Equities markets in a state of flux

Written By: Matthew Craig LAPF Investments

As LGPS funds consider their allocations to equities, Matthew Craig examines the options available to investors seeking to benefit from the growth potential of equities

Since the middle of the last century, equities have been at the heart of most UK pension fund’s investment portfolios, as the growth engine of a fund.

The central role for equities dates back in the 1947, when the 36-year old George Ross Goobey, pensions manager of the Imperial Tobacco pension fund, realised the time was right to overturn the received wisdom that pension funds should invest mainly in government bonds. At that time, the UK economy was starting to recover after the end of the Second World War. More significantly, government bonds, Gilts, had far less growth potential than equities, which were undervalued and had a higher yield than Gilts. Ross Goobey’s decision to allocate to equities was, as he almost certainly did not say, a no-brainer with the benefit of hindsight. His fund’s investment performance then persuaded many other pension funds to follow his lead and he went down in history as “the father of the equity”.

For investors like George Ross Goobey, a diversified portfolio of equities gives exposure to the benefits of economic growth and the ability of markets to allocate capital to successful enterprises. Equities can cover a wide range of markets on a geographical basis and companies that vary in size from small cap stocks to the largest in the world. But at the same time, equities can experience tempestuous performance, with large gains followed by sudden falls, which can be extremely unnerving for investors, particularly pension funds looking for stability. As a result, equity allocations at UK pension funds, particularly defined benefit funds with rising liabilities, have been gradually falling for some time.

The most recent annual report by the Local Government Pension Scheme (LGPS) Advisory Board shows that equity allocations are falling in the LGPS, perhaps due to the increasing maturity of some funds and a lower risk tolerance. In the year to March 31, 2018, the equity allocation in the £275 billion invested by the pension funds covered by the report fell from 31.8% a year earlier to 28.5%. In its comments on investment performance, the LGPS Scheme Advisory board noted that UK equities underperformed all major overseas markets for sterling investors, but active global equities came back strongly. Indeed, the average global equity portfolio outperformed the index by more than 2%, while the report named fund manager Baillie Gifford, the largest active equity manager across the LGPS, as performing particularly strongly.

The recent underperformance of the UK equity market has been attributed by some to the 2016 EU referendum, when the UK voted to depart from the European Union. According to Schroders senior European economist, Azad Zangana, the UK FTSE 100 and FTSE 250 indices fell by 9% and 12% respectively after the referendum result was announced, although the FTSE All-Share index has risen by 28.1% in the subsequent three years. However, the UK equity market has lagged China, the US and world stocks, which are up from 32.7% to 42.1%, and Zangana added that global asset managers have been underweight the UK over the last three years. However, Schroder head of UK equities, Sue Noffke, said that UK equities are now at a 30% valuation discount relative to their global peers, making this an attractive entry point for investors with a long-term perspective. Noffke added: “If we do experience a recession in the near term, we would expect it to be local in the UK, (possibly the result of a disorderly Brexit), rather than a global one. This gives a degree of comfort that the UK equity market’s current yield of around 4.5% is sustainable, as the large majority of UK stock dividends arise from overseas.”

While UK equities might be underperforming, recent investment conditions have created a benign environment for most assets, including global equities. MM Investment Partners principal strategist multi-asset, Patrick Moonen, commented: “The combination of a recovery in growth, low inflation and easy monetary policy has created something that resembles a mini Goldilocks environment.” Moonen was speaking after equity markets started 2019 strongly but before what is often a quiet period, over the summer months. And he added: “Even if the environment does resemble a Goldilocks scenario, there are some dark clouds on the horizon that could take its shine away very quickly. Growth rates, and hence the equity outlook, will depend heavily on the political decisions and announcements that will be made over the coming weeks and months on Brexit and on trade.”

Whether or not this is a good time to invest in UK equities, the new asset pools created by LGPS funds are setting up new equity portfolios for their members. One recent example is the Border to Coast Pensions Partnership, which has appointed four equity managers for its global equity alpha fund. For the asset pools, the art of choosing different managers for a global equity allocation is blending together a mix of styles. Border to Coast’s chief executive officer, Rachel Elwell, commented: “The Global Equity Alpha Fund combines concentrated, high conviction and complementary strategies into a portfolio that benefits from diversification across investment styles. The fund has exposure to factors such as quality, value and size as a result of the investment philosophies of its underlying managers.”

Elwell added that the four managers selected, Harris Associates, Investec Asset Management, Lindsell Train and Loomis Sayles, offer a mix of deep value, intrinsic value, quality growth and quality defensive philosophies. She added: “The mandates are expected to be concentrated (25 to 60 stocks per mandate) with high active share and, as such, are typically benchmark and tracking error agnostic. The fund will be comprised, in total, of 140 to 160 stocks, with an active share of around 80% and a target tracking error in the region of 2% to 5% a year relative to the MSCI ACWI index.” Elwell added that the global equity alpha fund is benchmarked to the MSCI all country world index, with each manager taking a global unconstrained approach which can result in significant deviations from benchmark country weightings. Elwell commented: “As part of our complementarity process, we aimed to ensure that there is no structural bias at the fund level to any specific region or sector.”

Finding the right approach to ESG is another consideration for equity investors, especially LGPS funds. For its recent equity manager appointments, Border to Coast’s Elwell said: “Each manager was scored explicitly on the degree to which they integrate responsible investment considerations into their investment process and we will continue to work closely with the appointed managers to understand how ESG is embedded in their portfolio management. Border to Coast votes on all its holdings (both those invested internally and those with externally placed mandates) with support from Robeco, our voting and engagement partner, and also works with external managers on engagement matters.”

For the LGPS pools, as well as blending different active equity styles, another option is simply to appoint a passive equity manager, which charge low fees to replicate the performance of a market index, such as the FTSE 100. For many pension funds using equities, the choice nowadays is increasingly between large passive managers, which avoids the problems of trying to find active managers capable of consistently beating the benchmark, or going the other way and looking for alpha, or excess return from manager skill. If it is the latter, many investors are now ready to look at boutique equity managers offering distinctive approaches. Both active and passive approaches can be used together in a “barbell” strategy, where the low cost of one approach is balanced against the potential to achieve higher returns of the other.

Another likely result of the LGPS asset pooling is a consolidation in the number of equity asset managers used. The LGPS Central pool, which acts for a number of Midlands-based funds, recently appointed three equity managers for a £2 billion global active equity fund. Another pool, Brunel Pensions Partnership announced in March 2019 its appointment of two equity managers, Quoniam and Robeco, for a low volatility, global equity mandate, initially worth £400 million, but likely to rise to £600 million. Larger mandates can help the LGPS funds achieve lower fees, through economies of scale and a better negotiating position. At the same time, the LGPS funds are part of a drive to greater cost transparency and it is hoped that shining a light on manager fees will also control fees. One criticism of equity managers in the past was that it was possible to earn healthy fees for performing merely in line with the market, or by being a closet index-tracker, masquerading as an active manager.

In conclusion, equities are still a vital part of the investment portfolios of the LGPS members. Equity investors face a range of decisions as they contemplate using active or passive approaches and a wide range of different styles and options. But the key benefit of equities, their growth potential, is still as good a reason to invest in equities now, as it was the late 1940s when UK pension funds first started to raise their equity allocations.