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Equities: living in an uncertain world

Written by European Pensions team
March/April 2011

Recent economic turmoil
Chairman [Michael Kinney]: The first question we have on the agenda is: what impact has the recent economic turmoil had on equities’ reputation among European pension funds? Starting locally, as we are in London, UK growth figures for the last quarter of 2010 were somewhat lower than expected. Are there any conclusions to be made for equity markets from this?

Gallagher: I don’t like to give too much credit to any one data point and I know there were some extenuating circumstances surrounding those figures. Also, I don’t think one bad quarter is necessarily anything to get too concerned about; obviously it is worth paying attention to, but it’s only when you start to see subsequent quarters experience poor growth that you need to worry.

Nusseibeh: Let’s take it in two stages. First, what does it mean to Britain within the context of Europe, and what does it mean in the wider context?
Within the local European context, we do have very clear data points that indicate we have an inflationary issue. Mervyn King predicted earlier this year that things were not only going to get worse economically, but inflation was also going to get worse, and you could say that justifies what the UK government has done in cutting its deficit so quickly in order to try to protect its position and allow it to begin financing itself.

But the worst possible thing that could happen would be to, ultimately, have low or no growth with inflation. That would lead to the dreaded ‘s’ word, stagflation.

Prior to these results, the view was that the UK had dealt with its problems better than the rest of continental Europe, so it was closer in some ways in the recovery cycle to North America. But this makes you wonder. We have had massive amounts of quantitative easing, and it now looks as if the transmission mechanism of inflation has changed, so it is transmitting to emerging markets and then transmitting back to the US, and if that is the case, then you desperately need growth otherwise the ‘s’ word becomes a possibility.

O’Malley: It was interesting to see that as soon as the announcement came out, the Bank of England spoke out backing the government and said that they should not stop their cuts. On the one hand the UK government should be given credit for acting quickly in order to deal with its deficit and praised for doing so in comparison to somewhere like Canada in the 90s. But at least when Canada did it there was a lot of growth going on around the world.

Also, there does appear to be a global tug of war going on between emerging markets and developed markets. In the emerging markets, particularly in countries like China, they are trying hard to limit inflation at the asset level, whereas the developed markets are doing things differently, trying to ease it so that they can re-flate in that sense.

Wilson: I think from a global equity fund perspective it is obviously worrying – low growth in the UK is not something that you want to see; but it is not necessarily going to have a massive impact in comparison to some of the other dynamics going on at the moment.

Asset allocation
Chairman: How does this affect our views on asset allocation – equities versus bonds, ignoring the liability part of the equation for now?

Nusseibeh: I think we need to re-think how we evaluate bonds versus equities. Part of the results of 2008 and the fact that you have growth in the sovereign debt of developed markets, coupled with the fact that some European countries, at the periphery at least, might have question marks around their ability to repay back their debts, means that bonds might be more volatile than people assume.

So, funnily enough, it makes equities more attractive and it potentially makes developed market equities more attractive because there is no political risk attached to them. With developed market equities, you get the best of both worlds.

You get some ability to benefit from an inflationary environment, you get the ability to benefit from the growth around the world, and you get stability – albeit not completely, there is volatility in there but if the other assets are also volatile, the equation changes and you have to rethink what the risky assets are.

Gallagher: Well, when you look at the balance sheets of the three players – governments, consumers and corporations – consumer balance sheets, at least in the West, are awful. Government balance sheets are awful and getting worse. But corporations that over expanded in the run-up to Y2K and that have been on a diet for the last ten years have done a great job of extending maturities, so their funding position is much more stable. I think the corporation balance sheets therefore are the star in the mix. The risk has gone out of corporations to some degree, while it has increased at the government and consumer level.

Wilson: I don’t think any of us would disagree with that and, going back to the question of asset allocation, I don’t think there is any doubt that if you just took the pure asset allocation viewpoint at the moment, you would be increasing your equities and decreasing your bonds. The reality is, of course, that we are not in that situation.

It is all about regulatory risk here and what the regulators say, whether that be in the UK, Holland, or Scandinavia. In places like Holland, for example, you are seeing more and more pension schemes having to move towards liability driven investment, so they are being pushed towards bonds, while in the UK we are trying to get to a situation where we are fully funded and so can take the risk entirely off the table. So the drivers have just gone completely away from what they should be.

