Written by European Pensions team
Chair: Jerry Moriarty - CEO and Director of Policy, Irish Association of Pension Funds
David Archer - Director, Pitmans Trustees Limited
Andy Barber - Investments Partner, Mercer
Chetan Ghosh - Chief Investment Officer, Centrica
Colin McQueen - Head of Global Equities, FOUR Capital Partners
Terry O’Malley - Senior Vice President, Director – International Institutional Sales, Calamos International LLP
Philip True - Equity Fund Manager Research, Aon Hewitt
Chair: Starting off with some questions on the economic and asset overview, what is the current case for equities in a pension portfolio? What are the risks versus the rewards for European pension funds and which sectors and markets should be championed going forward?
Ghosh: In terms of the case for equities from a strategic perspective, equities do indeed have that strategic role where predominantly what we are after is the return. Within our wider framework we manage our assets through a liability related benchmark and therefore the strategic role that equities are aiming to play within that is to deliver gilts plus 4 per cent per annum.
Our focus is on producing the best risk adjusted returns after fees from our equity investments. Passive market cap allocations are a particularly poor allocator of capital when you are looking at risk adjusted returns. That is not to say we don’t hold passive equities but we view the role of passive equities differently to the traditional role of passive for many pension schemes.
Barber: I agree with the case for the strategic role for equities. They are neither expensive nor cheap so I think that they should continue to have a role to play in people’s growth portfolios. That said, most pension funds are on a de-risking path and within their growth portfolios pension funds have been diversifying away from equities to other forms of risk premia. It is difficult to see that there will be huge additional demand for equities from pension funds because they are in the de-risking mode.
O’Malley: Current valuations are quite attractive for equities. The main growth areas at the moment are emerging markets and there is a lot of opportunity in India because of the loosening of the strings around government controls.
McQueen: When you compare the risk premiums and the return potential compared to other asset classes, equities look relatively undervalued. According to our numbers the current level of equity markets suggests a future real return of around 5 per cent. When we look at that compared to index-linked gilt returns, equities still look to be very good value. In terms of specific areas, we prefer to form a portfolio bottom-up, individual share by share, and that leads us to more exposure to European listed stocks at present. Many of these are exposed to demand growth from other parts of the world, but are selling at a discount due to their European listings.
Archer: Typically trustees are bred to be risk averse. Equities can help hedge against inflation as well as being used as a currency hedge. I think equities are extremely attractive and still offer one of the best opportunities for growth over a long-term timeframe.
True: The extra return that is required by a lot of pension funds can be achieved by investing in equities. Clearly there is a desire to liability match as much as possible but beyond that there is normally a gap to be made up and equities are one of the most obvious ways to do that. Having said that, there is probably more interest in limiting volatility perhaps by allocating a bit more to absolute return or lower volatility strategies. The allocation to emerging markets is still not enormous so I think that will be an ongoing move within the equity allocation.
Chair: A number of you have touched upon Europe and emerging markets. Is that where you are seeing opportunities?
McQueen: In general, we tend to think that the connection between equity returns and GDP growth is pretty weak. You need a business model that can translate growth in revenues and demand into cash flow, and a management team that can translate that growth in cashflow to shareholder return.
For us, the tilt towards European equities simply comes out of the fact that the valuation opportunities seem to be there. Some of the best opportunities to gain exposure to emerging market growth are from some of the companies listed in the developed world.
Archer: There are lots of great reasons to include emerging markets in a balanced portfolio, but we do tread with some caution with pension scheme money, naturally. Russia has made increasing steps towards decent governance and Eastern Europe could be included in this as well.
True: I think over time opportunities will increase in this area as well as within frontier markets, even though there are some quite significant risks in those areas in terms of custody, liquidity and transparency.
Barber: I don’t think that we have any reason to think that over the medium to long-term emerging markets will do better than developed markets. In a lot of cases we are leaving it to active managers to arrive at the exposures. We do see a lot of managers of global equity portfolios who are playing emerging markets indirectly. This can be through purchasing companies in developed markets that have exposure to those markets, for example.
O’Malley: Our exposure in Europe within the global portfolio is quite high at almost 30 per cent, but that is usually because the companies are getting a lot of their revenue from emerging markets. Swatch is a prime example of this. More than 50 per cent of its revenues come from the emerging markets as opposed to its domestic markets or the rest of the global markets.
We can get exposure to emerging economies through other people’s expertise.
