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New horizons

25 Apr 2019

Last year Brunel Pensions Partnership gave its member funds an early Christmas present. In early December, the £30bn pool, which manages the retirement assets of 10 councils in the South and Southwest, launched an active UK equity fund designed to outperform its benchmark by 2%.

To help achieve this, the pool spread the decision-making across three firms, picking Invesco, Baillie Gifford and Aberdeen Standard Investments to manage the £1.6bn Active UK Equity fund.

This was the first fund launched as part of its £7.5bn tax efficient ACS structure, which has been designed to benefit government workers in counties including Cornwall, Dorset and Gloucestershire.

When launching the search for firms to manage the fund in April 2018, Brunel’s chief investment officer, Mark Mansley, said: “UK equities is still an important allocation for many investors.”

However, Brunel appears to be taking a contrarian view here. Institutional investor exposure to London-listed equities has been declining for years.

Indeed, UK DB pension scheme allocations to domestic equities had slumped to 7% by 2018, according to Mercer, a consultant. Yet the level had stood at more than 30% in 2008.

“Corporate defined benefit pension scheme allocation to equities has been coming down consistently for quite a long time now,” says John Belgrove, a senior partner at Aon.

GOODBYE GROWTH

It appears that UK pension schemes are not falling completely out of love with equities, just those listed in London. Exposure to overseas equities is 18%.

UK institutional investors do not have as big a domestic bias as their counterparts in France, where the level of overseas listed-company shares is as low as 4%.

Almost no (1%) DB schemes serving UK workers plan to increase their allocation to domestic equities, while 23% intend to move capital from listed companies to other assets.

Of those with an overseas equity portfolio, 8% will invest more in these assets, which is half of those planning to reduce their exposure.

UK government debt is the preferred destination, a sign that schemes are locking in any gains secured from the prolonged stock market bull-run that is believed to have all but ended. Of those looking for a new home for their capital, 28% intend to increase exposure to gilts and 31% to inflation-linked versions. Fixed income and fixed incometype assets have proved popular. UK final salary schemes were 50% in bonds last year and 21% in alternatives.

“That is not being driven by investors’ predictions of what the returns will be over 10 years or even 10 months,” Belgrove says. “It is being driven by structural de-risking issues. Those are the external impacts that trustees are thinking about. They are thinking about their journey plan as well as meeting their obligations and liabilities.”

One of the reasons behind this change in strategy is that time horizons are shrinking. Trustees are pulling out of growth assets, such as equities, and are moving into assets that provide stable and regular cash returns.

Many are maturing in that the sponsoring company is no longer making contributions and the trustees are looking at the endgame. This could be handing over the responsibility for the scheme to an insurer through a buyout, merging with one of the so-called super-funds or focusing on self-sufficiency.

If you look within the equity components, the allocation to UK equities for your typical UK pension plan has been decimated.

John Belgrove, Aon

To help meet these endgames, diversification has been the name of the game among pension schemes for the past 10 to 15 years. Schemes have been moving out of growth assets and into investments such as infrastructure debt and investment-grade corporate bonds.

It makes sense to get certainty of return and to take less risk as a scheme moves closer to its endgame, but still generate the cash needed to pay its pensioners.

“If you look within the equity components, the allocation to UK equities for your typical UK pension plan has been decimated,” Belgrove says. “Since 2000 we have seen a move away from a domestically-focused equity portfolio to a global portfolio.

“So you have two things running at the same time,” he adds. “You have a move from local to global and a move out of equity going on. So that has accelerated a reduction in a direct allocation to UK equities.”

PROS AND CONS

Defined contribution (DC) retirement scheme NOW: Pensions’ equity allocation is typically spread a third in UK, a third in the US and a third in Europe.

With its UK allocation to domestic equities higher than the 7% Mercer says institutional investors are holding, NOW: Pensions has a bias towards the asset class.

“There’s always going to be a bit of a UK bias,” says investment director Rob Booth, while speaking at an event hosted by portfolio institutional in March.

A drawback with UK institutions building a portfolio of overseas equities is that they need to hedge currency risk, which, according to Pete Drewienkiewicz, chief investment officer, global assets, at Redington, is “quite difficult to get”.

Booth says that his scheme uses a lot of futures in its investment portfolio.

