Written By: Matthew Craig
Equities are a key part of most investment portfolios, and local authority pension funds are no exception. Equity holdings at UK institutional pension funds may have fallen from around 65% in 2003 to 50% in 2013 according to a recent study by Towers Watson, but they are still the largest asset class and the biggest source for risk. However following two severe equity market crashes – following the tech boom around 2000 and the subprime crisis in 2008, equities are unloved by many. Pension funds are now acutely aware of the propensity of equity valuations to drop sharply, and, in an era when defined benefit schemes are becoming more mature and carefully managed, investing in equities is something investors have to reassess.
In 2013, many local authority pension funds carried out triennial valuations, and JLT Employee Benefits senior consultant, Jignesh Sheth, said: “We expect that local authority pension funds will either hold or moderately reduce their equity exposures.” Sheth cited a number of reasons for this. One is that many funds need growth and with a large deficit and a long-term outlook, have limited scope to reduce their equity allocations. Another factor is that market conditions have helped local authorities in the past and could do in the medium term. Sheth said: “Local authority pension funds have held higher allocations to equities than most private sector schemes, thus benefiting from the double-digit returns from equities over the past five years. Equities appear to have priced in the improving economic outlook and therefore the continuing economic uncertainties going forward may tempt some funds to take profits.”
Whereas many private sector pension funds have made wholesale shifts from equities into liability-matching assets, following their closure to new joiners or any future accrual of benefits, local government pension scheme (LGPS) funds have kept equity allocations reasonably high. As Sheth notes, this has paid off recently, but there are signs that funds are diversifying from equities into other return-seeking asset classes, as they both take profits and seek to widen their sources of returns. At the West Midlands Pension Fund (WMPF), director of pensions Geik Drever commented: “We are reviewing our investment strategy following the actuarial valuation, but we are not expecting WMPF to change its overall allocation to equities significantly in the foreseeable future.” Drever added: “Some diversification into other return-seeking asset classes makes sense for investors with the resources and governance budgets to manage them properly. That said, equities should remain a key asset class for investors with long-term time horizons and the capacity to tolerate market volatility.”
Equity investing covers a multitude of regions and styles, from index-tracking the largest, more efficient markets, to using specialist active managers in emerging and frontier markets. Emerging markets have had a difficult time since May 2013, when the US Federal Reserve raised the subjecting of tapering its quantitative easing programme. The prospect of less “easy money” caused an outflow from emerging markets, but this has now reached the point where some see value in emerging markets. This could strengthen the nerve of risk-averse investors, and the structural case for the emerging markets remains strong. Allianz Global Investors is set to launch a new EM equity opportunities fund and its manager, Kunal Ghosh, said: “The growth of middle-class consumers in developing nations is a significant global trend which means emerging markets still represent one of the few genuine growth stories investors are able to access. The fund will capitalise on this opportunity and invest in 100-150 companies with attractive risk/reward profiles.” And JLT’s Sheth added: “The long-term growth story for emerging markets has seen many funds increasing the allocation to this area, particularly given the significant underperformance of emerging markets over the past few years. The interest in frontier markets has gathered momentum, and a number of local authority funds have either started to research the area, or have made allocations, albeit small.”
At the same time, there are also opportunities in the developed world. Societe Generale chief investment officer, Eric Verleyen, said: “Bearing in mind that interest rates are now close to zero in the Eurozone, we expect German equities to perform well in 2014. Especially since Angela Merkel is now ready to add €23 billion in government spending over the next three years, and plans to introduce some tax incentives for companies. We recommend exposure to the DAX or to German small- and mid-caps.”
A perennial question for equity investors is whether or not to try to beat the benchmark with active management. In recent times, macro factors rather than market fundamentals have driven returns, making life harder for active managers. Sheth commented: “Many active managers have struggled in this environment and some local authority funds are taking the view that, given lower governance and management costs, higher proportions to passive management within an equity portfolio is appropriate.” Strathclyde Pension Fund head of pensions, Richard McIndoe, said: “Our experience is that active management can add value in specialist markets such as small companies and emerging markets. We also have a global active strategy, but the value-add is less clear. You do have to be very clever or lucky with your choice of manager, and not everyone will be clever or lucky. At 42.5% passive, we set less store by active management than previously.” And WMPF’s Drever added “There are successful active managers in a number of areas, for example in global equities. But careful selection and monitoring are important. Questions remain whether there will be consistent alpha to cover the additional fees.”
In the last few years, equity investors have gained the option of smart beta, or systematic approaches which seek to exploit equity pricing anomalies and risk factors. While some investors are sceptical as to the value of these methods, others see them as useful additions to the investment toolkit. Speaking as an investment consultant observing this trend, Sheth said: “There is a tentative approach towards alternative passive indices e.g. fundamental indexing and smart beta, but higher potential transaction and management costs, and inconclusive evidence that such approaches outperform traditional indexing, means that LGPS retain a high proportion of their passive holdings in traditional indexing funds.” His view is echoed by Drever, who commented: “New approaches to investing in equities look well worth exploring, but their track records in different market environments and implementability need to be checked. Our concern is the herd-like following into a particular style being promoted by both asset managers and consultants.” However, Strathclyde Pension Fund has already made the move. McIndoe said: “We have introduced some smart beta (£650 million in fundamental indexation) following our last triennial review.”
One trend which could appeal to local authority funds is to take steps to control the downside risks from equities. Many pension funds need growth, but at the same time either they cannot afford to see assets fall in value, or they believe equities could be due a correction. Either way, using tail risk hedging, as it is called, can prevent losses if equity markets crash. In the past this might have entailed the use of expensive and complex strategies, or financial instruments which were forbidden to local authority investors. But Schroder Investment Management said it has developed a suitable product for local authority funds which is based on an overlay programme using exchange-traded futures contracts, which most investors can use. Schroders head of Portfolio Solutions, John McLaughlin, commented: “Volatility control techniques are widely used in the insurance industry – this is a tried and tested approach.” While volatility capping works best when volatility rises before and during a market crash, McLaughlin said that Schroders has developed the ability to use it even when a market fall is not associated with rising volatility. “One instance of this was in the period 2000-2003, when the technology bubble deflated and markets fell by 40% over the period. It is also possible to have a market recovery associated with high volatility, as when the market rebounded in 2009. In this scenario the hedge will act as a drag on performance, however it will have outperformed when we also take 2008 into account.”
Another aspect of equities which is important to long-term investors is the application of environmental, social and governance (ESG) criteria. While in theory ESG factors can be applied to any asset, in practice equities are a key area for investors to express their ESG policies. On ESG and equities, Sheth said: “Rather than focusing on the traditional negative and positive screened portfolios, pension committees are more focused on how ESG considerations are taken into account in the investment process for active managers, the UNPRI status of their investment managers, and collaborative action through bodies such as the LAPF Forum.”
While many investors may have fallen out of love with equities after recent market scares, most know equities are vital to their investment objectives. Private equity and various hedge fund techniques also depend on a healthy corporate sector, as does much of the fixed income asset class. Becoming more sophisticated and discerning about how to invest in equities is now the priority for local authority funds who want to improve their funding while avoiding the periodic bouts of extreme volatility that equity markets can produce. Equities can underperform for long periods, but perhaps being out of the market is a bigger risk than being in it.