Equity Panel (March 2007) - Ways to add value

Donny Hay
Director, UK institutional business
development
Martin Currie Investment Management
Hay is responsible for developing Martin Currie’s relationships with UK pension funds, institutional investors and consultants. He worked in Australia with KPMG Hungerfords and MacQuarie Bank before joining Edinburgh Fund Managers in 1986, where he headed the European team. In 1995 he joined Armstrong Jones in New Zealand as general manager for wholesale funds’ management, returning to Scotland in 1999 to join Martin Currie.

Stephen Holt
Head of UK institutional sales
Principal Global
Investors
Holt qualified as an actuary while working at Hymans Robertson in Glasgow, and has held senior investment sales positions at Barclays Global Investors, Threadneedle and Santander. He joined Principal Global Investors in 2006 to spearhead the $200bn (£104bn) US asset manager’s entry into the UK institutional marketplace.

Alistair Wilson
Head of institutional business
Neptune Investment Management
Wilson joined Neptune in 2005 from Legal & General Investment Management where, from 2001, he was a business development manager in the corporate pensions department. During that time he was responsible for promoting LGIM’s funds to corporate pension schemes through a variety of investment consultants. Prior to this Wilson was a client account manager at LGIM.


Most UK pension schemes are still heavily invested in domestic equities. Is this the right approach?

Hay: Domestic equities offer UK pension funds greater familiarity, no additional currency risk and higher dividends. And the UK stock market also offers more of an exposure to the global economy than investors might expect, particularly through the largest stocks.
However, pension schemes with a heavy UK bias would miss out on some of the world’s most attractive companies. They could also suffer from the concentration of the UK stock market in a few very large stocks, and a narrow sector focus in banking, telecommunications, energy and pharmaceuticals, each of which is heavily represented in the UK stock market.
In an environment of more modest investment returns, “squeezing” a pension fund’s assets has never been more important. UK pension funds have been reducing their bias to domestic equities for a number of years. This has helped to reduce their overall risk profile and, in most cases, enhanced returns.
Almost all UK pension funds now have a material exposure to international markets. The opportunity cost of not doing so is simply too great.

Holt: While a degree of local bias is both understandable and justifiable, our concerns would focus on the magnitude of this bias.
There is little economic rationale for the magnitude of home country biases by most UK pension funds, where the portfolio weight is multiple times that of the proportional representation of UK stocks in global market capitalisation weighted benchmarks, and also multiple times that of the UK’s overall contribution to global GDP.
In addition, one could argue that defining “domestic” equities according to the stock market where a stock has its primary quote is increasingly arbitrary and difficult to justify given the global activities of mega-cap stocks like BP, Vodafone and HSBC.
Also, the pronounced concentration of the FTSE All Share index (with the largest 20 stocks representing more than 50pc of the index) can create unintended levels of risk concentration at current levels of domestic exposure.
History suggests that the conventional wisdom that local assets are the best hedge against local liabilities does not necessarily hold true for equities. But surely the best argument for reducing domestic bias is the much broader investment opportunity set available from a global rather than a local focus.

Wilson: Any investment approach, whether UK or global, needs to sit within a framework which analyses global dynamics.
When investing in the UK, given the increasing internationalisation of the UK stock market and the global factors impacting companies listed here, an investor is taking a view on the global economic environment.
Our belief is that by limiting exposure to UK equities a scheme is simply limiting the potential universe from which a manager can work. Increased exposure to global markets, without regional restrictions, allows significant value to be added over the longer term.
Within this context, the split of UK versus global equities becomes one of comfort for an individual set of trustees. The most efficient investment approach is to move to a fully global account.
Even where a scheme wishes to maintain significant exposure to UK equities, this needs to be done in a global context.


In which international markets do you see the most attractive investment opportunities?

Hay: We tend to look for the best stock ideas regardless of where companies are based. Top-down asset allocation requires you to make a few big macroeconomic calls, and very few investors get these right consistently.
That is why we are seeing
the growing popularity of global equity portfolios that allow managers to choose their best stocks worldwide, irrespective of where they are based, and without being constrained by benchmark weightings.
The overall outlook for international equities is positive. The US, after a flat year, offers good value, while in Europe we anticipate a good year for equities, although not as good as 2006. Liquidity on the continent is abundant, while valuations, particularly against debt, are attractive.
In Japan, following a disappointing year, the market has real upside potential. Earnings are the main driver, and these should be better than market expectations thanks to a weaker yen, lower input costs and continued restructuring.
In Asia the bull market is approaching its fifth year, yet equity markets still trade at a meaningful discount to their long-run averages. Of course risks remain, but we are cautiously optimistic.

