COMMENT: Irish equities may be a better match for Irish pension fund liabilities than European stocks despite the arrival of the single currency, writes Tom Healy

For the last number of years Irish pension fund managers have moved to reduce significantly their exposure to Irish equities while at the same time increasing their holdings of equities in companies listed elsewhere in the euro zone.

Between the end of 1998 and the end of 2002, exposure to Irish equities as a percentage of pension fund portfolios declined steeply to about 16 per cent from about 32 per cent.

Of course this was offset by foreign pension funds and other institutions buying into Irish equities, the main reason for the 35 per cent increase in turnover in the Irish market last year.

There is some evidence to suggest, however, that this flight from Irish shares by Irish pension funds may now be coming to an end.

Some experts are beginning to suggest that those same funds may once again become purchasers of Irish equities as the experience of life in the euro zone becomes more significant than the theory.

To understand why this change of heart might be occurring, we must look at how the introduction of the euro changed the outlook of Irish investment managers.

The creation of the currency (January 1999) immediately widened the universe of currency-risk-free stocks available to Irish investors. It also encouraged people to believe that over the medium to long term the euro would accelerate economic convergence between Ireland and the other participating countries.

The managers of Irish pension funds eagerly grasped the opportunity to broaden the geographical diversification of their equity portfolios. Since December 31st, 1998 they have progressively reduced their exposure to Irish equities while increasing exposure to those in Europe.

The attraction was a significant reduction in "stock specific risk" which had previously resulted from their necessarily high exposure to the largest Irish companies.

We have already seen how the exposure to Irish equities, which had accounted for an estimated 32 per cent of pension fund portfolios at end 1998 had fallen to about 16 per cent by the end of last year. Over the same period, exposure to European equities rose from 13 per cent to an estimated 19 per cent of total funds.

Total assets of Irish pension funds at end 1998 are estimated at some €40 billion.

The disposals of Irish equities by Irish pension funds in the period amounted to some €6.4 billion at end 1998 prices. But economic convergence within Europe has been slower to develop than had been originally anticipated. Indeed, in two key areas for pension funds the Irish and European experiences have been very different.

Irish inflation has accelerated in response to strong economic growth and low unemployment. European inflation, in sharp contrast, has remained low as the major Continental economies stalled.

Meanwhile, the Irish equity market has significantly outperformed its European peer group, and this despite the persistent pension selling discussed above.

Both these influences have operated to the disadvantage of Irish pension funds. High Irish inflation has boosted their liabilities, while money diverted away from Irish equities has performed significantly more poorly than if it had been left where it was.

For some time this reduction in Irish equity exposure has been viewed as a continuing process with some advisers suggesting that the appropriate weighting for Irish equities is perhaps at 10 per cent of total assets.

Others have suggested an even more dramatic reduction, arguing that Irish equity exposure should equate to Ireland's weight in a pan-European index, currently around 2 per cent.

But real life experience has a habit of upsetting academic theories. The evidence of the past four years points to a need to revisit this strategy and to reconsider the role of Irish equities within portfolios.

Irish equities may not be a perfect match for Irish pension fund liabilities but, in a Europe of only slowly converging economies, they may be a better match than European equities.

They certainly would have been over the last number of years. The absence of currency risk, of itself does not mean that Irish and European equities are interchangeable.

This is not to argue for a return to the end 1998 position. A reduction in Irish equity exposure was understandable on spread of risk grounds.

But in the light of experience to date some experts suggest that a balance between an appropriate matching with liabilities and stock specific risk might be prudentially struck at nearer 15-20 per cent of funds than at the much lower levels previously envisaged.

Tom Healy is chief executive of the Irish Stock Exchange.