Investing in global equities

FOR MOST LONG-TERM INVESTORS, GLOBAL EQUITIES ARE STILL A POPULAR FILLING IN THE INVESTMENT SANDWICH, DESPITE THE ARRIVAL ON THE MENU OF ALTERNATIVE CHOICES

For most long-term investors, global equities are still a popular filling in the investment sandwich, despite the arrival on the menu of alternative choices. This is shown in the asset allocation of local authority pension funds. Like many pension funds in recent times, members of the Local Government Pension Scheme (LGPS) have reduced their overall equity allocation. According to data presented at the LAPF Strategic Investment Forum, held in London this March, the proportion of assets held in equities fell from 66% in 2000 to 54.8% in 2010. But at the same time, the proportion held in overseas equities rose from 16.4% of assets to 28.1%, showing the importance of this asset class to pension funds.

Equity investors have seen precipitous falls following the dotcom boom up to 2002 and following the global financial crisis in 2008, and this has shaken the faith of many in equities as the best source of long-term growth. However, there are still strong reasons why equities are still widely used. They are highly liquid and transparent, they provide wide coverage of the world by region and economic sector, investors can use a range of equity investment styles and they can give both income and capital growth. For long-term investors, the odd shock is often regarded as a necessary price for holding equities. And the alternatives can be problematic. Assets such as private equity, hedge funds and property certainly have a place in LGPS funds, but can be expensive, illiquid, and opaque and are arguably driven by the same underlying economic cycle that drives equity markets.

BNP Paribas Investment Partners, chief investment officer, equities, Michael Gordon said that in contrast to households and governments which are still indebted, many corporates have paid down debt and have healthy finances. “The safest place to invest is with corporates and the question is, do you lend to them via corporate debt or own corporate equities? Which part of the capital structure do you want?” Gordon said there have been huge inflows into corporate debt, creating the risk of a bubble. “There is no argument that corporates are where you want to buy and on a risk-adjusted basis, I would say that investors should favour equities over corporate bonds.”

Bedfordshire Pension Fund has a 29% allocation to global equities, which is in line with the average LGPS fund and Geoff Reader, head of pensions and treasury management, said this can vary. “The benchmark weight is 29% – although there is an approved range that the weighting might operate in depending on market conditions and expert advice.” In terms of the overall structure of the global equity allocation, Reader said the majority of the allocation is actively managed – with unconstrained mandates, while there is a passive allocation in specific regional funds. Adding that in the latter case, tactical asset allocation can be used to express tactical views with the passive holdings. “Global equities are a significant part of the funds’ strategy to regain a fully funded status,” he said.

Strathclyde Pension Fund head of pensions, Richard McIndoe, said the Strathclyde fund still has a large allocation to global equities, but in recent times has moved more to passive management. “Essentially, we still have faith in equities as the best source of returns, as 73% of the fund in invested there. But our faith in active management of equities has been shaken, reflected in the fact that 35% of the fund is in passive equities and that is increasing to 42%. That is more than I would have expected a decade ago.” McIndoe said one reason for passive management is that markets such as the US and the UK are seen as relatively efficient where active managers are unlikely to be able to add value.

As well as passively managed, developed market equities, Strathclyde has some unconstrained global equity managers and some specialist mandates. “We have about one-third of the fund spread over half a dozen global equity managers. Some are excluding the US, which is unusual for a UK fund, but the rationale is that we would be overweight in the US otherwise, given our passive US equity allocation. These managers are mostly unconstrained; we used to be indexdriven but are now much less so and we expect them to be active.” The third element of the global equity strategy is with specialist managers, who are mostly in private equity and property, but also include a global small-cap manager and a dedicated emerging market manager. McIndoe said the mandates for the latter two managers are being increased: “These specialist managers have been successful for us, more so than the unconstrained global equity managers.”

In terms of where to invest globally, a case can be made for most main regions; from the US, to Europe, Japan or the emerging markets. For instance, Fidelity European Fund portfolio manager, Sam Morse, described European equities as laggards since the financial crisis with investors, concerned about the Eurozone’s problems, avoiding European equities. But Morse said 2012 has seen better conditions, with the European Central Bank’s liquidity operations boosting equity performance. Morse said that the risk of a disorderly disintegration of the Eurozone has not completely gone away, but qualified this by saying: “I continue to believe, however, that the Eurozone will stay together, as the cost of exit would be too great both for those who leave and for those who stay.” It should be remembered that many European businesses are strongly linked to the global economy; it was recently reported that China is now BMW’s largest market, based on its partnership with a local Chinese car maker. Another positive for European equities is that their dividend yield is attractive when compared to low government bond yields, which may mean that bad news is already priced in to European markets.

Another interesting market for equity investors is Japan, and just as some European export-oriented companies are benefiting from China’s growth, according to Schroders Japanese equities product manager Taku Arai, the increasing affluence of Asian consumers is providing a major opportunity for Japanese companies that have offshore production which can meet this demand. Arai added: “The Japanese equity market appears undervalued relative to other developed markets, and very good value compared to its own history. Japan is one of the broadest equity markets in the world but is also relatively under-researched, making it an ideal hunting ground for seeking alpha.”

These comments on both European and Japanese equities show the importance of China to the world economy now. This has made calling the state of the Chinese market an increasingly important, if inexact, business for investors. Royal London Asset Management economist, Ian Kernohan, said: “If we find it hard to understand the economic and political twists and turns in the Eurozone, which is right next door, how much more difficult is it in China?” At present, growth is expected to fall from 8% plus a year to around 7.5%, and the government has set an inflation target of 4% as China seeks to move away from an export-led economy to one relying more on domestic consumption. Kernohan commented on this transition: “It is becoming clear that the glory days of China’s export plus investment model of growth are now behind us. It has become difficult to wean China off this growth model, without seeing an unacceptable fall in the overall rate of expansion. An added complication is that the shadow financial system has grown in response to negative real savings rates, which has made it more difficult to control the economy using the usual policy levers.”

The United States is a key region for global equities, given the size of the US economy and its deep and vibrant equity market, and views vary on how well it is currently recovering from recession. Lombard Odier Investment Managers chief investment officer, Jean-Louise Nakamura, commented that the US productivity cycle is moving to a point where future growth is based on more solid, sustainable foundations, with growth possibly above 2.5% in 2012 if the rebound from late 2011 continues. However, he added: “The sources of vulnerability are still numerous and make this analysis very fragile. The short-term economic risk most frequently discussed is another explosion in oil prices and consequently in gasoline prices.”

iShares chief investment strategist, Russ Koesterich, was more positive, saying: “The US is improving faster than other parts of the world. So far this year, economic data from the US has been better than expected, confirming that the world’s largest economy has experienced a strong first quarter.” He added: “Looking further ahead, we are keeping a close watch on rising oil prices, which are likely to be a drag on the economy when the summer ‘driving season’ commences.” The US election this year could also be a factor, and Koesterich said: “Investors will start paying closer attention to the upcoming presidential election, and the effect future administrations could have on the market.”

For pension funds, global equities are likely to remain a key asset class as long as growth is a consideration. Most LGPS schemes are still in growth mode, because they are either cashflow positive or need returns to reduce deficits, so will have a place for global equities. But there are still myriad ways to invest, from passive, indextracking mandates to active, unconstrained or specialist mandates.

Matthew Craig