Downsizing UK equities

“For an equity portfolio we would be starting from 10pc in the UK. We do not believe it is necessary to have a home equity bias.” This is the UK’s market weighting in the global equity market according to Cardano chief executive Kerrin Rosenberg and his opinion on the logical position for an investment fund to hold. Rosenberg, previously a significant investment consulting figure at Hewitt, is pursuing some radical investment advice at new consulting firm Cardano, which recently won the consulting brief for the £3bn Astra Zeneca pension fund.

Few, though, are willing to accept Rosenberg’s stance on UK equities just yet, even if UK equity holdings have been moving steadily south.

Research by Mercer this year puts the typical pension fund holding of UK equities at 53pc of their total equity allocation. Being an average, this figure suggests that a good proportion of funds are now moving UK equity holdings as low as 30-40pc. While it is not known if any funds have yet gone as low as 10pc on UK equities, Rosenberg believes this is a logical stance.

“Our approach to equities is to be global,” he says. “So, just because you are in a UK pension fund does not mean you should skew your portfolio to UK equities, unless you have a very positive view on UK equities compared to the rest of the world.

“We are not negative on UK equities, but we do not have a very positive view on it compared to the rest of the world. If you want a bigger proportion you are expressing a view. That is OK if you think the UK is a better place to be than America or Europe or Asia, but if you don’t actually believe the UK is going to outperform why would you bias your portfolio?”

These are quite radical views, not least because UK equities have looked a pretty safe bet over the last four years. There are other reasons against this view too.

Traditionally, a 70pc equity proportion for the UK was seen as a good way of hedging liabilities that were to be paid out in sterling. Though according to the UK’s biggest manager of equities for UK pension funds, the time when a switch to a totally global view on equities is a long way off.

Legal & General head of DC strategy and governance Ian Richards says: “There is a difference between what the consultants might believe and what clients are prepared to accept. We have witnessed a trend over a number of years to cut UK equity size, but very few have got down as low as 10pc.

“For most pension schemes a 50/50 split is where they feel comfortable. Though we have clients who are saying we still feel uncomfortable about the UK, so we will go lower than that. The advent and resurgence of currency hedging has enabled more and more of them to say we will go below 50pc UK, but we will hedge the currency risk. The question is how much do we hedge?

“I would be surprised, however, if there are many people out there with a 10pc UK holding and a significant overseas currency hedge. If you hedge the whole lot you are effectively back to square one again of it being effectively 100pc UK.”
Another sceptic of the 10pc view is Standard Life Investments global thematic strategist Frances Hudson. Her role is to look at investment themes that play across asset classes and markets.

“Choosing 10pc because 10pc of the world equity index is UK is a little bit simplistic,” she says. “Many of our largest companies get a substantial part of their revenues overseas, so buying the UK does not mean you are buying domestic-only exposure – some of our biggest companies are in the oil sector or mining with most of their operations overseas.”

Hudson adds that the traditional logic of pension funds holding UK based assets to match UK based liabilities has other merits too.

“This position avoids taking unnecessary risk. If you put all your money into China on the basis that China is the fastest growing stock market, it might look superb but then if China alters its currency and does it substantially, or if China says that you cannot take your assets out of the country – which has happened in other countries in the past – then you are not left looking quite so clever.”

In addition to avoiding greater political risk, Hudson points out that corporate governance in this country is very well policed and that this gives pension funds with large allocations to UK equities a degree deal of comfort.

Pension funds with strong socially responsible investment principles are going to find it easier to vote on issues they understand with UK companies than companies based overseas. Trustees find it easier to understand UK equities, and introducing currency hedging to marry in with a large global equity coverage will only complicate things further.

Hudson sums up: “In looking where to invest you have got your investment goals on the one hand, but you have got your risk budget too. That is what actuaries are all about – creating a sophisticated risk profile – so you take into account political risk, supply and demand issues.”

It should be borne in mind too that many pension funds have got more pressing concerns than their UK equity exposure.
“The relative size of the UK and overseas exposure is a minor issue compared to overall equity market risk and interest rate risk,” says Aon Consulting investment consultant and actuary Daniel Peters. “These issues probably dominate trustees’ agendas more. The very big schemes will have time and governance to be able to deal with this and we are seeing some schemes going for 40pc UK equities exposure.”

Diminishing UK
If 10pc is extreme and 50pc is the norm for holdings of UK equity, what are some of the more high profile pension funds current allocations?

The BT Pension Scheme is looking to switch from an approximate 43pc equity holding in UK equities to one of 40pc. As a proportion of its total assets its UK equities represent 21pc, while its overseas assets represent 28pc. However it plans to move 2pc of total assets from UK equities to increase a 13pc allocation to alternative investments.

The JS Pension and Death Benefit Scheme currently has a 30pc UK holding in equities. As a proportion of total assets its UK equity holding is 15.9pc, whereas overseas equities represent 37.1pc of the total. It plans to reduce the general equity proportion but does not say where to.

