Equities: pursuing a bear?

Pension fund portfolios have seen massive equity outflows as schemes look for protection against market volatility. Traditionally, equity investments have been regarded as the portion of the portfolio providing both the necessary returns to cope with the fund’s liabilities and an inflation hedge through dividend payments.

Dutch, UK, Irish, Canadian and US pension schemes have traditionally had a high allocation to equities, which could make up more than 50% of their portfolio. From the second half of 2008 well into the second quarter of 2009, the balance changed for many pension funds who decided to shrink the share of their portfolio allocated to equities to the benefit of other asset classes. It is unclear, at this stage, whether this trend will continue in 2009 or whether equities will gain ground again.

A recent survey by Mercer – which polled around 1000 schemes from 11 countries – found schemes were increasing their allocation to non-traditional asset classes in a bid to manage their risks more effectively.

The consultant’s latest European Asset Allocation Survey found 35% of UK schemes and 60% of European schemes (excluding the UK) expected to introduce new investment classes into their portfolio to help manage future investment risk. 

Findings showed UK schemes favoured hedge funds, global tactical asset allocation and active currency. The survey found over 50% more UK schemes have allocated to these asset classes in the last year.

Mercer principal Crispin Lace says: “Both in the UK and Ireland the move away from equities is driven by both the market downturn and the increasing maturity of schemes. 

“As schemes close they tend to reduce their exposure to equities in favour of bonds, with the average closed scheme having a bond exposure that is around 10 percentage points higher than the average open scheme.”

In April, a different survey by bfinance pointed out that European and North American pension schemes were set to increase equity allocations at the expense of fixed income.

The consultant’s latest Pension Funds & Insurance Asset Allocation Survey found 46% of pension funds planned to increase their equity exposure over the next 12 months. In contrast, 35% anticipated a decline.  

In addition, 42% of schemes said they foresaw a decrease in their fixed income exposure over the coming year – while only 25% expected an increase in their bond exposure. bfinance said that since its last survey in 2008, 44% of pension funds had seen their allocation to fixed income increase.

According to bfinance chief executive David Vafai, the survey indicates a “surprising change of sentiment from investors”, with almost half of the respondents expecting an increase in their equity exposure in the next 12 months compared with only 19% in the consultant’s survey last October. The results seem to suggest that investors think the worst of the financial crisis is over.”  

The recent rally

Since their trough in early March, equities have gained [at the time of writing: mid-May 2009] around 20% in the London Stock Exchange. The other main markets saw equities climb in a similar way, prompting cautious hopes that the market had bottomed out, but also widespread feelings the market was switching to a bull phase. Experts tend not to share the recent enthusiasm of the market.

Sourcecap chief executive Andrew Parry points out that the big challenge for pension funds is to distinguish whether they are witnessing a bear market rally – which can be very significant in size and quite long in duration – or the start of a new bull market. 

He says: “If you combine this relief rally with quantitative easing and the various stimuli packages, it undoubtedly gave a healthy tailwind into a market, which is almost crying out for some positive news.”

However, he says Sourcecap believes this is clearly a significant bear market rally that could still last for quite some time, but which is bound to reverse.

Asset managers refer to the structural problems the global economy has not resolved yet to explain the nature of this rally. Stimuli packages coupled with quantitative easing are generally believed to be helping, however, concerns over inflation and worse economic data to be announced might cause the rally to stop.

Redington’s founder and co-chief executive Robert Gardner said the outlook was still one of extreme uncertainty. He says: “What we have seen over the last two months is a technical rally. Our view is that fundamentals are not there to underpin the recovery everybody is talking about. Economic statistics across the UK, Europe and the US continue to point to rising unemployment and sub-sustainable growth in GDP; this impact on the real economy will continue to be negative for the outlook on equities.”

 What has happened, Gardner continues, is that the rate of change on the down side has become a lot slower than during the last 12 months. In addition, he says: “The rally has been driven largely by investors who are either short or underweight, and are now struggling to get back overweight as the market runs away from them.” However, he points out a similar pattern happened in 2008 when the market rallied strongly and then crashed again. 

Many industry players refrain from predicting when the situation could change. On the other hand, most maintain a positive outlook over the short term. Legal & General Investment Management equity strategist Georgina Taylor says: “We think that the move we have seen so far will continue in the next few months, namely that equities will continue to rise. There will still be an upside over the next few months. But, later on this year, there will be more volatility on the basis of the readjustment of economic forecasts.”

Pension funds

Such a scenario clearly does not offer any obvious options to pension funds, which on the one hand need more than ever to generate higher returns on their investments, but on the other cannot afford to have further losses.

Gardner points out it is difficult to suggest to investors that they make any significant increase in new allocations to equities until the fundamentals return. 

On the contrary, he says: “A core theme for our clients is the use of credit and, in particular, investment grade credit to match scheme liabilities. We are also recommending that clients add inflation swaps over the top of that credit exposure to better match liabilities.”

“There is a general consensus that strategic asset allocation, i.e. the capture of long-term risk premiums, is the only sensible approach to asset allocation. According to academia, markets are impossible to forecast. However, managed futures have proven the opposite for quite some time now. In the same way in which you do not invest all your money in one single equity, why would you bet all your risk budget on one asset alloc­ation approach? Long-term risk premiums are neither easy to forecast, nor that profitable to invest in. How about trying something new?”

According to SEB Asset Management portfolio manager Hans-Olov Bornemann, the equity market would not drop to the negative levels of 2008. Nonetheless, he says there were going to be “some short-term hiccups” on the way to full recovery. 

Taking that into account, Taylor says pension funds seemed to be tentatively coming back into the equities market, but she does not think they are repositioning for an overweight at all. She says: “They are starting to test the water but there is still a long way to go.”