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Alternatives anxiety: the Chilean AFPs' reform dilemma

Alternatives anxiety: the Chilean AFPs' reform dilemma

In its June issue, Citywire Americas explored how uncertainty surrounding a measure to expand the ability of Chilean pension funds to invest in alternatives prompted them to freeze their investments in that asset class.  

Last week, the Superintendencia de Pensiones, Chile’s pension regulator, issued a draft framework of the measure. Among other points, it outlined the six sub-asset classes the AFPs would be able to invest in.

The draft measure also revealed that as of April 2017, investments in alternatives were $4.7 billion, versus $3.3 billion roughly a year ago. Chile’s pension regulator confirmed to Citywire Americas that the increase was due chiefly to market appreciation and not to new investments in the asset class.

Read below to learn more about why uncertainty breeds caution among the AFPs.

The majority of Chile’s pension funds have frozen investments in alternatives due to uncertainty around incoming financial reforms, at a time when clients are pressing for higher returns.

As of March 2016, investments in alternative assets accounted for $3.3 billion, a paltry 2% of the AFP’s total assets under management, according to the Superintendencia de Pensiones, Chile’s pension regulator.

A year on and that figure has barely shifted, according to the regulator.

Between October last year and January, the AFPs did not invest in any new private equity strategies, says Chilean distributor and asset manager HMC Capital.

Meanwhile, in August last year, Chilean president Michelle Bachelet said her government would seek to modify ‘hidden commissions,’ a term for the fees charged to savers’ accounts for the cost of investing in vehicles such as mutual funds.

A month later, the government issued a law to expand the AFPs’ ability to invest in alternatives by creating a separate category for those assets within their portfolios. The AFPs had been able to invest in alternatives already, but the allocation was restricted by the limits set for equities and bonds.

The new move is expected to come into effect in November, while the country’s central bank weighs up how much AFPs will be allowed to invest in alternatives. However, uncertainty over the final framework has stalled interest in alternatives, as has the fact that the law doesn’t address Bachelet’s proposal surrounding fees.

‘Why buy an illiquid asset with a relatively high fee, from the private equity sector for example, when you have that sort of uncertainty?’ says Fernando Larraín, CEO of the Asociación de AFP, the Chilean pension fund association.

A senior AFP investment manager, who wishes to remain anonymous, says his pension fund doesn’t invest in alternatives but he’s seen the industry’s enthusiasm for those assets wane.

‘In general, alternative managers charge higher fees and because they’re illiquid assets it’s difficult to exit,’ he says. ‘With mutual funds and ETFs, if that were to happen, you can sell and buy the underlying asset.’

Potential impact of reforming fee system

Under the current scheme, the management, custody, trading and legal costs levied by the asset managers pension funds invest in are charged to the gross returns of each savers’ account.

This approach aligns the AFPs’ interests with those of its savers, as it encourages pension funds to invest in assets that charge bigger fees with the prospect of higher returns, says a veteran AFP asset allocator, who also wishes to remain anonymous.

In 2016, these fees were equivalent to 77% of the six AFPs’ annual earnings, according to data from the Chilean pension regulator. Billing these costs to the AFPs would force them to invest in cheaper assets, such as ETFs, that generate less alpha, the allocator says.

The reform on fees could lead to a change in geographic allocation, the allocator says, as it tends to be more expensive to buy emerging market ETFs, which the pension funds have favored in recent months, than US vehicles, where they’ve been pulling money from.

‘That’s the problem with this regulation,’ says the senior investment manager. ‘There’s a trade-off between the interest of the administrator and the interest of the funds.’

Separately, the AFPs charge a monthly fee on savers’ salaries for managing assets. However, Bachelet also proposed last year that pension funds should return fees charged during periods with negative returns.

‘In general, private equity investment has stopped since August due to the intention of the reform,’ says Santiago Arias, head of institutional distribution at HMC.

‘In part it was down to the lack of clarity in terms of fees, but also because of the J curve, as the reform talked about penalizing negative returns. This makes it impossible to invest in assets with a J curve.’

The ‘J curve’ refers to assets that initially yield negative returns before recovering, which tends to happen with private equity.

Bonanza for Bonds

In the past year, the AFPs have grappled with another situation that could complicate investments in alternatives.

The AFPs offer five portfolios with increasing levels of risk labeled alphabetically from ‘A’ through ‘E.’ An app called Felices y Forrados, ‘Happy and Loaded’ in English, prompts its 65,000 users to switch funds to avoid risk, moving up to $3 billion in a short time.

This forces the AFPs to rework their asset allocation quickly and to keep a cushion of liquidity to facilitate the changes.

However, a requirement such as this doesn’t square with a shift towards alternative investments, Larraín says. ‘A change that allows larger investments in alternative assets, which are more illiquid, is unlikely to be taken up because of liquidity issues.’

Instead, the app has encouraged users to move toward the ‘E’ fund in order to avoid risk. Grassroots movement ‘No + AFP,’ which translates as ‘No More AFPs,’ has also persuaded savers to switch to the ‘E’ portfolio, arguing its more conservative stance is less prone to losses.

The ‘E’ fund can only invest in investment grade assets and its growth encouraged asset managers to register at least seven funds for the AFPs

to invest in between June last year and January, according to data from HMC.

‘Here in Chile, interest rates are relatively low, and there aren’t many alternatives in external markets with equivalent risk,’ says the senior investment manager.

‘It’s an asset class of reasonable size, larger than that of local corporate bonds,’ he says. ‘It makes sense because of that. There hasn’t been a lot of issuance in this country.’

While local asset managers might be focused on developing more Latin American funds, the AFPs are sitting tight while the reforms are finalized.

‘Nobody is doing anything at the moment because the reform is an unknown quantity,’ he adds.

This article was originally published in the April edition of Citywire Americas magazine. To sign up to receive our free magazine, follow this link.

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