Title

Crispin Derby chairs a round table event asking some of the top names in investment what they think CD: The WM Report on local authority pension funds for the year to 2007 says 10 years ago the average local authority fund split its investment in shares (equities) 74% UK and 26% global (overseas). By 2007, that had dramatically changed to 54% UK and 46% global. Traditionally, local authority pension funds have put most of their money into UK equities, but the statistics clearly show them increasingly moving into global equities, and not into bonds as corporate funds are. Are they right in what they are doing? RL: From a pure investment perspective they are absolutely right to be moving from UK into global equities. That is not a reflection on the prospects for the UK economy, or the UK equity market, but simply a way of ensuring they have a more diversified portfolio. In addition, they want to have a better opportunity for alpha generation (high performance) equity portfolio. It is consistent with what you see in every investor market around the world, including local authority pensions in Sweden, the United States, Japan or anywhere else. The second part of the question perhaps touches on that interplay between investment and politics. No doubt, politics have some influence on that UK versus overseas split and the emotional resonance of holding UK securities, but certainly on the bond side the situation between corporates and local authorities is very different because of the ultimate sponsor. At the end of the day, the taxpayer picks up the tab. DR: With respect to diversification away from UK equities that trend is in place and I cannot see it easily changing. Within the UK market obviously there are the concentration issues, but also those large companies are by definition global companies and a reasonable proportion of their revenue, earning and dividend streams comes from international markets, as well as a whole host of risks as well. If you are investing in Glaxo, you are taking on US regulatory risk in your portfolio. If you are taking on that risk you have to ask yourself whether you are getting the best possible return from that risk, and therefore you have to consider that you might be better off in Roche or in Merck. Having set that question, the answer is almost self fulfilling, therefore you will naturally diversify towards the best opportunities, which in some industries will be outside of the UK domiciled global companies. JH: The point was made about the massive differences between the corporate sector in perceptions of what funding risks mean for potential default, and the public sector where that is not an issue. If you have to make some form of judgement between going on the investment side of the spectrum and moderating that with things which dampen down medium term volatility because of funding concerns, the pendulum will swing in the corporate sector, and has swung, very much more towards damping down volatility because of the circumstances they face: more than it has swung in the public sector. The public sector does not have as acute concerns and therefore can, for want of a better expression, afford to take the longer term view to maximise returns. Hence the momentum to buy bonds is not really there. With regard to how it should be invested, the domestic bias was partly because of where we started from, partly familiarity, and partly currency risk. The passage of time has meant that they are each less important. In particular, currency. Having sterling based liabilities and whether you want to have non sterling based income streams, can be managed through currency strategies separately and so the decision becomes more one of what the opportunity set is. If you look at the world market and the potential for growth, you are likely to end up with a conclusion that a domestic bias towards UK is less relevant than a broader spectrum. I cannot see any reason why the trend should change. DW: From a finance director's point of view, my worries first of all are about equalising the impact on council tax over a number of years. That probably gives local authorities a different set of options to corporates on how we invest. Furthermore, it gives us the opportunity to take a longer term view, which may enable us to take shorter term risks. We are in a reasonably fortunate position but still have a long way to go. RP: Clearly, there is a trend in favour of overseas diversification and that's quite right. All research shows the more widely you cast the opportunity, the better the chance there is of adding value. Overseas investment per se will be more volatile because there is the addition of currency risk, bearing in mind that pension liabilities are in sterling. Hedging the currency will reduce that volatility, but in a sense it switches the volatility to your cash position because you could have some very uncomfortable cash influences. CD: What then is the long term destination for equity portfolios, particularly regarding the allocation to global equities rather than domestic equities? RL: There will be an increasing acceptance of the concept of separating the market return, which is the beta that you get from investing in equities as an asset class, from the alpha which is the skill that managers deliver by their stock selection. The two go hand in hand. One link is the growth of the 130/30 strategies Some people say it is this year's flared trousers. In reality there is sound investment logic behind those strategies and a link to the separation of alpha and beta. For instance, you are allowing managers to express their views when they have the skill in a way that is independent of the benchmark. Consequently, if you are running a UK strategy you can go short on a stock if you think it is really overvalued. If you are going global, it makes a great deal of sense because you have a much larger opportunity set. Furthermore, if you free yourself from the constraint of not being allowed to short, you can see you are moving to a situation where you have made a decision about how much you want in equities, which is your beta decision, and then you just want to search for the best available output. The