Ghosh: I believe in the long-term emerging market growth story. Obviously we are vigilant about the fact that GDP growth doesn’t necessarily translate into stock market growth however.
Chair: Staying on the issue of emerging markets, why is economic freedom important in this area?
O’Malley: It is down to research and finding out where your capital will be treated well. We take a lot of information from the Heritage Foundation which produces a survey every year on economic freedom and it scores every country that it can in the world on these terms. It scores on regulation efficiency, government intervention, open markets and so on. Principally it comes down to how easy it is for foreign investors primarily to invest in that country and within companies. We look for changes in taxation law and fiscal policy which will allow other investors to come in and invest in the country or companies in a freer and open way. India is a classic example at the moment. Quite recently the government allowed foreign investors a little bit more ease of access and small things like that are an open indication that things are moving in the right direction. Brazil on the other hand has gone the other way, even though two years ago it was most people’s favourite market. Government intervention has meant that they are taking a much more active interest in everything that is going on and it’s stopping some companies from going forward with big projects. Economic freedom for us is vitally important.
Ghosh: More of our concerns revolve around the governance side of emerging markets. The classic story was that there were much poorer levels of company govern-ance in emerging markets 10 or 15 years ago. Over the last five or so years the governance side has changed out of all recognition.
We have a reasonable degree of comfort that things have got a lot better, companies are keen to attract capital from the developed world and therefore do adhere to a high standard. Within Asia in particular, you do get concerned about the level of family intervention within some of the businesses that you hold. We rely on our investment managers on making the investments with a view to governance aspects in mind and therefore we do not go passively into emerging markets. We delegate the governance considerations to our managers.
Chair: David [Archer], as a trustee how much of a concern are these issues?
Archer: It certainly is an important factor. Governance definitely seems to be improving quite rapidly.
True: Some managers who have had a bad experience in a particular country might not invest in it almost on a long-term basis until significant change has occurred. Others take a more opportunistic line that quite often these factors are recognised in the valuation of the stock and they are prepared to take that risk but they will control it within the portfolio.
Barber: I agree – I can think of a number of managers who have had bad experiences of Russia and therefore will not touch it. That doesn’t make them a bad manager. As a result of these bad experiences, you are more aware of these governance issues when you go elsewhere however. Economic and political freedom is important. It is a prerequisite for capitalism to be successful and yes it is improving in most of the emerging markets. You could still have some worries about what motivates companies in certain parts of the world. Are all Chinese companies really run for the benefit of shareholders? Is return on capital a secondary consideration for some of the stocks you might come across there?
Archer: I don’t think that any of us would mean to suggest that there have not been some important governance issues with regards to Western companies, in the way that some of them have been managed either.
Chair: How do you judge what is emerging or what has emerged or developed? Does it really matter anyway?
True: I think the newer more fringe markets will probably have less developed structures particularly around government infrastructure and financial infrastructure. That probably adds more risk to investing in those areas. With some of the emerged markets one sees that the population gradually gets higher income and that provides investment opportunities not just in export markets but also in the domestic market.
Ghosh: I struggle with the term ‘emerging’. These countries are still on a high growth trajectory and therefore you can sympathise with the term emerging. But in terms of whether they are yet to arrive, they have arrived already. These countries are big parts of global GDP, and in the cases of the BRICs, they are countries that are significantly larger from a global GDP perspective than many of the current developed European markets. It astounds me that some of these countries are not part of the investment portfolios of some pension schemes. If we look forward five or 10 years we are going to find that the boundaries between the current emerging economies and developed economies will almost go away and actually global portfolios will incorporate many of the BRIC countries at least.
Barber: What is maybe more interesting in the active management world is the way you are seeing new products launched in areas that are sub-sets of these, like small cap emerging market products, for example.
McQueen: What is emerging and what isn’t is becoming more of an artificial question. One thing that could potentially change is some of the cohesion that we have had within emerging markets. As China’s growth begins to slow a little bit going forward and the working population peaks, I think the differentiation between those countries that have their own economic internal drivers and those that are linked to China’s demand may become greater.
O’Malley: When talking about BRICs/MIST it is almost a misnomer in some respects because these are some of the oldest economies in the world, but they are classed as emerging. Turkey has to be one of the oldest economies ever but the growth story there over recent years is that it has become an emerging market and that sometimes is difficult to understand.
Chair: In terms of pension fund experience, we’ve talked a little bit about the theoretical side, but on the practical side, how are European funds utilising equities in their portfolios, which sectors/markets are they most keen on and are they making the most of the opportunities out there or are they missing out on key prospects?
