Shares in London-listed companies have been out of fashion with domestic institutional investors in recent years; could the Coronavirus epidemic change that?
One way or another it was destined to be a year that would see the relationship between pension schemes and UK-listed equities tested. The hidden hand of the market that Adam Smith described centuries ago was painting an economic backdrop that would encourage cautious investment behaviour. Looming on the horizon was the great disruptor, Brexit.
This time last year, it was not even clear to the most sagacious of market observers whether the UK would exit the European Union, or if it would do so with a trade deal. The latter issue remains unresolved at the time of writing. Against such challenges there was also a long-term but discernible trend for pension schemes to move away from having a home bias in the form of a large, oversized exposure to UK listed equities.
Instead, pension funds moved towards global mandates, whether that was within a passive vehicle or global unconstrained exposure or a combination of the two. According to Koray Yesildag, an asset allocation specialist at Aon, the case for pension funds extending their equity exposure beyond their home shores is clear cut and one that consultants have long been advocating. After all, reposing all of one’s equity eggs in a single geographical basket goes against the oft-repeated investment mantra to diversify, diversify, diversify.t
We went into this with the UK market looking cheap, it’s now looking cheaperEmma Mogford, Newton Investment Management
The trend towards pension funds diversifying out of UK equities is one that sits well with Yesildag. “Pensions schemes have done quite a lot but there is more to do,” he says, adding: “Companies like us had been reasonably successful in educating pension schemes and their trustees in terms of diversification.” Regardless of attitudes to UK-listed equities, to the future of the UK economy and Brexit, it does not make sense from a portfolio construction perspective to have so much in one market, Yesildag explains.
“From a perspective of optimal diversification at the portfolio level, it makes sense to not have too much exposure to a limited number of companies,” he adds. The rationale for this broader investment approach is an obvious one: restricting exposure to one geographic basket is at the opportunity cost of foregoing potential returns elsewhere. “Remember,” Yesildag says, “if you are looking at UK equities the pool is relatively smaller and tends to be in certain sectors.
“So you are narrowing down your options quite a lot and certain things that might happen with the big dominant companies can affect your returns. So from that perspective it makes sense to be more global and investors are moving in that direction,” he adds. Surrey Pension Fund is a case in point. The scheme is gradually reducing its exposure to UK-listed equities. Its equity asset split 18 months ago, when the scheme had 45% in domestically-listed shares and 55% in global equities, has been rebalanced to 20% UK and 80% global, which is 60% of its total portfolio.
“Our journey is towards a reduction in UK equities,” says Neil Mason, head of pensions at Surrey Pension Fund. “We have made a gradual movement away from UK and towards global equities because we were overweight in domestically-listed shares.” One of the reasons for pension schemes shifting away from UK equities is the kinds of stocks which inhabit British indices, Yesildag points out.
The FTSE100 has a strong leaning towards large telecom giants. UK indices are also rich in supermarkets, banks, energy and mining companies. The fates of such UK stocks are closely intertwined with the fate of the global economy. “What that means is if the global economy is doing well then people tend to use up more materials that will stem from mining, oils or metals and the companies producing these materials do well,” Yesildag says.
“So that’s why we get this phenomenon that when value of sterling drops, the FTSE tends to do much better because a lot of these companies make most of their money from outside of UK.” Thus, with a large exposure to UK equities the question arises whether that is made up of large or mid-cap companies because larger entities, arguably represent a global exposure, whereas the performance of smaller companies tends to be more linked to the domestic market.
Now and then
So caution was the order of the day and pension schemes were reducing their exposure to UK equities and all was relatively normal. And then there was that fabled thing, a black swan event, which crept into the world with sniffles before laying waste to vast swathes of people.
Such has been the impact of Coronavirus – which is like an asteroid crashing into the planet – that it makes sense to speak of before and after this crisis. Before Covid-19 hit the world, Surrey Pension Fund’s Neil Mason espied some opportunities in UK equities. “We actually saw some opportunities in the UK market before this all happened,” he says.
