Every two months or so, Chile’s pension funds brace themselves for an alert that could throw off their investment plans.
The notice doesn't come from a government regulator or an asset manager. It comes from a local startup.
Web-based app Felices y Forrados issues alerts every other month to its 65,000 users recommending the best investment portfolio they should have their money in given expected market risks. The result is that over $3 billion can be reallocated in one short swipe among the five different portfolios each AFP offers its clients, causing their investment teams real short-term asset allocation headaches.
Self-professed long-term investors, these sudden portfolio shifts force the AFPs, which collectively manage $186 billion, to make trades over a matter of days based on client demands rather than their asset allocation outlook.
Two AFP investment managers, who spoke to Citywire Americas on condition of anonymity, confirmed they had witnessed first-hand the effects of the app on their asset allocation and seen significant amounts of money move in response to its recommendation.
Their view is backed up by data from Chilean research firm CIEDESS which found that, since the app launched in 2011, transfers among the five portfolios have tripled, going from 47,264 changes a month in 2011 to 140,804 in 2016.
The very nature of the five portfolios the AFPs offer means that the trades they need to carry out run the full gamut of their investments, from international equity ETFs to local bonds.
Every AFP has five portfolios that feature increasing levels of risk, from very aggressive to very conservative. Labeled alphabetically they start with the most aggressive ‘A’ portfolio, which by law can invest up to 80% of its assets in equities, to the most conservative ‘E’ portfolio, which is limited to a maximum of 5% in equities with the remainder in fixed income.
Santiago Arias, head of institutional sales at Chilean distribution firm HMC Capital which issues monthly reports on the investment flows within the AFP pension industry, said these changes are ‘very difficult to handle and have a negative impact on decision-making.
'The AFPs have to devote more resources on trading and changing accounts at a time when the market demands higher returns with lower fees. This situation is counterproductive,' added Arias, who previously worked as a portfolio manager.
Cramping their style
Gino Lorenzini, CEO of Felices y Forrados, which translates to 'happy and loaded’, founded the app in 2011 hoping to help his country's pension system avoid a loss like the one it recorded during the 2008 financial crisis.
He developed a model to spot events that could boost asset prices or send them spiraling down. Lorenzini said he aims to always avoid risk, a strategy that can at times lead him to compromise returns but also skirt losses.
‘Nobody knows when the crisis will come,’ Lorenzini said. ‘Today we see risk like a mountain full of snow. You know an avalanche will happen, but you don’t know what snowflake will trigger [it].’
Felices y Forrados claims that its strategy of backing the portfolio best suited for the current market environment has returned close to 57% since the app launched six years ago, beating the aggressive 'A' portfolio's performance of 52.15% over the same time period, according to the app's own calculations.
In 2013, a report by the Superintendencia de Pensiones, the Chilean AFP regulator, said that recommendations from non-regulated advisors such as Felices y Forrados ‘significantly explained' the increase in portfolio changes.
In total, Felices y Forrados has issued 37 recommendations, many of them encouraging pension contributors to switch from the riskier funds to the safer 'E' fund.
Last year, more than 533,036 accounts transferred $12.4 billion from the 'A' and 'B' funds toward the 'E,' which closed the year with $37.4 billion in assets. Only portfolio 'C,' the most moderate of all, registered a higher AUM with almost $61 billion.
By contrast, the 'A' fund saw close to $6 billion in outflows, ending the year with $21 billion.
AFPs don't have to enter or exit positions in full to complete the changes but handling an exodus from a portfolio poses challenges.
‘They have to do unnecessary trading. [They] have to buy and sell and that obviously generates transaction costs,’ said Arias.
The influx of capital into the 'E' portfolio last year led the AFPs to increase their exposure to Chilean bonds by $17 billion to $89 billion. Local bonds made up 51.4% of the total AFPs’ investment in 2016, an eight-year high.
Contributors also switch to safer portfolios on their own in response to sharp market drops, and to riskier setups when there's a potential for a short-term gain.
However, these changes are more spread out so the effect isn't as large, said an AFP investment manager.
‘There are people switching from A to E and the E to the A, so the movements compensate each other,’ he said.
Although a headache for AFPs, the portfolio shifts have created opportunities for other firms.
Seeing the trend toward the 'E' portfolio, the investment arm of Chilean bank Bice Inversiones created a Latin American bond fund to fulfill the demand for investment grade debt with compelling yields.
For the AFPs, January brought some breathing room as the portfolio shuffling of 2016 slowed down.
That month the number transfers from the three more conservative funds towards the 'A' and 'B' dropped by 38%, according to CIEDESS. Changes in the opposite direction dropped by 60% compared to December.
'Every time [the app is] having less impact,' Arias said. 'It's still important but every time it’s losing strength as their results have become more questioned by users.'
Plus, pension funds have learned to cope with the swings by boosting their liquidity through ETFs and money market trades.
‘The AFPs have been more careful with the impact that the entries and exits have on their active managers. This is better handled today than in the past,' Arias said.