Barber: Historically equities were just the sole growth element of portfolios, now they are being used in conjunction with other asset classes. People are thinking about correlations with other growth assets. Within equities, a move away from domestic to global equities has happened. There is more interest in alternative forms of indexation. Use of smart beta in equity markets is also more prevalent now.
Chair: Do you think there are any opportunities that are being missed out on?
Barber: I’m sure there are. Governance budgets for trustees determine what you can and can’t do. Realistically even if you think that there are lots of opportunities to develop very sophisticated portfolios there is not much point in doing that if you do not have the governance budget to manage those portfolios properly.
Ghosh: We have moved to a framework of risk adjusted returns. If you look at some of the various styles that exist within the equity market you can get some quite surprising results in terms of risk/return efficiency from an investment perspective.
There has been a move in the industry to what people are calling smart beta. I would be slightly guarded about this particularly the low volatility phenomenon, however. We are also seeing pension schemes trying to bring in strategies that are lowly correlated with each other within the equity portfolio.
We have actually removed fixed allocations to regions as you can’t really see through to where the true economic exposure is anymore.
Therefore what we try to do is put in idea strategies and managers on a more bottom up basis and then look at the totality of our portfolio to make sure that there is no undue biases within the portfolio. Also where we don’t have performance related fees with our managers we are looking to move to an approach where we don’t stipulate benchmarks in the contracts that we have with our fund managers to try and take away the incentive for managers to hug the benchmark.
Archer: When did you make the move about moving away from geographic sectors?
Ghosh: Our principles were decided the latter part of last year.
Archer: So you haven’t seen the effects yet then? It will be really interesting to see whether you do experience better results.
McQueen: You say that you don’t set a benchmark for fund managers, so how do you assess whether they are doing a good job for you and are doing what you expect of them?
Ghosh: Outside of the managers’ reports, we compile our own performance comparators and it won’t just be one, it will be a variety to try and triangulate data to see if they are doing a good job. Certainly there will be a representative stock market index that you can look at but you can also look at the capital preservation characteristics.
O’Malley: Are we making enough of the opportunities out there? Opportunities are linked to resource. If you have the resources you can do anything. There is no one manager that can say they are making the most of every opportunity, it just doesn’t work like that. Hence there has been a rise in specialist managers and also a rise in fiduciary management and implemented consulting. There has also been a rise in appointing complementary managers. When a scheme is of a decent enough size, then they can afford to look at getting their exposure through complementary managers, so different styles within a portfolio. That can either come from the in-house team if you do it that way or it can come through fiduciary management.
McQueen: From clients that we have spoken to, people are being more open to thinking differently about the equities in their portfolio, but at the same time there is a natural tendency to gravitate back to the benchmarks that everyone is familiar with if we are not careful.
Chair: Are there still differences inherent in pension fund thinking across Europe, with some countries reluctant to move away from local equities, and others prepared to venture further afield?
O’ Malley: Scandinavian countries have been predominantly very patriotic and have kept significant weightings in their local equities. It is changing however without a doubt. In the UK the drift away from local equities has been going on for some time. Of course there will be differences in pension fund thinking across Europe because of state regimes but by and large the function is still to do the same thing and that is to pay the liabilities.
Barber: The UK is more advanced in moving away from domestic equities. The Dutch were early adopters of new strategies and other parts of Europe, such as Spain and Portugal, are quite conservative and have a fair amount of domestic exposure and still use quite a bit of balanced management.
Archer: Trustees, where there are trust-based pension schemes, would be negligent to not at least consider a much broader investment strategy than just investing in your local economy.
Ghosh: I would echo that particularly when you have a small European country and if you are over weighting the local economy you could get yourself into a position where you have undue concentration in a handful of stocks. By biasing small local European markets you could be introducing concentration that is not desirable.
Chair: Moving on to risk management, how should pension funds best manage equity risk and are they doing enough to manage their risks?
Barber: Most pension funds are now setting their risk budget relative to their liabilities and are thinking of equity risk in this context.
McQueen: Anything that moves away from a focus on tracking error as a measure of risk is a good thing. Risk for us is a drop in the value of the business that you are investing in and a lot of the quantitative techniques don’t capture that particularly well.
Ghosh: Tracking error is an easy definable quantitative measure of risk but we all know that risk is multi-dimensional and if you actually were to holistically incorporate the qualitative measures you would probably structure your equity portfolio quite differently. I would caution against over reliance on tracking error which is the default position in the industry as it stands.
