Uncertainty abounds in equities

Written By: Matthew Craig LAPF Investments

Changing market conditions and moves towards asset pooling in the LGPS are creating challenges for equity investors. Matthew Craig investigates

Equity investments are a cornerstone of the portfolios of most local authority pension funds, but investors are constantly tinkering under the bonnet, just as a car mechanic seeks to find the ideal blend of performance and economy.

Equities should provide growth, through exposure to economic activity or superior company management delivering success, but the downside to this is volatility and also cost. Pension funds, like local authority funds with a funding deficit to close, therefore want growth, but need to avoid losses and do not want to overpay for equity returns. As a result, investors are exploring concepts such as smart beta, or other ways of getting growth in a controlled and cost effective manner.

The Strathclyde Pension Fund has £15 billion in assets under management, and at the end of 2014 it had a 72.5% allocation to equities. It recently made some rebalancing moves to the equity portfolio. One element of this will be less use of market capitalisation indices for passive equity investing and more use of fundamental indexation, in particular the RAFI indices produced by Research Associates and FTSE. While market cap indices have advantages such as being easy to understand and replicate, they are also pro-cyclical in nature, by allocating more weight to companies which are already very successful with a high share price. In contrast, fundamental indices aim to take a more objective approach, by looking at indicators such as sales, cash flow, book value and dividends, when calculating how much weight to give to a company within an index. Strathclyde Pension Fund first invested in fundamental indexation in 2012 with global and emerging market equity RAFI indices. It now plans to increase its use of fundamental indexation to 13.5% of its equity allocation, up from 7.5%.

Commenting on this type of investment approach, Erik Rubingh, head of systematic strategies at BMO Global Asset Management, commented: “If you want low to moderate fees and governance, without the hassle of monitoring a lot of fundamental stock-pickers, then the use of smart beta and rules-based approaches is attractive for the local authority market.” One interesting twist for local authority funds is that under the proposed reform template for the LGPS, funds will have to justify the use of active strategies as against investing passive in listed markets, such as equities. One complication is that views can differ on definitions of active and passive investing. The use of risk factors, such as value, quality and momentum, which is a part of smart beta investment, is often seen as active rather than passive, and for some experts, anything but market capitalisation indices is a form of active investing. Rubingh commented: “If you deviate from a market cap index, you are investing actively. Maybe you are outsourcing the decisions to a smart beta index provider, if so you are putting faith for some investment decisions into their hands.”

Another question is if smart beta-type strategies are here to stay. Dorset County Pension Fund head of Treasury and Pensions, Nick Buckland, said: “There will always be strategies that become ‘the flavour of the month’. I think that smart beta investing does offer significant potential for achieving the diversified returns that investors require, but I am sure that in a few years’ time there will be new strategies developed that will offer similar characteristics.”

While LGPS funds will need to see if active investment is providing value for money as a result of the LGPS asset pooling reforms, we should not expect to see major asset allocation changes. Mark Chaloner, assistant director (investments) at West Midlands Pension Fund, commented: “LGPS investment pooling is hugely important but it is very unlikely to affect WMPF’s allocation over the year ahead.” Dorset’s Buckland said that he did not expect to to see asset allocation changes as a result of pooling. On his fund’s overall equity allocation, he commented: “In terms of our allocation to equities, we will be formally reviewing our strategy in 2016, but I don’t see an increase in equity allocations being on the cards, we may even continue our recent trend of diversifying away from equities.”

One long-term factor which equity investors now have to consider is the question of global warming and climate change risk, following the recent Paris climate change talks. This could lead to changes to equity portfolios held by institutional investors, with lower holdings of carbon-emitting stocks, such as oil and gas companies. Strathclyde Pension Fund head of pensions, Richard McIndoe, agreed that there are likely to be some changes but added: “It is not clear yet what form it will take – more engagement with existing holdings or allocation and/or stock selection changes.” Nick Buckland said that while his fund has always focused on the financial prospects for any investment, “I can’t see how it will be possible not to take account of climate change as one of the factors that you consider when making investments.” And WMPF’s Chaloner commented: “The Paris conference is an important milestone and will contribute to greater emphasis on the consideration of climate change in the making of investment decisions.”

If LGPS members want to see an example of how investors are taking more account of climate change risk, then fellow LGPS member, the Environment Agency Pension Fund, is a case in point. In October 2015, it announced that it had set itself the objective of ensuring its investment portfolio is compatible with the aim of limiting an increase in the average global temperatures to less than 2ºC. It has therefore set itself three targets by 2020: to invest 15% of the portfolio in low carbon and energy efficient areas; to cut its exposure to future emissions by 90% for coal and 50% for oil and gas; and to support progress towards a transition to a low carbon economy by working with a wide range of other bodies. This policy builds on the fund’s work on managing climate change risk over the last decade.

While the Paris agreement has been hailed as a breakthrough, index provider MSCI has said that more companies need to cut their carbon emissions by more than the publicly stated goals if the 2°C is to be met. In plans to cut their carbon emissions, MSCI has pointed out wide variations between both individual companies and countries. One implication is that laggards, which are slow to cut carbon emissions, could be punished. “Companies that continue to lag could face greater risk of increased cost of compliance with regulations in the form of carbon tax, fines and increased capital expenditure to switch to low carbon technologies in light of the gradually strengthening climate policy scenario.” So it could be that taking account of climate change risk is not just good behaviour; regulators and markets could punish the worst offending equity investments.

Looking at equities in 2016, investors may review their strategies to take account of changing market conditions. However Mark Tinker, head of Framlington Equities Asia at Axa Investment Managers, said: “Investors are struggling with the concept of ‘where are we in the cycle?’ as traditional models seem to be failing.” Tinker added that eight years of quantitative easing has completely distorted capital allocation decisions and broken the link between interest rates and economic activity. As a result, investors may be fearful of an equity market correction. In this case, investors are more likely to trim equity allocations and look at more defensive strategies.

In conclusion, equities will remain an important part of local authority pension fund portfolios. The pressure to reduce costs and the moves towards asset pooling mean that index tracking will be widely used, while smart beta strategies and fundamental indexation will attract assets. Finding good active managers is always a challenge for investors, but when this happens, good performance could help funds start to reduce their funding deficits.