Keeping an eye on UK equities

These are nervous times for equity investors. Trustees would do well to remember the much-preached mantra that pension funds invest over the long term and should not be swayed by short-term volatility. Nevertheless, if the current global equity crash is sustained then tactical geographic allocations to the asset class could be revisited by scheme investment consultants.

UK pension funds have long held a significant domestic bias to the equity allocation. In today’s environment this seems more of a legacy constraint than a pre-meditated decision. The allocation to UK equities has come down gradually as trustees seek to diversify risk and customise their assets to closer match the particular liability profile of their fund.

“I see this trend continuing,” predicts Credit Suisse Asset Management head of UK institutional equities Phil True.

He continues: “Investors’ decisions tend to be subject to various biases, one of which is called ‘familiarity bias’. This simply means that as investors we prefer to purchase stocks and assets that we are familiar with. Trustees are no different and for this reason pension funds worldwide tend to have the largest proportion of their equity allocations in their own domestic market.”

Interestingly, Courtiers chief investment officer Gary Reynolds says the UK has, for some time, been the less affected by this “familiarity bias” compared to US and Continental pension funds.

Reynolds says: “However, one of the conveniences of investing in the domestic market is that your assets are generally held in the same currency as your liabilities. Further, as pension liabilities are invariably valued based on a discount rate that is determined by reference to the long-term yield on domestic market bonds, choosing domestic market fixed interest can mitigate the risk that assets and liabilities move in different directions.”

Watson Wyatt senior investment consultant Nick Sykes says: “Equities are held in pension schemes for return purposes rather than liability-matching, so global equities with currency exposure hedged would be the logical end-game for pension schemes. We are not there yet but would expect this to be the direction of travel.”

The proportion of assets invested in UK equities has been gradually reducing over time. Schemes have been moving these assets in bonds and overseas equities. Within overseas equity the move has been towards emerging markets and Asia pacific (ex-Japan).

“Our previous house view was that 50pc of a plan’s equity investments should be invested in overseas markets, for diversification rather than return purposes,” says Stephen Dowds, head of international equities at Northern Trust Global Investments. “Of the overseas assets we either recommended a market cap approach, GDP approach, or equal weighting across the major asset classes – clients tended to opt for the equal weight, particularly UK subsidiaries of US plans, so to avoid too much US exposure.”

CSAM’s True adds: “Fortunately, UK equities can provide some diversity and good income characteristics of their own. It would be impossible not to have noticed a big pick-up in volatility in share prices, and this reflects concerns about how much the global economy is slowing.”

Central banks have a difficult juggling act to keep growth and inflation on course, but weak markets always throw up interesting opportunities. It is the sort of market to back tried and tested management teams, preferably ones that have seen difficult times before.

True adds: “The UK market consists of companies with a wide geographic base and they will not escape any economic
turbulence. On the plus side, dividends have always been an important part of shareholder return in the UK and most companies will still be able to afford a higher payment even after recent events. In the long-term, dividend growth will take share prices higher.”

The UK equity market has discounted a considerable amount of bad news in recent months, and is cheaper than it has been in some time.

“We feel that a cautious stance is still warranted over the next few months, as earnings expectations have further to fall and the repercussions from the credit crisis continue to play out,” warns Aegon Asset Management’s head of equities Innes McKeand. “There may be rallies on optimism over the potential for interest rate cuts. Longer term, we feel that the market has valuation support versus bonds, and has the potential to re-rate as interest rates fall.”

The fallout from the credit crunch has sapped the expectations of even the most bullish of managers. Investment consultants, equally, are talking down the market; the road ahead is uncertain and bleak.

Jewson Associates, a relatively new independent investment consultant established only 15 years ago advising UK pension funds and private clients, says there are question marks over the UK property and housing sector in addition the broad global economic growth malaise.

Jewson’s director of research and strategy Charles Franklin says: “Stocks in some UK sectors have fallen dramatically but the market as a whole has probably not yet fully discounted the deterioration in the outlook for corporate earnings.

Valuations may therefore not be as attractive as they seem and although one would expect interest rates to come down as growth slows, they will probably not come down as fast as needed given the inflationary pressures in the global economy.”

The case against UK equities
The evidence to posit a negative outlook for UK equities in the near term is almost overwhelming. Sterling is weakening – and may well continue to fall – driven by a combination of a large trade deficit, prospectively lower interest rates and the potential for an unwinding of the boom in house prices that has been such a feature of the UK economy in recent years.

UK consumer confidence hit a 10 year low in December, as shoppers were squeezed by rising fuel and food bills, higher petrol prices and mortgage costs – and any significant fall in house prices can only augment this feeling of diminishing wealth.

Weak Christmas sales by high street stalwarts such as Marks & Spencer, Tesco and DSGI, the Dixons group, seemed to confirm this trend, as these companies reported sales growth below that anticipated by the market. Furthermore, significant cuts in interest rates by the Bank of England are by no means guaranteed as the spectre of inflation continues to haunt the central bankers.

