The allocation conundrum facing Iceland’s investors

Iceland has definitely turned a financial corner as its ‘real’ economy improves. But policies put in place to solve its financial crisis are now hampering allocation to and within the country.

Fund and asset allocators working in ­Iceland face a set of challenges, ­particularly in the institutional investor and pension fund space.

On the one hand, the young demographic and recovery in the ‘real’ economy since the country’s financial system tipped into chaos in 2008 means that monthly inflows into both mandatory and voluntary savings schemes (pension funds) are actually relatively strong, while assets under management are growing.

In addition, the younger average age of those working means liabilities are much further into the future than in any of the struggling peripheral eurozone members, and the system is still accumulating rather than paying pension incomes.

But on the other hand, capital ­controls in the form of foreign exchange restrictions introduced in the wake of the country’s financial crisis mean that those charged with selecting buckets into which to put the accumulating cash are finding their choices restricted.

One asset manager working on behalf of one of the top five domestic pension funds says that the capital controls present by far the biggest challenge as it stops all additional allocation to foreign assets. Existing overseas assets can be ­re-allocated overseas. But if the money is repatriated, it cannot find a way out again.

Besides leading to difficult ­allocation questions, the build-up of cash within Iceland’s long-term ­savings market threatens to create a local asset price bubble because the accumulation is set to keep growing until 2020, when net inflow to the system is projected to ease.

In practical terms, what ­allocators can do is put the cash coming into the system into three main buckets, the manager says: government bonds, cash, and domestic listed and unlisted equities. A fourth bucket that has not been used in any significant way is municipal bonds.

Yielding problems

Changes in yields from the three main asset classes will determine which is preferred, but there is little else that can be done to boost returns. Activities such as currency hedging, overlays, swaps or other related ­activities are either not ­possible or made very difficult to execute due to the capital controls.

The benchmark real return that is required from the perspective of those allocating assets on behalf of pension savers is 3.5% per annum.

Sounds reasonable, but analysts fear there is simply too much money chasing the key available domestic asset – government bonds – which means real returns are being made much more difficult.

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