Chairman: What does that mean for equities within a growth portfolio?

O’Malley: If you are trying to decide what the allocations would be within equities, it really depends on what you are trying to achieve over the piece. You then have to decide whether you believe in the growth aspect and try to put the two together. What the last couple of years has done has brought de-risking to the forefront of thinking, particularly in Holland where they now have to give a monthly report on where they are. But it has also made short-termism come to the fore.

In the last couple of years, there has been this de-risking shift and people have moved to bonds where they can and there was quite a lot of movement towards credit which did quite well for some time. But now, over the last year, yields are nothing like they were or what they should be, so it makes a case for equities, both for emerging market and developed market equities.

European equities at the moment are the sick equity of the world, yet we are finding that there are an awful lot of opportunities from a bottom-up perspective in European equities, because a lot of them have exposure to emerging markets. There is a great amount of faith placed in domesticity when it shouldn’t be. It should be about a company’s revenue generation and where it’s derived.

So from our perspective, we see a lot of growth opportunities and we think going forward there will be much more in terms of growth opportunities.

Developed versus emerging
Chairman: One of the simple divisions when it comes to structuring an equity portfolio is developed versus emerging, and we have seen a lot of activity in emerging and indeed a lot of the good managers reaching capacity. Is there a pressure building there that says we should be careful of the emerging allocations going forward?

Wilson: But pension fund allocations are still very low when you look at their overall equity portfolios. We are seeing huge numbers of listings and these markets are growing.

At the moment, for example, another three or four Russian companies are coming to raise equity capital in London. So these markets are going to grow in terms of size.

It does depend a little bit on how you access these markets in terms of the size of companies you are looking at. If you are a traditional bottom-up emerging market manager you are probably going to struggle to take on a lot of assets. If you are looking at the higher end and you are doing it on a global scale, then it is probably quite accessible and there is still plenty of scope for increasing that weighting.

Nusseibeh: I am a great believer in the emerging story but let’s take a step back. Yes there is a lot of growth. Yes, you can access growth in a variety of ways, but to a certain extent everybody is getting over excited and forgetting about the risks.

These are pension funds we are talking about and they may be taking for granted some ridiculous statistics that are pushing them to put more into emerging markets than they should. We mustn’t forget that there is no political stability in emerging markets – it just doesn’t exist and to pretend that it does is nonsense. As long as we remember that and we factor that into our risk budgets and understand that by definition emerging markets are riskier, that’s OK. So, yes, emerging markets are interesting, yes you should expand to them, but I would say the safer way is through developed market companies.

Wilson: I couldn’t agree with you more and you have got to take all of this into account whenever you are investing directly. That then leads to the debate as to whether you go by developed markets or emerging markets.

Nusseibeh: But as an industry we should warn the pension schemes not to get too influenced by the hype. There is now a higher trend also of putting more and more into emerging market debt for example, which is something I question because of the market structure.

Gallagher: I do think there is a short-term and a long-term perspective that we have to consider here. There is no question there has been a lot of pressure to invest in emerging markets, and in the rebound emerging markets have seen better performance than the developed. Growth is clearly stronger in that part of the world.

Of course, there will be a bump and when that bump comes there will be some underperformance from the asset class. However, looking longer term, the secular underpinnings are very strong, primarily the increase in consumer income in those markets and the movement of those consumers into what can be considered middle class. That number of consumers is projected to come close to doubling in the next decade, so that is a very strong underpinning and I wouldn’t want to miss it.

Over time, there is no question that investors need to be focussed on emerging markets, but I would question whether you need to be in the next six months as emerging markets still have a little bit of work to do to manage their inflation issues.

Nusseibeh: Yes there is growth, I absolutely agree there is a growing wealth and it is right to try to benefit from that. My concerns are two-fold: firstly, everybody is in the same trade, so it is a very crowded trade and that is always a sign of danger. Secondarily, I think, with the exception of India, the political structures aren’t stable and that worries me.

Gallagher: I think there was a change about ten years ago. If you look at emerging markets relative to developed over the last 50 years, the GDP never grew, it was 18-22% of the world’s total from 1960 to 2000.

