Think local, act globally

Following almost a year of unbroken growth, at the end of last month the world’s stock markets faced a sharp downturn, triggered by an unexpected global equities sell-off.

Blame for the slump was widespread, ranging from China’s 9pc plunge a day after the markets reached a record high, to former chairman of the US Federal Reserve Alan Greenspan’s comments that it was possible the US economy was on the brink of a recession.

However, Threadneedle’s head of international and global equities Dominic Rossi says the falls were not a reaction to any economic event, but an overdue correction that had been predicted to be coming for some time. The timing of the shift merely took investors by surprise.

Rossi says: “In recent weeks, equity market volatility had fallen close to all-time low levels and credit spreads were also approaching historic lows. From such a tight technical position, there was always a risk of a short, sharp correction. During any bull market, even the smallest incident can trigger a correction.

“In this case, it was triggered by a widening of credit spreads in the US sub-prime mortgage market and a sharp sell-off on the Shanghai stock exchange, which was prompted by liquidity reduction measures by the Chinese authorities. The domino effect of equity market selling has been exacerbated by hedge fund activity, whose ability to influence markets should not be underestimated.

“Indeed, a bout of investor jitters in China will not affect economic conditions or monetary policy. In short, the macroeconomic backdrop remains favourable. Growth is robust and a lack of inflationary pressures prevents the need for substantial monetary tightening.”

State Street Global Advisor’s managing director of global equities Arlene Rockefeller’s explanation for the dip is based on the idea that investors are constantly looking for growth opportunities, which in turn pushes share prices above what they are actually worth, eventually leading to a need for correction.

Rockefeller says: “When you are looking forward, looking for growth, people tend to over pay. I think we have seen a little too much money chasing some of these markets and I don’t see necessarily a collapse going on here, I think we are seeing the pendulum swinging back a bit on things that were pushed too far forward.”

“For example some of the pre-emerging markets, like Vietnam where there are only five companies that are large enough for institutional investors, have in the past year gone up something like 250pc.

“There is a lot of money chasing some of these smaller opportunities and it gets to the point where they may be good opportunities but you do have to consider what price you are paying for them. While people do want to have growth exposure, they have to be prudent about it.”

Rossi says although the drops were dramatic and caught the attention of investors and the media alike, the losses effectively cancelled out gains made in the first two months of the year, with most major markets now back to their end-December levels.

He still holds a positive outlook on the world equity markets.

Rossi says: “We believe the falls represent nothing more than a temporary re-pricing of risk and that investors will begin to refocus on positive fundamentals in the very near future.

“Investors must accept that, during any bull market, they will have to bear these short sharp shocks as a reminder that equity investment is not a one-way bet.

“Our positive view of equity markets is unaltered and we have been taking advantage of the falls by increasing exposure to favoured stocks at more attractive valuations.”

Martin Currie Investment Management’s investment director of global equities Alison Hamilton, agrees with this prognosis.

She adds: “Clearly the short-term outlook is a little uncertain given the recent turmoil in global markets. But the economic outlook remains good and we believe this is a short-term correction rather than any more structural change.”
Investec’s head of global equities Mark Breedon is more cautious about the outlook of the equities market, although he says he does expect to see more volatility in the markets than there has been recently.

Breedon says: “I think some of the complacency about volatility staying low will be shifted out and we will get a bit of a push back, certainly in the near term, towards less risky stocks.

“But in the context of where people are going in terms of allocating global mandates, it actually will not make much difference. It would suffice to say that this might make a better environment for hedge funds as basically there is more volatility in there than there was, but to us it’s not a major event and won’t distract from the trend of global mandates.”

Rockefeller points out that investing in the equities market is all about looking for future growth – in essence trying to predict the future – and slight wobbles should be expected by investors and factored into their risk taking.

She says: “Chasing growth is a risky thing, but people want to have some exposure to these markets because they do not want to have only markets that are growing at a very slow rate. So the point is to go back to diversification and look at your overall portfolio, rather than trying to make huge amounts of money or big debts on more risky markets.”

Breedon does not believe the dip will have any effect on pensions investors, as they have a much longer term view of markets than retail investors.