Archer: Trustee bodies are slow at making and implementing decisions so, often for larger schemes, having agreed mechanisms in place so that decisions can be made quickly is something the trustees should consider.
An investment sub-committee is also important for larger schemes. The bottom line really is the strength of the employer covenant. If you have a healthy employer covenant because ultimately the risk is falling back on the employer, then this is the main way of managing equity risk. If you have a weak employer covenant then trustees are bound to be that much more prudent about the downside.
True: The question is what kind of equity risk should you take and can you have too much or too little? This depends on how heavily the scheme is underfunded. You can afford to take a lot more risk if the scheme is underfunded with a strong covenant than if it is underfunded with a weak one. Risk management cannot just be looked at from a fund management point of view – it is for the whole specific scheme position.
O’Malley: I agree that anything that takes people away from tracking error has to be good. It does go back to the case for low volatility or defensive equities.
True: The classic ‘defensive’ equity approach is more about the underlying stocks in the port-folio and one of the long running winning formulae for investing in equities is backing good quality companies with a defensive flavour to the business. The question mark there is whether the valuation of those types of companies is getting fairly full.
Ghosh: If you just take low volatility and bluntly implement it by taking that universe of stocks, I would have little conviction that it is going to do better over the near to medium-term future. That said, we do come across strategy managers where the by-product of their investment approach is lower volatility relative to the market but also they have displayed higher returns. Just to reinforce other points that have been made, I am particularly wary of the price of these low volatility stocks at the moment and whether you are paying too much and it is very important to be wary of where the flows go. If a lot of money goes towards low volatility stocks invariably the benefit will be squeezed out. The final point on low volatility for me is that I personally get very worried when I see back-fitted economic rationale as to why low volatility should exist and persist in the market. That economic rationale was not there before people were raving about low volatility so I’m naturally a bit sceptical.
Barber: With these strategies, clearly they have had a very good run. I’m not sure I am quite as sceptical as the rest of the panel on the roles that these strategies may play in pension fund portfolios. It seems to me that when pension schemes start de-risking again, which they will when funding levels improve, they could change the nature of their equity portfolios to move towards something which in absolute terms and relative to their liabilities is lower volatility than market cap beta.
O’Malley: There are different ways and different measures of low volatility. The only way we look at it is to beat the index over the full market cycle with lower volatility and less downside risk. We’ve managed to do that in our strategies over a number of years. If it’s not a wholly equity strategy, we have equity-like investments so we use convertibles to dampen the downside. That has been very successful for us but there are other ways.
Chair: Turning towards the issue of global growth, what are your thoughts?
McQueen: Our base view for a couple of years has been that we will experience a more tepid period of global growth but not negative. A lot of historical evidence seems
to suggest that the aftermaths of property bubbles have quite a negative impact on growth. It can take up to eight years to recover from that. The US property market has been correcting for over four years now, and it appears that the larger part of the adjustment is now behind us.
Barber: I agree. We had a boom period where we effectively bought consumption forward by borrowing lots of money and now we are in the middle of a big de-leveraging position and it strikes me that that is fairly likely to lead to tepid growth. I think there is a difference between the Western world and the developing world where they don’t have those same issues and overall growth will probably be reasonably attractive, but I can’t see it being attractive from where we are.
Archer: I’ll embrace optimism. I think we are over the worst now and it will get better.
True: Unemployment in Spain is about 25 per cent at the moment and Greece is even higher and that’s before the austerity measures have come in really, so I think there are still a lot of problems to work through and we won’t see growth like the way we have seen it over the last 20 years.
O’Malley: As a growth manager we are cautiously optimistic. It is going to be fragmented, it’s going to be led by emerging markets because that’s where the consumer growth is going to be more than anything. It is also where you will see companies trying to grow using the debt markets. We are seeing some encouraging signs in the convertible market for instance. Most of the new issuance that is coming out is in the emerging markets and Europe. People use the convertible market as a cheaper way of raising capital. Where you have emerging middle classes that are coming out of emerging markets who are desperate for things that they have never had before, then there will be growth where it can be had.
Ghosh: I take a longer-term view on global growth. We have the rest of the world with a population of three, four, five billion that basically is going to become more middle class. There is going to be a massive amount of saturation with goods in that population and that will drive the global economy in the long-term. My personal view is that the world is not in a bad place but the developed markets are particularly worrying. If you look at the UK and allow for its unfunded pension liabilities and other debts that the government has, we are worse off than Greece, which is quite scary.