These figures would back up Legal & General Investment Management’s view that some funds are finding their size of UK equity holdings uncomfortable. However, the Sainsbury’s and BT pension funds are two of the best maintained and resourced schemes in the UK, and the bold moves they make may be beyond others.

Managing the switch
While the logic of shifting away from UK equities due to fears over concentration of risk in a few shares and market sectors maybe sound, the move to overseas equities involves complexity. Principally this is the cause of currency risk.

The current low value of the dollar in comparison to the pound means that any big gains you are making on US equities are potentially lost through transferring them back into sterling. The strength of the pound against the yen has also hit earnings on Japanese equities. Basically, the bigger the allocation to overseas equities then the bigger the currency risk.

This risk is encouraging more and more funds to appoint currency hedging services. Notably the BT pension fund, which has 28pc of total assets in overseas equities, currently uses currency hedging for half of this exposure (as does the London Pension Funds Authority, which recently appointed Record Currency Management for this purpose). Both funds also use their currency managers as a chance to make alpha gains on currency markets too.

While this is clearly becoming best practice among pension funds – and according to Mercer one-in-four of its clients currently use currency hedging – it poses new problems too. Some would claim that the use of hedging adds new uncertainty and another risk for the scheme to manage when it really should be focusing on the end game and focusing on liability-driven investment. Typical of the complexity is the suggestion that pension funds not only use currency hedging, but take a punt on currency through futures and options as well.

Crossroads
Managing the complexity of a move away from safe familiar asset classes poses a cross road for pension trustees.
NAPF investment advisor David McCourt says that both trustees and consultants must rise to the challenge.

He says: “If consultants are going to bring these new strategies to the table they need to explain them at the outset. They also need to keep the communications fresh so that the trustees can follow them over time. It is all very well giving them a training session in January, but by June when they get the first performance data through they may have forgotten what the principle was. This is a challenge to the whole industry, as trustees have equally got to commit to keep abreast of these new strategies.”

The better resourced board of trustees may take this in their stride, but for those with less time the added understanding, monitoring and governance could prove unwelcome.

Some believe the answer is for trustees to adapt their roles and to take on better resourced and more capable advisors.
Investment consultancies such as Cardano have geared themselves up for the new complexity in fund management by hiring people from investment banks and fund managers who have hands on experience in using currency hedging, derivatives, alpha equity management and more. The idea is that this skill-set should make trustees more comfortable that their new complex investment strategies are in good hands.

Rosenberg says: “Trustees have to ask themselves how much of an expert can I really become? To what extent can a trustee become an expert in all areas, or should they be looking for a partner who is an expert and on whom they can rely? That is our proposition. If we have the right kind of relationship with our clients they do not have to become experts in everything and that’s pretty much how a non-executive role works on a board of directors.

“A trustee, like a non-executive, has to be comfortable that the management team that is in place understands what they are doing. If they do not do their job, then change them. I think it is very difficult for the trustee to be an expert in all areas. If you think of the time restraints, it is almost by definition a non-executive role.”

Clearly this will not be the answer for all funds, especially those looking at the end game. Possibly, if such complexity is to become best practice, this will push more sponsoring employers into looking for a buyout of their funds.


Concentration risk
Major worries over several companies dominating UK equities started in 2000. That year Vodafone acquired Germany’s biggest mobile phone operator Mannesmann and gained a 12pc weighting of the entire FTSE100. This meant that many UK pension funds were left with more invested in Vodafone than some of the major world economies.
Up until this point the logic of holding 70pc of equities in the UK and 30pc overseas had not been challenged, but now there was a rethink.
Many funds shifted to a 60pc:40pc ratio as a result. However, concerns have grown and the five largest stocks now account for around a quarter of the UK equity market. Notably the four biggest stocks – BP, Shell, GlaxoSmithKline and HSBC –underperformed in the last financial year. This has led to a further decline in holdings; Mercer calculated in 2007 that on average UK pension schemes now only have 53pc of their equity assets invested in the UK market.
One of the problems of the FTSE being heavily weighted to a handful of stocks is that it does not give full exposure to all types of industry. UK equities are dominated by banking, natural resource and mobile phone sectors, which means too much investment risk is focused on limited opportunities. This leaves funds with little exposure to growth in key areas such as the information technology sector.
Concerns over UK equities have coincided with exciting opportunities in emerging markets, which have been one of the beneficiaries of a downsizing of UK stocks.
There has also been increased interest in global weightings. A few years back many funds grew their European equities on the understanding that the UK would replace the pound with the Euro. Another trend was to place an increased emphasis on UK companies that derived the majority of their income from overseas, as a way of diversifying from the UK. A mid-way trend is for a 50:50 split between UK and the rest of the world, but the most extreme trend is to simply invest along global weightings for equities, for which the UK just represents around 10pc overall.