halfway house we are in at the moment is that there is still a UK bias, yet trying to generate alpha in the UK equity market with issues such as stamp duty, the limited universe, and the liquidity problems, is fighting with one hand tied behind your back. DR: With the evident bifurcation in our industry between beta and alpha, there are more alpha opportunities in the broader global equity markets. If you want to pay your manager on the basis of the value added rather than the beta they are managing, then the manager would want to go that way too because there is an opportunity to add value. There are mutual interests here in developing a global strategy. The limiting factor is currency because of the risk on the liabilities' side and making sure you have sufficient protection. Therefore, currency should increasingly be treated as a separate asset class and managed in aggregate. There you will also have opportunities on the bond side to manage currency risk. From a local authority point of view, given the liabilities are basically all sterling based, as you migrate out of UK equities and into international or global equities, an active currency strategy has to grow with that. JH: I do not think in five years' time we will have reached 90% overseas equities and 10% UK, if that is the balance of the World Index. I do not think everybody will just be investing in equities and then hedging out all the currency risk. Familiarity with currency is the constraining factor in the short term. There is an element of expectation that emerging market growth will be higher than developed market growth, and particularly European growth. Therefore, there will be a desire to go into emerging markets, and then issues about currency hedging become more difficult to implement, and less well developed derivative markets will be a constraining factor. What is assumed to be off the agenda is the UK becoming part of the Euroblock, which produced a certain amount of debate in the late 1990s for the UK. At that stage, it was perceived it would accelerate the process of changing the dynamic of saying ‘the UK and overseas' to ‘Europe and the rest of the world'. That is not part of the equation anymore because it is assumed we are not going into the Euroblock. However, in five years' time, can we be as sure? CD: No local authority has put out to tender a mandate for UK equity this year. All equity mandates are global so far this year. Can you see any UK ones coming through? DW: Certainly from a local authority perspective that is off the radar now. It is just a question of how far we move and how quickly. Looking ahead, we must preserve the balance within any investment portfolio. We are still carrying about 20 25% in gilts and bonds on overall investments, which given a long term view, is quite top heavy. That is what many local authorities will be looking at over the next couple of years to see whether they can get better value through a global strategy, or active management. RP: Actuarial assumptions in West Yorkshire do not make a great deal of difference in terms of volatility and expected returns from UK or overseas equity. If that proves correct, then clearly the advantage of overseas equities is that you are increasing your opportunity set in a diversification and that has to be a good thing. I do not know where this trend will end, but the trend towards overseas equities will continue at the expense of UK equities. CD: What are the advantages of a global portfolio versus simply a collection of regional funds? RL: We have been changing the way we approach global and non domestic securities from one where we did combine regional portfolios – in other words, if you had a good regional team they would get the best portfolio together – to one that is global. That was partly in recognition of this decline at the margin of the country factor, but perhaps more specifically the rise in the significance in some sectors and industries of industry factors. If you do not do that you end up not using your risk budget very effectively because you cannot offset one position with somewhere else. At the margin it does improve the portfolio construction if you want very high returns. RP: In West Yorkshire we have a global portfolio, and particularly a global unconstrained portfolio. How many stocks would you expect to see in there, for example? RL: Our global unconstrained has more than you would expect. It has about 120/160, but it is a sort of benchmark unaware strategy. It is not a ‘40 best ideas' portfolio. Some people would say that is a normal global equity portfolio. The difference about it from our perspective is that it is benchmark unaware. It is an absolute return portfolio. RP: If you are going to have discrete portfolios for Europe, North America, Japan, you finish up with a diversified portfolio in each region and you would probably have 600 or 700 stocks in it. You might have thought 150 was large, but actually it is extremely small in relation to what might be a traditional approach to overseas investment. That is very telling. It is a very different strategy in terms of looking at overseas investment. DR: The dedicated global equity fund manager has a set of opportunities which are not available to regional managers constrained by local benchmarks. Only the global equity manager can take the decision between Roche, Glaxo and Merck. Over five and 10 years, the average global equity manager has outperformed the MSCI all country index by 1%. Either the average global equity manager is a genius, which I do not believe, or is going for something that is truly there. It arises from being able to shrink that total number of stocks from 600 to 120. When we got to the volatilities of our returns, they have not been very different between our specialist global equity fund with 120-150 names, or indeed our regional ones with 500 names. JH: The intellectual case is more in favour of the global approach. If I put it in order of magnitude within our client base, roughly two thirds have their overseas equities managed on a global approach, whether that be equity UK, or whatever, and roughly one third use regional portfolios. If we look back 10 years, and