Cash to funds shift looms
It might have been a grim year for investors overall, but as Sector Analysis research shows, the European funds industry is alive and kicking, especially in the UK, Spain and Italy.
The brutal fall in share prices around the world during the 12 months to March 2003 hurt the European funds industry in three ways.
Most obviously, it caused the value of aggregate fund assets to fall. Secondly, distributors moved away from open architecture – the promotion of other suppliers’ funds – in part because they saw a financial advantage in selling their own products. Thirdly, investors moved towards cash and other low-risk assets usually held outside funds.
Nevertheless, a key message from the grim 2002–3 year was that funds are here to stay. In early 2003, Sector Analysis estimated the total investment assets of universal banks, insurance companies and pension plans we interviewed amounted to US$18,756bn (E16.3bn). Of this, US$8177bn was invested in funds, while US$10,579bn was invested directly or through segregated mandates.
In other words, funds still represented 42 per cent of investment assets. There was a time when the European funds industry was so underdeveloped that swings in global financial markets had little impact. This is no longer the case.
Funds are markedly more important in some countries than others. Chart 1 shows funds account for a clear majority of overall investment assets in the UK, where the asset management industry is most developed, and in markets such as Spain and Italy, where growth in demand has been recent and rapid.
Low interest rates
By contrast, funds account for rather less than half of all investment assets in the Netherlands. They are even less important in Germany, Switzerland and France. These are the countries where there are the largest absolute amounts of cash that could, potentially, move into funds. If interest rates in continental Europe remain at very low levels over the next six months, such a shift could easily happen.
The message from Chart 2 is that low interest rates could also cause large shifts within, and not just into fund assets. The chart looks at allocation of third party fund assets to cash/money market instruments and hedge funds. These are “absolute return” asset classes that are fairly immune to movements in global markets. We were not able to quantify the size of fund suppliers’ own money markets funds, but believe they would have been substantial.
Across Europe, cash/money market funds amount to 17 per cent of all third party funds. They account for less than 5 per cent of third party funds in Belgium, the UK, Switzerland, Sweden and the Netherlands, but over 20 per cent in Spain and France, and 42 per cent in Italy. It is these last three countries which have greatest potential for a shift out of third party money market funds if interest rates remain low. In France and Spain, it may be that investors move into hedge funds, which are already well established. In Italy – with little acceptance of hedge funds to date – investors are more likely to move into traditional “long-only” products.
Weak dollar
As Chart 3 shows, we estimate 11 per cent of all third party fund assets were invested in US$ denominated stocks and bonds in early 2003. We do not know what was the percentage of suppliers’ own in-house funds invested in US$ assets, but can see no reason why it should have been dramatically higher.
Dollar weakness relative to all European currencies (plus yen) has been a key feature this year. Most commentators expect the US dollar to remain soft, given the imbalances of the US economy and aggressive policies to sustain economic growth.
The chart suggests a continued US dollar slide is unlikely to have much direct impact on the European funds industry. In Germany and Italy, less than 5 per cent of third party fund assets were exposed to the US dollar. Of the larger markets, Switzerland and the UK are the two countries where a US dollar fall would have the greatest impact. Even there, only 20 per cent – or less – of third party fund assets were exposed to that currency.
What if bond prices fall?
A meaningful fall in bond prices would be more serious. Chart 4 shows 19 per cent of all third party funds were invested in bonds in early 2003. Given that many of Europe’s largest distributors are universal banks and portfolio managers with strong fixed income capabilities, it is a reasonable bet that the number would have been even higher if we had looked at distributors’ own in-house funds.
Except in Germany, a further fall in the price of government and high quality bonds would have a meaningful impact on the European funds industry. The effect would be greatest in Belgium, Luxembourg and Switzerland, three countries where clients of private banks have traditionally been attracted to bonds because of their low volatility.
If investors redeemed their holdings of bond funds in a big way, what would they do with the proceeds? Risk-averse investors might move into hedge funds. More aggressive investors might move into equity funds: this would be a likely outcome if rapid expansion of the global economy was seen to be the main reason why bond prices had fallen.
Technology revival
What happens if Japan and technology stocks enjoy a bull market next year?
A number of portfolio managers and commentators suggest Japan could, at last, be emerging from one of the greatest and longest bear markets of all time. Investors with good memories will recall Japan accounted for half of the world’s stock market capitalisation at the very top of the equity and real estate bubble in 1989.
From the point of view of distributors and users of third party funds, Japan is now an exotic asset class. We presume the same is true of organisations that distribute their own in-house funds.
As Chart 5 shows, Japanese equities accounted for 2 per cent of all third party fund assets in Europe in early 2003. The corresponding figures were consistently low in most of the countries surveyed. The main exception was the Netherlands, where insurance companies are relatively more important as third party fund investors than they are elsewhere. And in the small Belgian market, about 8 per cent of third party fund assets were invested in Japanese equities.
The bottom line from all this is that a new bull market in Japan would be unlikely to have much of an impact on the European funds industry. A renewed boom in technology and telecommunications stocks, though, would be another story.
We asked the organisations we interviewed to identify the percentage of assets of third party funds they distribute which were invested in global equity mandates or sector funds. Technology funds were not nearly as important as they had been in early 2000, but they still accounted for a significant portion of sector funds.
Chart 6 shows that, if investors forget the harsher lessons from the bursting of the technology/telecommunications bubble, the greatest impact could be on the funds markets of Germany and Luxembourg. Even though technology and telecommunications companies still account for one-fifth of global stock market capitalisation, the effect elsewhere should be fairly minor.
Andrew Hutchings, research editor, Sector Analysis
