Equity markets around the world reached record highs in early 2018 providing investors with not only the chance for strong returns but also much needed diversification. But where can value be found and what are the risks?
Richard, around 60% of the Islington Council Pension Fund’s equity portfolio is invested overseas. What countries are you exposed to?
Richard Greening: Allianz and Newton are our primary equity managers. Their investments are mainly in Europe and the US, so we have taken out a £100m emerging market portfolio with Legal & General. That is passive, but we’re looking to move to an active stance, which is more effective in the emerging markets.
Michael Bourke: The rise of passive should not necessarily be viewed as something negative. It forces everybody to raise their game. Though in the emerging markets there are particular difficulties in going overly passive. You’re buying something that’s increasingly dominated by a few large caps. Two or three stocks in the index have managed a 25% to 30% performance, which is fantastic, but when you look at the multiples on some of these names they are on 40, 50, 60, 100 times earnings. Plus, some of the tech names carry quite pronounced Chinese policy risk, which the passive investor may not be aware of. So passive is not as passive as it sounds. Whether you like it or not it’s an active choice because of the composition of the index.
With regard to ETFs, in the emerging market space they move around the NAV. So any saving you make on the fee differential between active and passive is wiped out when buying an above NAV ETF. So there are various pitfalls.
What role do equities currently play in a pension portfolio?
Greening: A pretty important one, particularly global equities. We’ve all had the huge benefit of Brexit’s effect on sterling. Relatively speaking, we are now in a much stronger funding position. We’re approaching 90% having been in the doldrums of around 70% for many years. Pension funds were once much more invested in the UK stock market, but as time has gone on people have concluded that global equities is a larger and more profitable market. So there has been an incentive to move to global. There is also this bet against the pound, which combined with quantitative easing, is inflating asset prices.
Donny Hay: Global equities play a crucial role in terms of diversification away from the narrowness of the UK. The IMF’s recent global growth forecast has increased to around 3.2% to 3.5% for 2016, 2017 and 2018. What’s unusual at the moment is that synchronised growth across the world, particularly in emerging markets. Having the diversified exposure to that for a pension fund is important in terms of maximising returns, but also getting the diversification benefits. We come across lots of different countries, stocks and currencies.
John Belgrove: Equities play an important growth role in any long-term portfolio in any prevailing market condition. A low return outlook doesn’t change that, but obviously it adds some challenges to meeting clients’ objectives. Long-term investors typically are looking to invest globally to benefit from diversification and although it will be fun to choose which markets look attractive, predicting markets is hard and professionally it has a high failure rate. Therefore it can be a stretch for trustees to take this on.
Hay: So many valuations are at extremely high levels. If you look at the cyclically-adjusted price-earnings ratio it’s about 30 times now. When you start getting over 22 times history tells us that in the following three years on average you should expect a downturn in prices of more than 20%. People are concerned but bull markets are born on pessimism and then they mature on scepticism and then they move into a phase of euphoria where things go badly wrong. People are nervous, but markets have a nasty habit of climbing a wall of worry and people have been sceptical about the rise in equity markets but it’s continued partly because bond yields are so low. It’s extrinsically linked to interest rates and what happens to the future direction of interest rates because we are in this synchronised world and if interest rates were to rise they would rise across the board, but as yet there’s little sign of wage inflation, so the party continues.