particularly 20 years, it is absolutely clear that the universe, the average fund, paid very little heed to the ratings of markets in the index and did its own thing. In the 1980s there was huge scepticism about whether Japan could continue, or the belief there was a big cash flow distortion happening in bad Japanese valuations which ultimately proved right, so there was very little exposure to Japan relative to other overseas markets. In the 1990s, we had something similar happen in America but it was less clear cut. Certainly, the proportion invested in the US in the 1990s was very much lower than its World Index at that stage. There have been historically quite large skews in the way in which funds are invested, which clearly means they were regionally based and applying this benchmark decision, as well as having it reflected in terms of the way managers positioned themselves against that benchmark and reinforcing that. The current situation is that there is still a slight skew within the benchmark. There are far more funds which have either the World Index as their benchmark or are following the global strategy principle. Tesco does not really think very much about what Sainsbury's is doing. It is more interested in what Wal Mart is doing because they own Asda, or more interested in what Carrefour is doing because it is going into Asia. Even very domestic businesses are interested internationally, and when it gets to companies like BP and Glaxo it is irrelevant. CD: How does a local authority typically approach this? DW: Local government thinking is changing. The focus is on returns. There is greater recognition that we cannot do the jobs that you guys do. It means a huge reliance on fund managers to push the boundaries and get the maximum returns. Having reached the point where you have a strategy which is clearly moving towards global, then in terms of where it goes globally it is down to you. It is quite a challenge for us just getting our hands off and allowing you to perform, not least in the context of some of the bad news stories that we have received over a number of years. CD: Just by way of contrast, Southwark has very different set up to West Yorkshire which you advise, Bob, where there is a lot of in house expertise. What do they talk about with regard to this issue of global? RP: It goes back to what the role of the investment panel is on a pension fund. Obviously, they are not taking stock selection decisions because whether it is managed in house or whether it is managed externally that is the job of the investment managers. In very broad terms perhaps amongst the many functions of the investment panel, one of the important ones is the overall asset allocation strategy because that reflects the risk budget, liability profile and the degree of aversion to risk. Investment panels are not necessarily versed in all these extremely complex administration and accounting type issues. How you monitor all this is a general question. It is very difficult to argue against the intellectual integrity of global investment, but the practicalities of it can be quite difficult because many of those issues are being thrown back on to the investment panel. RL: I get the sense that the issue that faces UK pension funds and some of the local authorities is that decisions have been made about the amount of resources that are going to be put in at the executive level that mean those challenges are significant. If you compare the UK with some other countries in Europe or elsewhere, often there is a much bigger or better resourced executive end; whether it is the investment panel, or a permanent fixture of people who are equipped to deal with those problems. In a sense a cost benefit analysis comes into it and you have to spend a lot more money in order that you can earn more as a pension fund by pursuing these more complex strategies. CD: When you are putting across a complex idea, you find the councillors who sit on investment panels can have a vast range of experience and knowledge, do you not? JH: In my experience of both the public sector and the private sector funds, those involved with the former are generally speaking more knowledgeable about what is going on in general and more accepting of new techniques and new strategies and so on than perhaps is the case in the private sector. They are certainly more amenable to new ideas. Nevertheless, there is this problem of ongoing training and education because there is perhaps a greater turnover of panel members. DR: I was a councillor. My experience was that there were always a couple of shrewd people on the finance committee who knew exactly what was going on. The members who knew nothing about finance, such as the chairman of social services or the deputy chairman of education, would defer their opinion to the members of the committee who knew what they were talking about. DW: There is a whole issue here of demystifying the subject. Of all the suppliers and contractors that I have come into contact with, the ones who are most difficult to understand are fund managers. There is a real issue about getting the core message across and actually translating that message to not only our elected members but also the officers who need to understand and turn that into a decision. We all need to communicate better together. We are looking at our commitments on the budget and we are in the middle of a triennial review. The results of that review are likely to look very different today to what they looked like three weeks ago. Readers of The MJ may pick up the magazine in future and ask What the heck was that group talking about? The context is that there may not be £2m to spend on health and social care because we are having to put it into our pension funds to fund the membership. That is a very fundamental message: health and social care or contribution to the pension fund, what is important? It is a difficult message to get across. CD: Something you have all mentioned in passing is the 130/30. It might be sensible for you to define that first. It has been described as the latest flared trousers. Should local authorities be wearing them? RL: This is a strategy where you start with £100, then