“Those opportunities w¿n/ bñere the value of the UK market relative to other markets, particularly the US. It looked undervalued compared to the US.” But since the coronavirus asteroid hit, capital markets have taken a battering and investors candid lny admit there are whole sectors of the economy whose future looks unsure. Yet paradoxically the carnage is also a bargain-hunters paradise.
Emma Mogford, manager of Newton’s UK Income strategy, sees opportunities in b¿UK equities for savvy institutional investors and stresses the importance of income stocks as a wellspringñ¿n of returns, noting that income funds tend to outperform in falling markets. “If you look at long term, ove 40 years, in the UK market dividends have made up to 80% of returns so it is an important source of return and is less volatile,” she says. Mogford looks back to the crash of 2008 as a precedent to the current turmoil and recalls that there were sparks of hope amid the market darkness. She notes that the last time the FTSE All Share cut its dividend distribution was in 2009 when several companies stopped returning cash to shareholders.
Where to look
Despite the convulsions markets went through, Mogford says that the overall experience for a UK investor in the income market was a positive one, particularly for those fund managers with strong eyes on companies that could afford to pay their dividends through market volatility.
“We went into this with the UK market looking cheap, it’s now looking cheaper,” Mogford comments, adding: “For those clients who have the potential to increase their allocations to equities now we’d certainly see the UK market as an attractive place to allocate capital.” Mogford says there has been a rise in client interest in allocating to the UK with some considering moving from an underweight position to a neutral or even overweight one because of the valuation gap.
Neil Mason agrees that certain UK sectors seem more attractive when glimpsed through the mirror of such once-an-epoch events. He singles out pharmaceuticals and retail as being of particular interest to investors. “Pharmaceuticals will be relatively attractive in the short term. Retail is going to be smashed in the short term but when this all boils over retail is going to reach the point where it is valuable to investors,” Mason says.
Indeed, one major institutional investor announced its intention to increase its exposure to the UK even before the virus made asset valuations more attractive. Norway’s sovereign wealth fund, which has £750bn under management, said it would continue to invest in the UK after it left the European Union, stating, that as a long-term investor, it is not concerned by short-term political decisions.
The fund has various exposures to the UK economy, including a 200-strong property portfolio, including a share in London’s Regent’s Street, more than £5.5bn of government debt and equity interests in around 400 companies, which include Marks & Spencer, Sainsbury’s, Barclays and BP. So with valuations improving we await to see what catches its decision-maker’s eye.
Yet at the time of writing the overwhelming feeling is one that markets hate above all: uncertainty, with a feeling of cliff-edge precariousness to all equity markets at the moment. But UK markets have fared notably poorly because of the kind of stocks which dominate their indices.
Yesildag says that UK-listed equities have underperformed other major markets due to the weak performance of energy and mining stocks. “Looking ahead, much will depend on the evolution of the crisis and the response, locally and globally,” he adds. What then can be inferred about the future of pension schemes and UK equities?
Appropriately, given Coronovirus’ genesis in China, Yesildag echoes Zhou Enlai: “It really is too early to tell what will happen as conditions gradually improve, which may be a year away.”
Whatever happens it seems likely that the lessons pension schemes will learn from the crisis will be the obvious ones of focusing even more on diversification and portfolio resilience. “In the near-term, we don’t think that the true bottom has been reached yet so, while some degree of partial rebalancing may be warranted, we don’t yet recommend a full balance,” Yesildag says.
Yet for all the uncertainty and market chaos, the trend for pension schemes to scale back their exposure to UK equities is too strong to be knocked out of shape by the Coronavirus crisis. Mason says that the rebalancing of the equity portfolio towards global assets that Surrey Pension Scheme started 18 months ago remains its strategy. “We still expect to do this, irrespective of capital markets,” he adds.