What next for investment?
Despite declines in the markets, equity investments were here to stay and investors should focus on the long term and stick to their strategic asset allocation. This was the message from panel members discussing their first topic of the session, namely, the future of the equity culture and focussing on some of the concerns among institutional investors regarding their strategies.
Poor market performance, coming just at a time when equity culture was taking off in some European countries, have made many investors wish they never joined the equity club.
Discussing whether we were going to see the premature end of the equity culture in Europe, Santiago Fernández said: “We are not going to see an end to the equity culture, premature or otherwise, for one simple reason. Premature children are those who are born before 40 weeks of pregnancy. The equity culture was not a premature but a late child. It has not been a pretty infancy in which it has developed, but it’s with us now and not about to disappear.
“Europeans are great savers and are now starting to feel what it means to have risk in their portfolios. Even with the natural ups and downs in the market, I think the equity culture is here to stay.”
On the same lines, Anthony Ashton, said: “Unless we see a prolonged recession and markets continue going down, we won’t see an end to equity investments. What we are seeing is a downing of the cult of the equity and the equity returns. Recent events, market falls and volatility have perhaps brought home to some investors the risk involved in equity investments and we have seen a moderating of expectations around equity performance.”
Another member of the panel, Silvio Vecchi, highlighted the behaviour that equities have had in the past: “Equity has been the outperforming investment in the past. We have plenty of empirical evidence that show how over the last 20, or even10 years, equities have beaten bonds more than 90% of the time. But it is also necessary to mention that investment in fixed income has been also changing. It looks like investors are investing in very long term and indexed instruments which wasn’t common practice even a few months ago, but definitely equity will stay here for a long time.”
Lower prices are also attracting investors. Todd Ruppert said: “In the institutional area we are seeing a number of pension funds reallocating assets away from fixed income into equities to take advantage of lower prices.” He added: “Returns tend to migrate too much on the upside and too much on the downside but now it’s a relatively attractive time to invest.”
He mentioned current short term interest rates and prices as some of the reasons for investing, adding: “But I think that right now it’s a relatively attractive time to invest. No one would have said that current prices are inexpensive, but they are certainly not extreme.”
However, it is true that in the recent months some investors have been moving in the opposite direction, away from equities. There was the case of the UK’s pension fund at Boots selling its entire equity portfolio. This made front cover news during the last months of 2001 and made many ask if other funds would follow.
“We were the advisers to Boots and the move was part of a strategic decision,” says Ashton. “It hit the headlines because of the timing of the announcement, and most pension funds, at least in the UK, wished they had done the same 15 months earlier.
“This was a strategic decision and not one based on timing. It resulted from a reassesment of the risks that the sponsoring company wanted to take with its liabilities.”
Ruppert commented: “I think this decision was driven by their specific liability structure. It is like if we ask ourselves why Yale University has so much money invested in private equity – it’s just to do with their structure. I don’t put any particular significance to the Boots case, other than a strategic decision for the particular organisation.”
The discussion moved on the topic of whether European pension funds are going back to seeking absolute returns or will still follow benchmarking in their investment strategies.
“First of all, it is necessary to note that these two options are not the only two alternatives out there,” says Ashton. “I can understand that given the current market falls, absolute returns have become very attractive. But we can’t forget that pension funds are there to meet liabilities rather than simply to preserve capital.
“Benchmarking is a very different issue. I think that, certainly in the UK, it has developed too much of an obsession with managing performance relative to a benchmark, rather than understanding what the benchmark is doing in relation to the liabilities.” Ashton concluded that far too much time and effort have been spent on managing benchmark risk which “in fact is an artificial risk”.
For Vecchi, benchmarking versus absolute returns is a very complex question: “As far as I am concerned, I can’t find any better solution than using benchmarks. It is a matter of using a proper decision hierarchy, knowing who is responsible for what end.
“Contrary to what could be the first impression when you look at the recent results in the market, in my opinion benchmarking is reducing risk rather than increasing it – as long as you have a proper structure for managing this risk.”
Vecchi said that absolute returns strategies sometimes give managers too much freedom that could be detrimental to the long term interest of the fund.
Another member of the panel, Ton Leukel, highlighted the fact that clients want to compare managers to benchmarks whether they like it or not. “We all know that clients like to rank you compared to others and it is also a fact that your strategies suit fit within the specific needs of the client. At ABP, we manage risk by not only focusing on relative but also absolute risk.
“We have to agree with the client of the targets at both the relative risk and the absolute risk levels, and on the return side, we must add absolute return instruments to the portfolio.”