Aegon’s McKeand says: “We retain a cautious view going into 2008. During 2007 we moved to become increasingly defensive in our UK equities portfolios, selling domestic interest sensitive and consumer-related stocks such as housebuilders, general retailers and real estate. We expect this stance to continue to work this year. We continue to play an ‘east over west’ theme via the mining sector in particular, as strong growth in China drives demand for commodities such as coal and iron ore. We favour the platinum group metals in particular.”

CSAM’s True adds: “We tend to look at the market in terms of broad themes rather than sector positioning. For instance, it is a consensus call to be underweight UK retailers, but some of the internet ‘e-tailers’ did well over Christmas as the penetration of broadband in UK homes accelerated and consumers became comfortable in ordering online. So although we have been underweight consumer stocks generally, there are always opportunities.

“We like the Aerospace sector as a ‘defensive growth’ late cycle industry, and some of the high quality cyclical stocks in the engineering sector look to have been de-rated too far. On the negative tack, I think the big run in mining stocks looks to be nearing a conclusion and I wouldn’t be in a hurry to climb back in. There is a consensus bet against mid-cap stocks, but the fact is you can only get exposure to some interesting opportunities by buying in this area, and I wouldn’t have size as a big factor in choosing a stock.”

Light at the end of the tunnel
The consensus view is that small and mid-caps are likely to under perform. They are more cyclically exposed, more expensive than large caps, have performed extremely strongly since 2003, and are vulnerable on premium valuations.

“We have moved in recent months towards large cap stocks, as we believe that the market will increasingly ‘pay up’ for quality, growth and predictability. We favour stocks such as Scottish & Southern Energy and Vodafone. We remain underweight financials, as the banks face margin pressure, a deteriorating credit environment, and the ongoing fall-out from the sub-prime crisis,” adds McKeand.

However, amid the gloom NTGI’s Stephen Dowds pitches a ray of hope. He says: “On the other hand the UK market has already fallen by more than 12pc since its summer highs – and the sell-off has been pretty indiscriminate. A more positive image is painted by the likes of HMV (which reported stellar sales in early January), Waitrose and Primark. Given that employment remains relatively high and demand for housing should continue to outstrip the limited supply, under a scenario of loosening credit markets and a soft landing in house prices, there is potential for a bounce in markets later in the year.”

In that scenario, such stocks demonstrate top line growth or which are strongly asset-backed could represent some attractive opportunities.

The method of investment in equities is still in some transition. The two routes – segregated mandates and fund of funds – offer different benefits. There is a long-term shift to specialist managers in UK equities, both via multi-managers and through segregated mandates. Many funds invested in UK equities are getting exposure to “beta” through low cost trackers, and “alpha” through high performance fund managers.

CSAM’s True says: “We offer both medium and high alpha products in a pooled pension wrapper, and the ability to run segregated mandates using the same investment team and process. We use market themes as the starting point, and then use fundamental-based screening tools to target the best stocks to play these underlying themes.”

In recent years, the fund of funds has become more popular for two critical reasons: the cult of the star manager and the fact that fund managers are more likely to work harder to maintain performance in its published flagship fund than under a private mandate. Based on very strong research and academic evidence, many trustees are beginning to realise that strategic long-term asset allocation will determine 100pc of their returns. As a result, they are looking for more efficient ways of taking their exposures.

Step forward equity derivatives. At the start of 2007, Courtiers launched three total return funds that are invested through the derivatives market. The notional value of derivatives is now in excess of $500trn.

“Derivatives enable trustees to synthesize returns in an extraordinary cost efficient fashion and we believe the use of synthetic mandates, like those provided by Courtiers, will become more popular in the future,” says Courtiers’ Reynolds.

One of the critical, yet sometimes difficult decisions, which trustees are charged at undertaking is deciding when to fire their fund managers. Corporate activity such as mergers and takeovers tend to be disruptive; high staff turnover is a good indication of an unhappy firm; a change in the key manager is an obvious concern; style or process change is often an indication of a firm in panic and even excessively good performance, which is often followed by excessively poor performance, i.e. reversion to mean.

“Watch out, for example, when the manager that told you they were an expert in large-cap UK stocks suddenly starts buying small-caps. Normally, this happens when the manager is under pressure and starts chasing returns in desperation,” argues Reynolds.

He continues: “Be careful when, after a period of relatively good returns, the manager starts telling you that despite the absence of prospects for significant returns they nevertheless believe there are reasons why losses will not occur. This normally means the likelihood of sustaining large losses has increased. As an example, take a look at some of the reports from commercial property managers towards the end of 2006.”

Trustees should be alert to broad shifts within the market and how that relates to their managers’ mandates and styles. For example, we believe that the out-performance of small and mid cap stocks over recent years has come to an end – it would be sensible for trustees to be reviewing this type of mandate. Trustees should also monitor carefully the performance and risk profile taken by existing managers to ensure that they remain consistent with expectations.

Trustees do face a difficulty in the event of poor performance, as it can take time to recognise and address the problem. Conducting new manager searches can take considerable time, and the industry as a whole tends to be slow to deal with underperforming managers and adopt new managers.