you sell £30 worth of equities that you judge to be overvalued, and the resulting £130 is invested in the equity market in securities that you do like. By doing so, you are able to express a view more strongly on securities that are overvalued, which is a very valuable thing if you have a lot of analysts who have good insights. You have more active money at work in the equity market both on the overweight and the underweight. Hence, if your insights are effective, you will get much better performance. That is the reason why we have ended up managing a lot of 130/30 strategies. DR: It is the same level of risk, but with the potential for more return. That is the key component. For example, you might have a European index that has 1% in Peugeot. I do not know what the index position of Peugeot is, but let us say the index is 1% in Peugeot. With a normal long only fund, if the manager does not like Peugeot, all they can do to outperform is have 0% in Peugeot, but on 130/30, 30% minus 1% or minus 2%. It is the same view, the same manager, but they can have a bigger negative bet against that view of Peugeot. JH: It is done through shorting. It is important to bear in mind that there are clear advantages intellectually. You have the same market exposure, which is 100, so you get the same market impact. You are just exploiting more and more the ability to add stock selection for the reasons mentioned. DW: There is no doubt that we need to be innovative. What works against this is if you look at who has done it so far: that is such an acid test for any finance directors. Notwithstanding that, if you are taking a balanced view of your overall portfolio you can take certain risks around small parts of that portfolio and see if it works. Clearly, you are accountable for it in terms of a decision, but if it is good for the members of the fund and good for the council contribution to the fund, then we should never say never. JH: It is not something that we have done in a segregated form for any of our local authorities. CD: Does the same argument apply to unconstrained and portable alpha in global equities? RL: In designing the unconstrained strategy, the size of the universe makes an enormous difference to success in the sense that if alpha is high enough none of the betas matter very much. I think the answer to the question is that 130/30 will take off. The question is how many people will compete with 130/30, how they are going to proceed in the next few years and how is a concentrated strategy going to be successful. DW: Unconstrained equities come out of this desire to have higher returns rather than have long shorting of anything to produce an absolute return. Now that they are, I wonder what the future is for unconstrained. I do not know if unconstrained will survive the withering fire of a market downturn. RP: The West Yorkshire strategy has never been to shoot the lights out, in terms of going for short term funds. The 0.50% per annum gets you well and truly into the top quartile of performance over 10 years. CD: On the face of it,with a global strategy it sounds more complex to address every governance issue. DR: We have signed up to the EU declaration on this and we are organising global voting. I do not think the issue of voting stops at the White Cliffs of Dover. JH: We vote on everything. In my perception, the UK is the world leader in the way it goes about governance, and to that extent everywhere else is playing catch up. It depends on whether you regard governance as something you have to do in spite of it, or whether it is something you do because it generates higher investment returns. RL: The investor base of companies is changing, particularly in Europe. These days it only requires a handful of investors, and not necessarily activists, to raise an issue for it to become something you have no choice but to address. CD: What about the current volatility in the market apparently caused by the sub prime crisis? How does that affect your thinking on global equities? JH: Our view is that this is not the start of a major downturn. At this stage, particularly with liquidity being provided by central banks, the risks of something material in terms of a financial market collapse seem less important. RL: There is no doubt that quantitative funds did underperform for two or three days in August and then performance began to come back. We were pretty confident we knew why that was and we did not take any precipitative action in the sense of selling or de risking any of our funds. We were confident that we knew it was a wave of selling that was basically a distressed seller or hedge fund of some kind that had positions that were quite highly correlated with ours. In terms of what we do about that, we double our efforts to improve our alphas because in the end we have a process that has to continually evolve. DR: In the longer term I am not worried about the equity market. However, I do not believe in the recent rally that we have had. I feel we are witnessing the inverse of the 1998 credit crunch. I was running a Latin fund at that time, so it is marked on every part of my body. My sense is that during that period the US economy was the driving force of the world and it drove up the cost of capital until it found the weakest link where the leverage was. The leverage was in the emerging markets with their current account deficits, currency mismatches, and so on. The markets came down a long way. Today we are seeing the mirror image of that. Now it is China and the emerging markets that are driving the world with an insatiable appetite for capital which is driving up the cost of the capital in a world boom, and guess what, it has found the Achilles heel, which is the leveraging. This time the leveraging is not in the emerging markets but in the global financial system, particularly the sub prime market, but it will be found in other places. The leverage has to be cleared through the market. This problem cannot be easily unwound without some indigestion.

Title

FINANCE

Should local authorities be going global in their efforts to secure the best results for the residents locally? (The MJ Finance

SUBSCRIBE TO CONTINUE READING