But I think something has changed since then and maybe it was China joining the WTO, Russia talking about joining the WTO, Eastern European companies becoming part of the EU, there have been some fundamental changes that have also occurred and I think that means we have broken out of the 50 year range.

O’Malley: There’s often too much focus on where the headquarters of companies are rather than where their revenue comes from. The companies in the S&P 500, for example, together derive about 50% of their revenue from abroad, with about a third of that coming from emerging markets. The S&P 500 has been globalised for years, but it has still underperformed the MSCI Emerging Markets index by more than 10% annually over the past decade.

We always show our clients both Revenue exposure as well as Geographic exposure.
There has also been a shift over the past 10-15 years in the thinking of the US and where they invest their money – 15 years ago the US were still pretty much home biased in terms of where they invested. The other thing that has been forgotten is the ease of which you can now trade in emerging markets which is much easier than it used to be and access to markets is much more open than it used to be despite the supposed political risks.

If you look at US stock now, about a third of it is non-US in terms of where you invest and that is a huge increase on what you had ten years ago. The MSCI All Countries World index is now 60% non US stocks and that is huge shift as well. So I think there has been a big shift with the biggest investor in the world.

Chairman: Do you have any views on the relative merits of the developed regions?

Wilson: We look at the world in sectors rather than regionally – we are trying to compare companies within sectors where their business is and comparing things that way. OK when you are valuing an emerging market company you of course take all those ‘emerging market’ risks into account.

So from our point of view, you look around the world – in the UK a plus point is that it is so international in terms of the companies that are here; in Europe, you can take a top down view of Europe and you can be very worried at the moment.

There are always going to be opportunities within any particular region around the world, so it would be difficult to pick one region over the other in terms of valuations.

Equity allocations
Chairman: Equity allocations in the UK and Ireland are much higher than in some parts of Continental Europe. Are allocations too high in the UK and Ireland or are they too low elsewhere?

Wilson: I would say equity allocations in Germany are too low - some are around 6%, but even there they are allowed up to 30-35% in terms of risk-taking assets but they normally run 10-15% or something along those lines, so it is still pretty low and there are signs that they are increasing some equity allocations at the moment. The big shift in Europe however is a move away from domestic allocations towards global allocations.

Chairman: That is also true of the US.

Gallagher: Absolutely. I think a lot of it has been about performance. There was a period when the US outperformed non-US equities and so the reaction was, why do I need to invest anywhere else, I am getting better returns here? And obviously that was the time you wanted to begin investing. I think right now confidence has been shaken in the US economy and people want their money elsewhere. They believe their money is going to be treated better elsewhere from a taxation standpoint and from a regulatory standpoint and I wouldn’t disagree with that too strenuously.

Nusseibeh: Do we have too much equity in the UK? My bias would be to say no, but the regulatory mood in Europe is pushing the UK closer to continental Europe rather than continental Europe to the UK. I think it is the law of unintended consequences – the regulator is trying to deal with something that happened in 2008, part of dealing with that is forcing pensions to take greater risks because they don’t really understand risk at the moment and are curtailing their possibility for growth.

It is like this whole discussion about LDI versus benchmarking. Everybody talks about it as if it is new and it is not. It is just a new name for it. I was talking to somebody who was in the Barings pension scheme and he explained to me that until the 1970s they used an absolute return target as normal and that is what they always used because that is how Barings bank paid for it.

So it is a matter of understanding risk and my worry is that the regulator's starting point is that sovereign debt is risk free and everything
else is risky. And I don't think that is the case.

Benchmarks and indices
Chairman: Picking up on the topic of benchmarks – there are a lot of different ones out there, but what role do they play? For example, is the market cap index relevant any more?

O’Malley: I think investors have become disillusioned with the performance of cap weighted indices.

Some of the fundamental indices are starting to be tentatively used, particularly in Germany and France etc which is maybe a bit of a reason why Germany is weighted where it is, but if you are a passive investor and you want the most diversified portfolio you can get, you are not going to get that with market capped weighted indices. If I said to you, you had £1m to invest, would you do it on the biggest companies available or the best opportunities?