Holt: We would suggest that Asian equity markets continue to offer promising growth prospects and the recent broad-based – arguably indiscriminate – declines in these markets may provide some interesting value opportunities for patient investors.
However we would also caution against excessive focus on tactical allocation to regional markets at the expense of a sensible strategic allocation. All international markets are sufficiently diverse to present attractive investment opportunities – the skill is in identifying them.
At Principal Global Investors, we adopt a pure bottom-up approach to active equity management that concentrates portfolio risk at the stock level rather than seeking to take large active positions at the regional and sector level.
The competitive advantage produced by the integrated quantitative and judgemental research approach we have developed is in identifying attractive stocks relative to their sector peers within regions.
This has allowed us to build diverse portfolios that have produced substantial outperformance of the MSCI World index, with relatively low tracking error and a very high information ratio, without the need to take large active bets on regions and sectors.

Wilson: We believe 2007 will be a good year for equity investment and we will see continued strong growth from the same markets that outperformed in 2006, notably China and Russia.
The key elements to their dramatic growth are broadly the building middle classes and wage growth. We firmly believe these markets will continue to drive world growth, despite any potential slowdown in the US consumer triggered by falling house prices.
Elsewhere, we favour Germany over France in Europe. The UK market will suffer from the uncertainty on the political landscape, namely the timing and execution of the Blair handover. We believe markets will be dampened in the run up to May when most forecast the change of power to take place.
Japan has its own dynamics and should be watched carefully in 2007. While it had a difficult year in 2006, corporate earnings will do well in 2007 and we remain neutral on the market as the consumer related parts of the economy look very weak and the political landscape is uncertain.


How should pension schemes approach emerging markets?

Hay: Emerging markets can certainly be volatile, but pension schemes can manage this by taking a long-term view on this exciting asset class.
Their economies still only represent 8pc of world stock market capitalisation, but around 50pc of the economic opportunity. They contain some world-class businesses, which tend to be growing their earnings faster than companies in developed markets. And because emerging markets have relatively low correlations with mature markets, they offer pension funds an opportunity to reduce their overall risk through diversification.
The “BRIC” (Brazil, Russia, India and China) countries have been receiving particular media attention – and rightly so. These markets are driven by very powerful forces, and are attracting significant fund flows. But we do worry when investors restrict themselves to just these four markets. Collectively they constitute only one-third of global emerging markets by capitalisation.
We believe pension funds should adopt a more diversified global exposure to emerging markets. Not only will they benefit from the strong BRIC markets, they will gain exposure to other equally attractive markets and improve their overall risk profile.

Holt: We believe this is primarily a question of risk tolerance. We advocate a global perspective, including emerging markets, to access the broadest opportunity set possible.
Emerging markets can be quite volatile in isolation, but in the context of a diversified global portfolio, exposure can enhance the expected returns and provide improved diversification through exposure to local economies in Latin America, Eastern Europe, Southeast Asia, the Middle East and Africa.
Given the long investment-time horizon of most pension schemes, we think emerging markets exposure is both wholly appropriate and desirable, and typically should represent 10pc to 15pc of total equity exposure.
A key caveat, however, is that we advocate a broadly diversified approach to emerging markets, rather than focusing on a narrow subset of countries (for example, BRIC portfolios or single region strategies).

Wilson: From an investment perspective these markets create a wide range of opportunities which should not be ignored.
We believe these economies are emerging at a quicker rate than most people expected and that they really should not be underestimated in terms of their global importance.
They have hit critical mass whether as an economic block or on a sector-by-sector basis, primarily as the significant source of incremental global economic growth, but also as the location of above average sales potential and as a supplier of low-cost components to OECD firms.
From a risk and return perspective, generally improved standards of corporate governance exist and mean investors can take greater comfort than was historically the case. The best companies can also be accessed via western listings where they meet higher accounting standards.
It is our view that these markets give significant opportunity to add value and should form part of any well-researched high-conviction global mandate for UK pension schemes.