great Britain and Switzerland), would lead Dutch funds to reduce integrated oil companies' weighting to 9%, while boosting pharmaceuticals to 11% from zero, according to the Merrill Lynch study.
It is unlikely, however, that changes will be made overnight. Rather, many pension funds, particularly younger ones in continental Europe, are expected to divert new cash flow into desired areas, effectively reducing allocations elsewhere. It might take more mature funds considerably longer, unless they use derivatives to shift their effective exposures.
In addition, continental European portfolio managers, who traditionally are focused solely on their domestic markets, will take time to pick up pan-European expertise.
Most European pension funds are not prepared for the change.
"My impression," said Koen de Ryck, managing director of Pragma Consulting NV, Brussels, "is this whole subject is only beginning to develop."
Winners and losers
However long it takes, that massive reallocation of assets appears likely. What's more, it will create winners and losers, as pension funds and money managers rebalance their portfolios.
For example, switching to an EMU index of nine countries from a pan-European equity index would cause a massive overweighting in consumer stocks -- at 22.7% in the EMU index vs. 31.7% in the European index, according to a study by NatWest Markets, London. Conversely, there would be an underweighting in energy, finance and utilities stocks, the study said.
At this stage, it appears that 11 of the European Union's 15 countries will participate, the exceptions being the United Kingdom, Sweden, Denmark and Greece. Switzerland remains outside the EU altogether.
The impact might be greater for continental European pension funds than for U.K. funds. "In Europe, the next few years will be characterized by switches away from existing benchmarks toward EMU benchmarks, primarily in EMU participant countries," a NatWest paper said.
Also, European pension funds might move out of non-EMU European countries -- notably, Great Britain -- and back into EMU markets. And European funds might continue shifting more money into equities, fueling domestic equity markets. "A switch of a mere 10% of the domestic bond holding of European pension funds into equities would result in a flow equivalent to $100 billion," the NatWest paper said.
However, some observers suggest European pension funds might increase their non-European allocations to obtain greater diversification benefits.
David Puddle, senior vice president, Putnam Europe Ltd., London, said European funds with high levels of European stock holdings might shift some of those assets to U.S., Far East and emerging-market equities.
Asset allocation implications
To date, there is a general consensus on some broad investment issues, including: a sectoral approach will become predominant; currency-matching requirements will be loosened as the domestic market is redefined in terms of EMU countries; elimination of currency risk will broaden bond investments; and credit risk will become more important in evaluating debt.
But many important investment issues still are unresolved.
Marinus Keijzer, chief economist for Pensioenfonds PGGM, Zeist, who has been at the forefront of euro preparations in Holland, said there are two schools of thought on the euro's implications for asset allocation.
One theory, he said, would have funds rapidly adopt a sectoral approach, abandoning traditional top-down country allocation methods in Europe. But the second theory says that, in the early years of the euro, country allocation will be a determining factor.
PGGM officials, in the midst of developing a five-year investment plan, haven't yet determined how the euro will change their own asset allocation strategy, he said.
Adoption of broader domestic-equity indexes also might lead to an increase of style-based investing, said Roger Yates, global chief investment officer for LGT Asset Management, London.
At the moment, style and sector correlations across Europe "seem to be pulling together," said Robert Schwob, chief executive of consultant Style Investment Research Associates Ltd., London.
In addition, the ways in which investors value European stocks, which now vary across the Continent, are likely to continue converging, ultimately affecting pricing for all investors.
For example, price/book value prevails in Italy, while price/earnings plus six months trailing performance is used for U.K. stocks, according to an analysis by Morgan Stanley & Co. International Ltd., London.
"All of a sudden, the signposts have no writing on them," Mr. Yates said.