Written By: Matthew Craig
Matthew Craig considers investors’ approach to global equity allocation and the current move towards factor-based investing
UK pension fund allocations to global equities have risen and fallen over time, as funds have changed strategy and equity markets have dipped and boomed. Statistics show that from holding 47% of assets in UK equities and none in overseas equities in 1962, by the end of 2016 the average UK pension fund had 29% in overseas equities and 16% in UK equities.
The beneficial effects of global equities when conditions are favourable, is vividly shown in the results of Lothian Pension Fund for the year to March 31, 2017, which delivered a 21.7% return. The foundation for this was the strong performance of global equity markets, which saw a 32.2% return for the MSCI world equity index. While the fund has a defensive approach to equities, it still benefited greatly from this performance, given that is has a global equity allocation of 55%, the bulk of which is managed in-house. “The fund’s equity investments, managed by the internal team and two external managers, combined to produce a return of 25.8% over the year, aided in no small part by the weakness of sterling [which boosts returns to a UK investor from overseas equities],” commented Bruce Miller, chief investment officer of Lothian Pension Fund. Miller added that, as long-term investors, Lothian does not place too much importance on a single year’s results, unlike much of the asset management industry. Instead, Lothian’s strategy is to have downside protection when equity markets are weak, so that it can smooth out some of the ups and downs of what can be a volatile asset class.
As well as seeing good returns from global equities in the last year or so, many investors are revising their global equity allocations in the light of two strong trends. One of these is a move towards factor-based investing, the other is the integration of environmental, social and governance (ESG) factors into investment decision-making in areas such as global equities.
Factor-based investing is also known as smart beta, or the use of risk premium factors. Essentially, this means that an investor aims to harness underlying factors or market characteristics such as value, growth, momentum or low-volatility. Factor-based investing can be seen as a middle way between pure active management, based on a manager’s stock-picking skill, which can be unreliable, and the blunt instrument of purely passive investing.
“We have seen interest in factor-based investing evolving to become truly global, compared to three years ago when interest was limited to specific markets, such as the Nordics, Netherlands and Australia. There is more demand for factor investing in the UK from across the board, including local government funds. Transparency and low cost are two key reasons for interest in factor-based investing, which it shares with passive investing, but it is an active strategy and aims to deliver better returns than market-cap weighted indices,” commented Jonathan White, head of client portfolio management, AXA IM Rosenberg Equities. Investors in global equities are also looking at systematic, or quantitative approaches as well. PAAMCO associate director, Cutler Cook, said: “Increasingly, we see the largest global institutions building in-house quant teams, whose job it is to develop proprietary tools and indices across equity markets; fundamental money managers are hiring quant jockeys to gain some quant angle on their stock picking and portfolio management; and quant shops are broadening their offerings, including alt beta strategies which continue to attract lots of attention.”
The London CIV could be one of the new LGPS asset pools which is looking at factor-based approaches to global equities, according to the June 2017 blog by chief executive, Hugh Grover: “We’re also in the process of finalising with the Investment Advisory Committee which strategies to go with for the second tranche of global equity sub-funds. At this point it seems likely that low volatility and low carbon strategies will be part of the mix and we’ll arrange for strategy presentations in the early autumn so that everyone has the opportunity to contribute to the final decision.”
For local government pension funds, as for many other large institutional investors with public responsibilities and a range of stakeholders, investing in a socially responsible way has become increasingly important. Indeed, for assets such as global equities, many feel that it would be detrimental to future returns not to take full account of issues such as climate change, or the sustainability of a company’s products, operations, supply chain and other aspects of its business. Tracey Milner, local authority client director at AXA Investment Management commented: “Responsible investing (RI) issues, particularly low carbon investing, is high up the list of concerns for many LGPS funds. In part, this is driven by campaigns by pressure groups for funds to consider divesting from carbon. As such, we are seeing interest in our strategies, including factor-based investing, which give consideration to RI issues.”
With much interest in ESG issues shown by investors, more and more asset managers are also embracing ESG as a key element in their investment approach. AXA IM Rosenberg Equities recently announced that it is incorporating ESG into all its factor-based and active stock-picking strategies. Jonathan White observed: “This is a big change for us. It was initially done for our portfolios for Australian investors and is now being rolled out globally. Our view is that taking into account ESG factors and investing in companies on the right side of global trends will improve returns. We are seeing rising demand for this approach from clients, including local government funds.”
Another important issue for local authority funds is the asset pooling reforms currently taking place. In the long term, larger asset pools should have access to a wider range of strategies for global equities, but in the meantime, many LGPS funds will continue to allocate to their current range of managers. While Scottish LGPS funds are not pooling yet, Richard McIndoe, director at £20 billion Strathclyde Pension Fund, gave an insight into what’s possible with greater scale: “We currently have eight equity mandates spanning passive, active, RAFI, specialist small company, specialist emerging markets, plus a fairly complex global private equity programme. I guess that would be difficult (and expensive) for a smaller fund to manage.”
Once the new asset pools are up and running, with internal expertise and the ability to customise and fine-tune their global equity exposure, we could see some interesting developments. PAAMCO’s Cook commented: “We see some of the very largest global institutions building out emerging market mandates on a country-by-country basis, taking the view that teams on the ground with focused and active mandates can create value by fishing for opportunities in their small ponds, trading nimbly around opportunities that others might miss. This concentrates country-allocation alpha in the allocator’s hands, while mandating managers to focus on generating stock selection alpha, which large institutions can negotiate creative ways to compensate.”
However, building advanced new structures for global equities will take time. At present, the eight new LGPS asset pools are expected to have ranges of sub-funds in place when they launch next April, which will include global equities and other popular asset classes. Over time, the various LGPS funds that make up each pool will be expected to transition into the new sub funds. Jeff Houston, head of pensions at the Local Government Association, commented: “If a pool does not offer a suitable sub fund, then individual LGPS funds will have to decide if they want to switch a mandate to the nearest equivalent sub fund, or if they adjust their investment strategy. This is where the governance structure has to find a way of putting in place the right sub funds, without replicating every single manager or fund used by the pool members before.”
The London CIV, the asset pool for the London borough pension funds, has already launched several sub funds, including a number with exposure to global equities. One of these funds, the global equity alpha fund, aims to outperform the MSCI world index by 2% after fees. On its website, the London CIV stated that the FCA approved two more funds, the Longview global equity and Henderson emerging market sub funds and added: “We’re working now to prepare our Global Equity Income and Sustainable Equities sub-funds for launch in September, with management delegated to Epoch Investment Partners and RBC. We’ve had encouraging levels of interest shown following the meet the managers’ day so expect the funds to have significant assets invested right from the off.”
Given this activity and its value as an investment bedrock, we can expect to see plenty more new about global equities as part of the investment mix for the LGPS sector. The new asset pools will seek to find the right blend of performance, sustainability and other criteria that LGPS investors want to see when they invest in global equities. If this can be achieved, the asset class will no doubt play an important role in providing future pensions to LGPS members.