So, are the existing benchmarks appropriate? Probably not, but they are what they are, and the request from trustees is that we need to be measured against something. Trustees understand them, some people are making an awful lot of money out of them, and so unless there is a fundamental shift in the industry, they are going to be around for a while longer.

Wilson: From an active management point of view, increasing amounts of money are going towards these indices and passive funds, and I don’t think that trend
is necessarily going to change.

That gives us the opportunity basically to ignore that benchmark and go overweight wherever we want to add value for pension funds. So as that trend increases it creates an opportunity for us as an active manager.

Gallagher: I think a benchmark has to be a reference point. You do have to measure yourself against something but it shouldn’t be an anchor, you shouldn’t be drawn towards the benchmark because sometimes the benchmark is the risky place to be.

Chairman: I prefer the expression of performance yardstick to benchmark.
Nusseibeh: I agree. Let’s remember what a benchmark is for – it is meant to be used as a yardstick. You have to be careful how you use it. It tells the plan sponsor whether one fund manager is as good another, and that’s all.

Chairman: Or has been historically.

Nusseibeh: Absolutely. It is purely a reference point but it doesn’t give you the world because the world is much richer and bigger an opportunity set.
Gallagher: I think the best benchmark at the end of the day is your pure ranking.

Risk management
Chairman: We have talked about risk in emerging markets, but within the context of risk management, more generally, does anyone see any particular trends or issues that they would like to highlight?

O’Malley: I think we have mentioned the main risk – double dip recession. You could argue that there are a lot of good balance sheets out there at the moment, a lot of cash. Most people at the moment have been prudent with their cash, but there is a risk that some of that cash is going to be off-loaded and it is not going to help matters.

Systemic risk is another risk that should come into the equation. Going back to a point that was made earlier – if you think everything is politically unstable then systemic risk should be in your thinking all the time. One of the things that we have done has been to buy put options on indices just to rattle that down. You can only do it when it is the right time to do it and when it is cheap enough to do it for the right reward, but it is one of the things we think about a lot.

Nusseibeh: We are not out of the woods yet as far as the banking system is concerned, we really are not. Particularly not in Continental Europe where systemic risk is not out of the equation – less so in the United States perhaps?

Gallagher: I think the US has got some issues. If you look at Europe in the aggregate and the US, there is not a lot of difference in terms of debt ratios, debt service costs and such. The reason Europe has been in the spotlight is because it is not a fiscal union but a monetary union and so it is easy to identify the weak link and attack it and see if the rest step up and defend it. In the US you have got to attack the whole thing at once and that is a little tougher to do.

I think one of the risks everyone has identified is the inflation risk especially in emerging markets and if you look at the statement coming from central bankers and government officials around the world, it has generally been that we are moving inflation up on our list of things to worry about, and we are taking actions to handle it.

Then you look at Ben Bernanke’s comments earlier this year and he says in the US deflation is still the biggest risk. So you have to ask yourself, does Bernanke know something that nobody else in the world, none of his peers, know? Or is the US really an island of deflation in a world of inflation? I don’t think so and Bernanke knows it too – he’s not an idiot, but he can’t talk about it because he has got other agendas.

So I think one of the biggest risks is the ignorance of inflation in the US until it basically is out of the bottom and too late to do something about.

O’Malley: I tend to be a little bit cynical in the sense that the US in the past has criticised the UK for being a little bit too socialist in the way it handles money. I think if the US was in the same position as the coalition government in the UK, i.e. in its first year, it could afford to do a lot more than it has. I think that within Congress there is a bit of a stalemate on what they should do. Unemployment remains high, but they just don’t have the appetite for the quick, deep cuts that perhaps the UK has made to try and fix things.

Cameron and Osborne believe that they have got 3 - 5 years to sort this out, and if they do all the hard stuff in the first two years, there will be a bit of recovery by the time it comes to the next election, whereas Obama is in his last year of his first term and his advisers don’t want him to do too much at the moment which is going to potentially impact his decision making.

Final comments
Chairman: I would like to invite each member of the panel to give a closing comment now, perhaps on a key message that you would like to get across to the readers.

