Equities – handle with care

April, 2013 Print

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Matthew Craig, LAPF Investments.

Investing heavily in equities is a bit like driving a high performance sports car; when it’s good, it’s very good, but when things go wrong, they can go very wrong, very quickly indeed.

This lesson was brought home to many pension fund investors, including local authority funds, in the last few years. The “Great Moderation” period between 2002 and 2008 provided low inflation, low interest rates and good returns. This encouraged many investors to hold more in equities than may have been wise. Then when asset values plunged in 2008, these investors saw the equity risk premium turn from a largely theoretical concept to an uncomfortable reality. Now, many of these investors are wrestling with the equity conundrum and wondering how they can get the growth they need without risking another 2008-style market wipe-out.

This dilemma was clearly illustrated by a number of findings at the recent LAPF Strategic Investment Forum. At the event, nearly 80% of delegates said they expect asset allocations to change as a result of the current round of local authority fund valuations, and just over half (51%) said they expect to see reduced exposure to equities as a result. This is despite the fact that equities were clearly seen as the asset class offering the best risk-adjusted return prospects in 2013 by 47% of the delegates, ahead of 32% for alternatives. So even though they are seen as a good source of growth, many local authority funds are likely to reduce their equity holdings due to their straitened circumstances. Most local authorities are currently facing deficits and in this situation, trustees and others become fearful of too big an allocation to equities; they could perform well, but risk aversion has increased. As a result, many investors prefer to trim equity holdings and diversify into a wider range of assets, in a bid to reduce exposure to the equity market rollercoaster.

Investors are also making changes in how they invest in equities. For example, some investors are moving from UK equity mandates into global equity mandates, while others are looking at ways of damping down equity volatility. And emerging market equities are an area of interest for some, as are equities associated with certain themes, such as food and water investing. Veritas Asset Management head of client service & marketing, Antony Burgess, said his firm has noted two distinct trends regarding equity investing. “One is an increasing interest towards global unconstrained managers as pension funds move away from more ‘benchmark aware’ global managers.” He added that the second theme is a greater interest in global equity income investing. “Up until about 18 months ago, global equity income was largely sought by wealth managers and institutional clients seeking an income, such as charities and family offices. This has broadened out to non-income seeking pension funds and local authorities who reinvest the income but feel income could form a larger part of total return as we continue through the post financial crisis deleveraging phase.”

Using equities for income is a recent development but it is one that more local authorities may follow in the future. With redundancies and other changes to the LGPS framework, many pension funds are becoming more mature and finding reliable income sources is increasingly important in order to ensure pensions are paid. At the same time, government bonds are becoming less attractive as an asset, because the yield has fallen to record lows and values looks vulnerable should interest rates turn, or, heaven forbid, inflation starts to climb from low single digit levels.

 

 

 

Another argument for using equities for income is the relative valuation levels of Gilts and blue-chip equities; if investors can get a better yield from equities than Gilts, plus the additional prospect of capital growth, then some see choosing equities over Gilts as a no-brainer. An example of an investor using equities for income approach was recently seen at Berkshire Pension Fund, which in December 2012 appointed Kames Capital for a £70 million global equity income mandate with an initial dividend yield of at least 130% of the MSCI World Index and income growth in excess of the UK Consumer Price Index. Commenting on this mandate, Kames head of overseas equities, Piers Hillier, said: “History teaches us that dividends dominate long-term global equity returns. Compared to capital growth, the importance of dividend yield and dividend growth across major markets has been profound. We believe there is a real opportunity for institutional investors to profit from the powerful compounding effect of reinvested dividends.” On the mandate, Berkshire Pension Fund chairman, Councillor John Lenton, commented: “We have confidence in Kames’ ability to deliver a reliable and sustainable income stream with the potential for long-term capital growth.”

As well as using equities for income, another post-2008 trend is for investors to look at smart beta strategies, which attempt to keep the return potential of equities but with less volatility. At the LAPF Strategic Investment Forum, 65% of attendees said they still believed in the active management of developed market equities, but this fell to 56% for LGPS officers and 33% for LGPS chairman. Interestingly, consultants and fund managers were far more likely to favour active management than investors, at 70% and 78% respectively. Towers Watson has reported a significant inflow of assets from institutional investors into smart beta strategies, and its head of global investment research, Craig Baker, commented: “These smart beta strategies range from relatively simple ideas such as real estate securities and specialist infrastructure strategies to create liquid diversity, to doing existing betas better, such as non market cap-weighted equities.”

As an example of what might be considered a smart beta strategy for equities, Investec Asset Management recently launched the GSF Global Endurance Fund, which it said aims to deliver superior performance combined with lower absolute volatility. It uses a portfolio of stocks paying an attractive yield, but excludes the more volatile stocks. Investec’s co-portfolio manager Christine Baalham commented: “The attraction of investing in equities is the prospect of long-term investment returns. However the downside is the volatility associated with achieving these returns. The question therefore becomes whether it is possible to deliver excess market returns, but with lower absolute volatility?” These strategies are attracting attention; if they can produce good returns with lower volatility, they could become an important way for local authority funds to continue to invest in equities, but with less fear of a disastrous fall in funding levels at the wrong time.

For UK local authority pension funds, the experience of Japan, which has seen a long period of deleveraging and equity market underperformance, could be instructive. It has seen a move away from conventional marketweighted indices among investors, as Hiroki Tsujimura, CIO at Nikko Asset Management in Japan, explained: “More investors are having difficulty in determining whether marketweighted indices can be positioned on the efficient frontier. In such an environment, investors are rethinking the use of market-weighted indices as benchmarks for passive investment, and we expect to see a partial shift to minimum-volatility indices and riskefficient indices instead.” And according to Tsujimura, another trend for equity investors in difficult conditions is to shift to concentrated equity investment strategies, which do not take beta into account.

 

 

 

Looking at the outlook for the global economy, there are, according to some seasoned observers, reasons for investors to be reasonably optimistic about future returns. Baring Asset Management chairman, strategic policy group, and head of the global multi-asset group, Percival Stanion, commented: “Our take on the fundamentals is one of cautious optimism as we continue to see further improvements in the global economy.” He added that the US economy is on a slow path to recovery, as is China. “As both China and the US recover, the great trading nations of Europe have seen their order books fill up. Even subdued parts of the region such as Italy have a spring in their step, with the latest data showing signs of recovery and bank lending starting to unfreeze. Only in the UK is the economic situation looking unstable. In part this is due to lagging data, in part due to a lopsided UK economy,” Stanion said.

In conclusion, investors, unnerved by the white-knuckle ride of 2008-09, are now much more careful drivers when they get into the equity investing sports car. Using equities for income as well as growth, and finding ways to reduce equity volatility are two tactics that local authority investors are likely to develop in 2013 and beyond. Equities will remain an important asset class for pension funds as they provide direct access to markets and the underlying economy. But as investors become more risk-averse, they will seek to handle equities with care in order to get to their destination without leaving the road or breaking down.

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