He says: “I suspect if it does have an impact, it would be on the retail side of things in terms of flows into global funds because retail investors don’t like a draw down and are going to be more hesitant of putting more money in. I think that pension plans have seen the obvious benefits of diversification and the opportunities, and that’s a process that will continue on and will not be affected by short term draw down at all.”

Rockefeller agrees, and says: “I really do not think people will be too wary about investing outside their domestic markets. Let’s face it, all the domestic markets are going down too, so I don’t think this will frighten people away unless they’re speculators.”

Increased risk versus diversification benefits
Global equities are often perceived as being riskier than domestic equities and the events of the last weeks have not helped this perception. While it is true they are more volatile than the established domestic markets, there are distinct advantages to investing overseas.

Rockefeller explains: “In terms of whether they’re riskier than domestic markets or safer it really depends on what you are looking at. Certainly emerging markets are more volatile than the developed markets, but the point isn’t whether the actual investment itself is more volatile, it’s what it does to your overall portfolio.

“So if it provides a diversification benefit, even if it is more volatile, the risk return tradeoffs of the portfolio may look better.”
Rossi says that because of the currency issue, UK assets or markets have a lower annualised volatility than global equity markets and therefore you will expect the global markets to offer a higher rate of return.

However, he points out: “In the course of the last five years that hasn’t been the case, just because the UK market has performed well and sterling has been strong.

“Over the last five you would actually be better off investing in UK equities than you would in global equities. But you have got to ask yourself, over the next five, 10, 15 years, where you think the growth is going to be.

“And you have got to look at what is taking place in China and India – we would argue that the potential for earnings growth rate is greater outside the United Kingdom.”

Hamilton agrees that although the UK has performed very well over the last five years – which has meant that having a strong UK focus has not been particularly damaging for investors – it is unlikely to continue to be that way forever.

She says: “Looking forward, reducing a pension scheme’s home bias to equities should help to reduce its overall risk profile, increase the opportunity set and enhance returns.

“One obvious risk for pension schemes is that their portfolios inadvertently expose them to macro factors such as the price of oil. While we are comfortable with some macroeconomic sensitivity in the portfolio, we look to pick the best stocks, while eliminating potentially damaging macro exposure for our clients.”

Rockefeller points out that pension funds only have the past to use as a gauge for the future, which is not exactly an accurate method.

She says: “People are trying to be forward looking – they’re trying to look for where the growth is in the future. The biggest problem with that is people tend to overpay when they are looking for growth for the future, because it’s always hard to identify, and when it is seen to be identified too much money often flows into it too quickly.”

Pension funds have historically had a strong domestic bias, often preferring to invest in sterling stocks than take the slightly increased risk factor that comes with investing off shore in different currencies.

Hamilton says domestic equities offer UK pension schemes greater familiarity and no additional currency risk, but the UK stock market also offers more of an exposure to the global economy than some investors might expect, particularly through the largest stocks.

However, it can also be said that pension schemes with a heavy UK bias are missing out on some of the world’s most attractive companies.

Hamilton says: “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 are heavily represented in the UK stock market.”

Rockefeller points out that this caution is not limited to UK investors but is seen worldwide.

She explains: “There is some sense to it in that the plan sponsors know their own country’s companies, they feel comfortable with them and their liabilities are in the same currency – so if their currency were to appreciate and their liabilities go up with the currency, having domestic investment will move with along with it.”

Breedon believes funds should take care to seek diversifications opportunities, and that restricting themselves to one geographical location may impede such endeavours, despite the fact that most UK listed companies source most of their revenue outside the UK.

He says: “Clearly the scope of the global opportunity is so large that I think a mandate that restricts so much of your potential reward to just one geographical area is probably overly restrictive, and that every pension fund should a enjoy the diversification benefits and the return opportunities that going global brings.”

Rockefeller adds: “There really is a benefit to diversification and I think we will see an increase in the domestic investment going forward, although I doubt we will see people going to a full market weight.”

Despite their traditional caution, UK pension funds have been growing their allocation to international equities over the last few years, driven by a desire to reduce their domestic risk, particularly given the heavy concentration of the UK stock market in a few large stocks.