“So we have some currency hedging built in, but there’s an underlying approach to say we’ll target roughly 100% currency hedging.

“It all comes back to the fact that if we have UK savers who are being paid in sterling, going to save in sterling and then spend in sterling, at the end of the day why would we have that floating currency risk going on all the time?

“Compared to the global cap there’s a slight overweight UK perspective across the board. It is UK inflation that’s rather more important to us than global inflation, for instance,” he adds.

Andy Scott, a professional trustee at Dalriada Trustees, says that he is having fewer conversations about equities, concerning the UK and beyond. “As time horizons get pulled in, schemes are investing less in growth assets,” he adds.

It is difficult to find evidence of a big consultant search for a UK equity mandate in the past two years.

“We actually did one at the end of last year but there hasn’t been a huge amount of activity in domestic equities,” Drewienkiewicz says. “People have definitely been going more global.”

Not limiting your investment strategy to one market has clear advantages. Investors have access to some of the world’s most high profile brands, including Apple, Samsung, Toyota, Nestle, Amazon and pharmaceutical giant Pfizer. T h e n there are emerging markets, which are forecast to be a huge driver of the world’s economic growth over the next decade.

On top of that investors could benefit from China opening up as indexes increase their exposure to the world’s second largest economy. “Things like that can be a driver of allocations,” Belgrove says.

As well as not adding currency risk to a portfolio, a benefit of UK investors looking for listed stocks domestically is that they carry high standards of governance and transparency. It also gives investors global exposure, as most FTSE members generate revenue from overseas.

The downside with London-listed companies is that the index is weighted towards certain sectors, namely energy companies, such as BP and Royal Dutch Shell, as well as banks, which feature prominently in the top half of the table of stocks ranked by market value. HSBC, Lloyds Banking and Barclays all feature.

Brunel has given the trio of managers making investment decisions for its active UK equities fund the freedom to avoid matching the index and weightings to build a portfolio of stocks that could outperform. That means a diversified portfolio that is not concentrated on a few companies that dominate the market.

A QUESTION OF GOVERNANCE

Belgrove explains that with the number of companies in the FTSE generating revenues overseas there could be currency sensitivities, and this could be where the biggest concern over the UK’s departure from the European Union lies.

“In a cap weighted way, the FTSE All Share or an MSCI UK allocation are dominated by some large global stocks. So even if you are invested in UK equities you are invested internationally anyway, rather than the local economy. All of these have dollar sensitivity.

“This where it becomes interesting for trustees in terms of how they can act,” he adds. “They think about currency exposure, their liabilities are in sterling and their assets are global. There has been more focus since the referendum, and indeed leading into the referendum, for pension schemes to think about their currency exposure as a more relevant risk measure for them than typically the UK equity component.

It all comes back to the fact that if we have UK savers who are being paid in sterling, going to save in sterling and then spend in sterling, at the end of the day why would we have that floating currency risk going on all the time?

Rob Booth, NOW Pensions

“Brexit is only a concern on the currency side of things,” he adds. “On a global tremor basis, folk are more concerned about a broader economic slowdown, trade wars and China. Sentiment around those things are going to be the dominate drivers of 12 month returns than Brexit at that level.”

So for those schemes that have a UK equity portfolio, are they following Brunel’s strategy of taking an active position? The answer, it seems, is ‘no’.

“Given that it is a small allocation and it seems to be getting smaller, there appears to be a trend towards indexation,” Belgrove says. “That is governance led.”

“It is about two things: cost management and governance. So if that proportion of your portfolio is not as significant as it used to be, it may not be worth the governance effort.

“We do see a desire for simplicity, for tracking. Choosing a tracker is still an active decision in its own right on a governance level,” he adds.

It is also worth pointing out that it is a lower cost option.

For Aon, its clients’ allocation to equities is nothing like it used to be. Institutional investors, therefore, want to spend their governance effort around active management in other areas, such as alternatives. It appears that the volatility we saw in pockets in 2018 would not be enough to tempt them back if it returns, as some predict, this year.

Volatility is often said to be an investor’s friend in that it creates entry and exit opportunities, but it might not be enough to tempt a few schemes into a few tactical trades in the UK equity markets.

They have found new strategies, are focused on new markets and have new goals.


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