In general, all agreed on the fact that absolute return strategies can be good, but they were definitely not enough. “The world is not large enough for everybody to invest in absolute returns strategies,” Fernández said. “Absolute returns are like those little chocolates that you get in Belgium when you ask for a coffee. It is a nice ending but it is not certainly something you can feed on.”
Ruppert commented: “The question is not about absolute returns or benchmarking. It is about what is the proper way to invest in an absolute return strategy and whether institutions and individuals are investing in this type of products for the right reasons or just running away from something they are unhappy with. In my opinion, you need an overall benchmark for absolute returns – which would be the chocolate around the entire portfolio!”
Another trend discussed in the panel was the increasing interest in indexing among institutional investors and how the market’s turbulence could affect its further growth.
“I don’t know if the turbulence causes one to think about active versus passive, but what brings some concerns on the passive side is that most money passively managed is invested in the large cap end of the market.” Ruppert said. “Typically, active management can add more value in the small and mid cap area.”
For Fernández, market downturn and growth of indexing were not linked. “If anything, the last year and a half has showed that those guys that were managing money most actively tended to get hold of the wrong stocks at the wrong time.”
Vecchi noted that generally active managers perform better when the correlation of stocks is low: “Since in times of turbulence correlation increases – it is probably more the case of going passive.”
On the same point, Ashton added: “Market turbulence brings home to people that passive investment is not risk free investing. What is more relevant is that the expectations of returns from equity markets has come down and this has implications for the relative value that active managers can add.” When markets have double digit returns – whether active managers are adding +1% or not – has relatively small significance. “But when, depending on your view on the equity risk premium, whether it is 2 or 3% and a manager can add 1%, that makes much more of a difference,” Ashton noted. “So, under the current market conditions, a good active manager us now much more valuable than before.”
Thinking about what this year will bring, the discussion concentrated on the panel’s advice on equities and whether 2002 is year to hold or to sell.
“The short answer would be buy some, hold many, sell a few,” said Fernández. “It is true that equity has been a very scary place to be during the last couple of years, until you consider what the alternatives are.
“The alternative is that you invest in some long term government bonds that, as it has been the case in the past, some government for some unexpected reason defaults on, or simply does not pay. We have seen it in the US and in many European countries over the years, so you do have to consider what the alternatives are.”
ABP’s Leukel said: “We are going to increase our allocation to equities this year because this is our answer to our optimal asset allocation.” Strictly tied to with the government in the past, APB had an investment strategy restricted to investment in Dutch government bonds. “They thought this was a smart way of investing because it meant cheap financing, but of course this strategy led to low returns. Now we have freedom to set our own asset allocation and we have been moving gradually towards our optimal asset allocation, so we’ll be increasing our exposure to equities.”
In this sense, members of the panel agreed on the fact that possible increase in equities exposure is more linked to an individual funds’ structure rather than market conditions. “Whether investors are thinking about investing more in equities depends on how they are investing right now,” says Ruppert. “But clearly, short term changes in perception are far greater than long term change in the economic value of a company and the greatest returns over time have been from investors buying into a difficult situation.”
Comments from the floor about the problems related to the ageing population, long term investment returns and wage growth and the effects that these factors are having on funded schemes, moved the discussion on to a more economic and political area.
With regards to this, Fernández mentioned that funded schemes are superior to pay-as-you-go schemes if the investment returns that you get are higher than the wage growth. He said: “Taking the view on funded versus unfounded systems requires a decision on whether, over the long term, profits or the economy as a whole is going to grow faster than wages. In my opinion, the answer is yes. It should be yes, because if they don’t, the profits will get squeezed more and more up to a point where it doesn’t make any more sense to be an entrepreneur and to have a company and everybody wants to be a wage earner. We have been through that and we know the kind of weather you have under those conditions: it’s called the Soviet Union in 1960s.”
According to the panel’s comments then, 2002 won’t bring any major changes to the way institutional investors are investing. Investors will be more cautious on their approach to equities but they won’t panic, and moves away from equity will only be made as part of strategic decisions to do with liabilities structure.
Benchmarking versus absolute returns, active versus passive and equity versus fixed income were the topics discussed and the conclusion could be that everything is valid as long it suits individual requirements and long term strategies.
Following the advice from the panel, investors have to be courageous and patient and use the different instruments operating in the market according to their own needs. And, certainly, a high percentage of assets in institutional portfolios will continue being invested in equities, despite turbulence and market falls.
From the consultants’ point of view, the need for investors to stick to their strategic asset allocation was highlighted. “We strongly advise our clients not to try and time the market. If a fund has a strategy it should have the courage to stick to it. All the studies we look at and our own experience says that unless there is a fundamental change in the economy, which we don’t think will be the case, people should follow reasonably close to their long term asset allocations,” Ashton said. “This pays dividends in both returns and reduced risk.”