Active versus passive
Chair: Looking at the active versus passive debate, how is this developing?
True: I think there is more of a focus on cost. People are prepared to pay for alpha but it has to be genuine alpha and not beta, so I think there is a high allocation to passive. I don’t get the impression that is going up. We are very supportive of good active managers and I think there will always be the need for that. I don’t think the shift is particularly marked from one to the other at the moment; I think it is more about whether the equity versus other asset classes is in the right proportion.
O’Malley: It is not so much a case of active versus passive anymore I don’t think, it’s a wider debate. A good active manager delivers alpha. They will always have a place.
Archer: Trustees are agreeable to paying for a good service that delivers results and we’re in business to try and achieve the best possible investment return results for the pension schemes that we are trustees of. I am personally leaning towards active.
Barber: I don’t see a big move towards passive but I still think that it has a role to play in some instances. The big change will be among active managers. They will move away from benchmarks to be truly active. It’s a better way to capture alpha rather than trying to capture incremental alpha through a semi-active approach.
McQueen: There is a role for passive but it cannot become 100 per cent of the capital allocation process in the market. For us as active managers, the more the world goes passive the easier it should be. One of the nice things in the market at the moment is that the spread of valuations is extremely wide, and that is usually a good indicator for active managers. We find that when we speak to a pension fund they don’t want to pay an active manager and get a passive service at a multiple of the price.
Ghosh: As an allocator of capital, the market cap has been particularly poor from a risk adjusted return basis. Why do we talk about active versus passive so much? It is because pension scheme experience has typically been poor on average when they have selected active managers.
The governance of looking after your equity exposure is key here. If you don’t have the time to deploy, or if your budget is better deployed looking at the more strategic items, then you probably don’t want to use active management; but if you do have the luxury of being able to deploy thinking and your time budget here, I think there definitely is a case for active management.
I would almost go as far as saying that you need to be quite contrarian in how you go about it. So following trends where everyone else has put money is something to be avoided. We have seen countless examples on both asset type and a manager specific basis where too much money has gone into these investments and they have blown up. That said, now that we actually have less pension scheme money in equities, particularly in the UK where pension schemes have gone more globalised, what you might see is less assets chasing alpha and when you have that scenario the scope for alpha to be delivered increases.
One thing that we have thought hard about is actually where you deploy your active management budget. So in some areas it is harder to get good active managers than others. What we have found rather counter intuitively is that in emerging markets we have struggled more to find managers. My final observation is that when you do find a good equity manager you have to pay a lot for these managers. I would say that post credit crunch the price for these managers has gone up.
Chair: Lastly, let’s look at the issue of ‘active share’. Why don’t all managers reveal?
O’Malley: I think more and more they do nowadays. A recent study showed that there is a positive correlation between a fund’s active share value and the performance. Funds with a higher active share tend to be more consistent in generating alpha but are not necessarily better at it all the time. If you are looking for active managers you might look for active managers with the highest active share.
Archer: It hasn’t been an issue for us really - the more transparency the better.
Ghosh: We would be able to get that information from any of our managers but actually we don’t even look at the statistic because our equity managers are unconstrained.
Chair: Any there any other issues that we haven’t touched upon?
Ghosh: A couple of points for observation. While we are reasonably confident on the reasonable valuation for equities the one unknown is the high level of profit margins that currently exist within equities. That is one area that I would be slightly wary of. Also when we talk about volatility typically the methodology is to annualise monthly returns.
But pension scheme investors have a much longer time horizon and if we actually looked at equity volatility relative to more longer-term measurements it might not be as risky an asset class as people are led to think when they just look at the pure risk and return modelling that they get from their advisers.
Chair: One of the issues that we have not really touched upon is the role of regulation in almost pushing people away from equity investment, in terms of accountancy regulation and The Pensions Regulator in the UK trying to push people to de-risk. Moving equities into bonds at a time where a lot of people would argue that it is not a good time to do that - how much of a concern is that for you?
Archer: I don’t feel constrained by regulation particularly at the moment. Matching liabilities is something that we have been aware of for a decade. As we are sitting in an ageing population this is inevitably going to lead to a more conservative approach. I hadn’t particularly attributed that to a regulatory trend rather it is just natural prudence.
O’Malley: Certainly regulation has an impact on the way a manager manages money.
Chair: In conclusion therefore we can say that there is still a place for equities within portfolios and still a place for active managers in the investment world.