Hamilton suggests it has also been driven by the potential for higher returns.

She says: “Traditionally, many UK pension funds have sought exposure to overseas equities through regional mandates. But this is changing, and we are seeing strong demand for global ‘best ideas’ portfolios that offer the best prospect of premium returns.”

Breedon agrees with this assessment of the situation.

He says: “Historically funds have done an asset allocation between Asia, Europe and North America, seeking the best managers in each one of those regions to manage their money. A lot of those funds are reassessing this now and wondering whether it makes sense for their global allocations to think about a more unconstrained approach to global investing.

“In other words, one will focus on just getting the best ideas for the large universe rather than slicing and dicing the allocation between various regions.”

Rossi says one of the issues that schemes need to consider is that in their domestic benchmark they have global companies where the vast proportion of their revenue has come from outside the UK, be it Vodafone, the banks or pharmaceutical companies.

He expands: “If you look at BP and Shell, they get the vast proportion of their earnings from outside the UK, so if you are making that decision anyway, are you making the best decision by restricting yourself to those two stocks, when you have got Chevron, Exxon, etc. based in other countries?

“When you are investing in the domestic equity market you are by definition investing in the global consumer. The question then is: if you are making that decision anyway, through default of the index, are you necessarily purchasing the right stock?

“That is the issue of concentration, which is the biggest consideration for pension trustees when comparing the domestic opportunity with the global one.”

Finding the right UK-global equity balance
Due to the nature of large multi-national companies, investors will find that although they are backing a company listed on the UK stock exchange that company is likely to have holdings in dozens of other countries, and most of their revenue will be generated off-shore.

Therefore, when considering how much of their equities portfolio should be held globally, they need to consider whether they will take the tactic of investing in certain countries to gain exposure to their individual economic cycles, or whether they invest in certain types of stocks, (for example, car manufacturing companies, regardless of where they are based).

Breedon says: “We can come back to the usual argument of: What is the point of looking outside the UK or outside the US when so many of your large companies here do have globally diversified operations and therefore you capture the global opportunity that way?

“However, I disagree with that tactic. I think the opportunity set of those companies is rather narrow, so by broadening yourself to be more global, to actually find a lot of these companies out there in the broader world, you get a better diversification of your portfolio across all the aspects of different sorts of risk.”

Hamilton says: “In the UK and Continental Europe we are still seeing demand from pension schemes for specialist regional portfolios investing in Europe, Japan and Asia Pacific markets.

“This is in contrast to the US where the majority of pension plans obtain their international equity exposure through diversified global ex-US and global emerging markets mandates.

“In the UK we are seeing more schemes moving towards the US model, with an unprecedented appetite for global equity portfolios. Particularly popular are those mandates that allow the manager to choose their very best stocks worldwide, irrespective of where they are based, which sector they are in, or what size they are. The focus is purely on making money for clients.”

Rockefeller agrees, and says: “Once again you have to go back to what gives you a diversification benefit and you do want to have some exposure to growth. But certainly, no one is going to recommend selling all your domestic equities and putting everything into emerging markets. Those types of radical moves are not really prudent for institutional investors.”

Despite the increasing investment overseas, Breedon doesn’t think global equities will ever be on the same level as domestic equities in the eyes of trustees. He says trustees are too concerned with liability matching to take on additional currency risk and the allocations to global equity are much too low.

Breedon explains: “It is clear to our mind the UK is not completely correlated with the rest of the world – but it is highly correlated. So we think that although it is a clear possibility trustees will bear in mind, the reality of the situation is that the fear of higher risk is probably misplaced, particularly in an environment now where equity markets worldwide will become somewhat more linked than they have been in the past.”

Rossi agrees it is unlikely schemes will have a 50-50 split of global and domestic equities in their portfolios in the near future, although allocations to global equities are slowly increasing.

He says: “If you look at the proportion of pensions equity invested in UK versus global equities, there is still a very significant amount of money invested in the domestic market.

“But over time we think consultants will be leading pension funds away from going to domestic-oriented benchmarks, because they understand the concentration issue and they understand a lot of the earnings from the UK markets are coming from elsewhere.”