Swiss fund CIO acting to thwart volatility and hold tight in downturn

After securing a recapitalization plan, the Caisse de Prevoyance de l'Etat de Geneve is turning its focus to hedging market volatility risk and protecting the 14 billion Swiss francs ($16 billion) pension fund's rate of return, its CIO says.

A fiscal package that voters approved on May 19 will raise CPEG's funding ratio to 75%, from 60%, allowing CIO Gregoire Haenni to turn his focus to modifying the fund's fixed-income portfolio to better manage the impact of growing bond market volatility.

Current economic conditions could result in "the first time that we could have negative yields in the U.S.," Mr. Haenni said. "The U.S. yields contracted so much that if we see more easing (from central banks), we will see negative yields," he said.

Mr. Haenni is also closely watching global equity markets, which he expects could see more volatility later this year amid an ongoing trade war between China and the U.S.

"The volatility (resulting from trade wars) will not be resolved soon, Mr. Haenni said.

As long as growth and company earnings offset risks such as Brexit or Italian populism, investors' portfolios are well-balanced, he said. But it could get rapidly worse, he noted.

The Geneva canton fund, which was created in 2012, strategically invested 23.1% of its assets in international bonds and 4.5% in domestic bonds as of June 30, 2019. And like many European pension funds, CPEG is faced with the dilemma whether or not to pay to hold bonds in its 4 billion Swiss franc fixed-income portfolio. It's not an easy task with 10-year Swiss government bond yields trading lower in August at negative 1%.

Mr. Haenni was able to shield the fund's overall portfolio from a slump in equity markets in late 2018 because he had rebuilt its fixed-income exposure. He started with adding more U.S. Treasuries to reach 8% exposure, from 7.4%, in the second half of 2018. The fund bought 10-year U.S. Treasuries at a 3.1% yield. CPEG's overall portfolio in 2018 fell only 2.6% as a result, compared to negative 3.2% recorded by Credit Suisse Pension Fund index, which tracks the performance of all Swiss pension funds.

CPEG's analysis of different portfolio hedging techniques showed that government bonds, in general, are still the cheapest and still the most effective way to hedge a portfolio, he said.

CPEG's models, drawn up in June 2017 as part of the recapitalization decision process, showed risks associated with investing in fixed income were higher than risks with equity strategies. "The models proved to be right, when the Federal Reserve started to raise rates," he said.

Due to falling yields, Mr. Haenni said the fund is not a buyer currently. But the fund still targets a 11% allocation to non-Swiss government bonds.

However, he added: "If the government bond market corrects, we will be buyers (again)."

Mr. Haenni thinks government bonds also can offer protection in case of a pullback of equity markets. Otherwise, equities are the most obvious way to get compensated for risk, he said.

"At some point we will buy more equity to deliver the expected return. We think the outlook is still positive based on resilient economic expansion, modestly rising corporate profits, and still-low interest rates," Mr. Haenni said. CPEG's strategic equity exposure was 31%. The rest of CPEG's assets are invested in real estate (30.4%), private equity (4.3%), cash (3.2%), inflation-linked securities (2.8%), and mortgages (1%), as of June 30.

As recently as March 2019, CPEG's funding ratio stood at 60%, exacerbated by unfunded legacy benefits of the two public funds that predated it. Those funds were merged, with the CPEG becoming operational in 2014.

In the May 19 referendum, voters approved a recapitalization plan that will have the Geneva cantonal government contribute between 4 billion to 5 billion Swiss francs to the fund through a combination of cash and real estate. Also in that referendum, the citizens voted to keep the fund in a DB arrangement vs. converting to a defined contribution arrangement, with a higher employee contribution rate.

The canton's contribution will boost the fund's funding ratio to 75% starting in 2020. Plan participants' benefits will not be altered after the fiscal package is applied.

The changes come during a period of depressed yields, making it harder to chart a course forward. While Mr. Haenni said equity market volatility could augur a need for bond portfolios, other sources said investors should be concerned as some 20% of the global bond market now trades at negative yields.

"Over July, nominal yields in particular fell by between 10 and 20 basis points across the curve, led by a deteriorating global outlook and increasing prospects of monetary easing," notes Niren Patel, investment strategist at Aviva Investors in London. Mr. Patel said: "Pension funds are having to work harder to generate the returns they need to meet their obligations. (For example, as) the entire bund curve is negative, investors are paying to lend to the German government for 30 years."

Still, with yields lower and few signs that the inflation is picking up, Mr. Haenni said that in these circumstances European central banks could end up purchasing equity, similar to the actions taken by the Bank of Japan. "It is an inevitability," he said. "We are moving into a notion of fundamental performance," he said, adding that over time a collection of asset classes' yields are the biggest drivers of the portfolio's performance, rather than the appreciation of financial markets.

No matter if central banks buy equities, he said, asset owners should be exposed to the asset class.

"Assets are richly priced but it is different than in 2000," he said, noting: "We don't see any bubbles yet."

Having resolved how to patch the deficit, CPEG is considering adding a green bonds allocation of 2% to its portfolio for the first time.

For the new green bond portfolio, CPEG will search for external managers, which he said will have more flexibility than the fund itself to source green bonds.

The fund executive is also planning to end the 50 million Swiss francs senior loans allocation due to concerns over weak loan covenants.

"You'll see more of the (senior loan) funds struggling," Mr. Haenni warned, adding there were fewer higher-yielding options at investors' disposal.