O’Malley: I would like to highlight that there is a compelling argument for growth. We believe that low volatility is a central core of your growth portfolio and if you are looking at particularly emerging markets and looking for alpha within the global equity portfolio then some argument will say, well, a lot of the alpha will be from small and mid and emerging markets and therefore you need a core allocation to something that is going to capture upside but protect you in the downside. The thing is – how do you define low volatility equities? I don’t think anyone has really done it properly. For us low volatility is outperforming the benchmark over a full market cycle with lower downside risk and everything that we have tried to do is capture as much upside as possible.

Gallagher: I think in the long term there are some very clear secular trends that are not going to go away and one can benefit very well from focusing on those. Equities in this environment are well positioned and more attractive than the traditional alternatives. Fixed income is becoming increasingly risky, especially sovereign fixed income.

In the short-term it is going to be a little rough but in the long-run, if you focus on the very clear secular trends you are going to be OK.

Wilson: I am going to agree that there are huge opportunities out there in equities, particularly for active managers who are prepared to move as far away from the benchmarks as possible.

There are huge opportunities in emerging markets that we should be grabbing hold of at this time – they are not a place to fear.

Nusseibeh: There are two messages I would like to leave on the table. The first is an ambition – an ideal that we as an industry have to re-engineer ourselves to better align ourselves with our clients, which we haven’t done enough of.

Talking about investment, I think risk is completely misunderstood now and we went through 2008 because people did not understand risk. They still don’t, and neither does the regulator. And I think we are setting ourselves up for another disaster because we do not analyse effectively where the risk lies. We don’t do enough tests on the models that are being used, and the net result is that we are lurching towards a crisis of our own making. I would argue that the de-risking trade, actually adds to potential risk.

Chairman: From my point of view, equities are far from dead. Despite the increasing need for de-risking now and into the future, there is still a huge role for equities in growth allocations, only exacerbated by the question of what is a risk free asset at all? Also, the challenges surrounding benchmarks mean that those active managers that are willing to step away from the benchmark have plenty of opportunities out there too.



Panel members:

Chairman: Michael Kinney, Principal, Senior Researcher, Mercer
Michael is a senior researcher within Mercer’s Equity Boutique. Based in London, he is responsible for coverage of equity sector strategies. Michael works with a range of clients, advising on monitoring and selecting managers. Michael joined Mercer in October 2007 from Bramdean where he held the role of head of research in the firm’s long-only multi-manager business. Prior to that he spent 3½ years at Northern Trust Global Advisors, where he was responsible for international strategy formulation, fund construction and manager research.

Brett Gallagher, Deputy CIO and Senior Portfolio Manager, Artio Global Management
Brett joined the firm in 1999 after serving as the senior investment executive at Chase Manhattan Bank (Singapore) and the head of private client investment management for J.P. Morgan (Singapore). In addition, Brett spent four years with Bankers Trust Co., serving as a senior portfolio manager, global equity and three years as a financial analyst at Irwin Management Company.

Saker Nusseibeh, Head of Investment, Hermes Fund Managers
Saker joined Hermes in June 2009 as a main board director and head of investment to drive, support and represent the investment capabilities of Hermes. He is responsible for ensuring that all of the Hermes investment capabilities can and do deliver investment excellence and are able to compete at the highest levels in the third party market. Saker joined from Fortis Investments where he was global head of equities, responsible for managing the company’s 12 Equity centres.

Terry O’Malley, Senior Vice President, Director International Institutional Sales, Calamos International LLP
Terry is responsible for developing the firm’s presence in the institutional direct and consultant marketplaces in the United Kingdom and Continental Europe. He brings more than 25 years of financial services experience to the firm. Prior to joining Calamos, he was head of UK distribution for a number of large global institutional asset managers, including Credit Suisse, INVESCO and Fidelity where he ran a variety of teams covering traditional and alternative asset classes.

Alistair Wilson, Head of Institutional Business, Neptune Investment Management
Alistair joined Neptune in April 2005 as head of institutional business and has led the development of this part of Neptune's business from the start. Neptune now runs money in excess of over £1.5 billion for over 80 institutional clients, including UK and European Pension Schemes. He joined from Legal & General Investment Management where, since 2001, he was a business development manager in the corporate pensions department.



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