It is difficult to know what conclusion we can draw from the second Gulf war. Certainly, life will never be the same for the Iraqis, but for the world economy the effect seems to be limited. Indeed, the SARS virus in southern China that, at the time of writing this column, had killed a lot fewer people than the Iraq war, seems likely to have a more profound long term economic effect, just ask the airline industry or the Asian tourist industry.
Ironically the country with potentially the most to lose from the fall of Saddam is the UK with North Sea Oil now past its peak. The decline in oil prices that the success of the war has brought together with the potential opening up the rich Iraqi oil fields has dramatically reduced interest in searching for the remaining North Sea Oil. This could leave the UK in the embarrassing position of having lots of oil left under the sea but with no one deeming it economic to drill to find and recover it. Already most of the majors have left the North Sea as they see better opportunities elsewhere.
So if the war is turning out to be a non event in macro-economic terms where does this leave the pension fund investor?
Although, equities have moved off their lows there does not seem to be any confidence in the market. There is still a big debate as to whether equities (and especially US equities) are now cheap or still expensive. Very simply looking at historic figures and last year’s reported earnings the market seems expensive at above 30 times earnings. Apparently, based on analysts’ forecasts of 2003 operating earnings, the projected price/earnings ratio works out to be only 16.
However, one must question whether these estimates are realistic. Apart from adding a contingency margin for safety, one has to factor in the effect of corporations putting more money into their pension schemes and the cleaning up of corporate accounts post Enron.
We still have to bring in the effect of stock option reporting as well as other accounting standard changes. Now if the long term average historic price earning ratio is 15, I would guess that the market is still some 30% or more overvalued. I have seen other apparently conservative estimates showing the degree of overvaluation at 40% or higher. As a result the really convincing argument for me regarding the outlook for equities, comes from the updated ABN Amro Equity/Bond Millennium Study with figures put together by the London Business School. This shows that when the P/E is higher than average the returns over succeeding years are much lower than when the P/E ratio is low.
Clearly just because the P/E ratio has dropped from its previous obscenely high level is no reason to consider it low enough to expect good return over the next five or more years.
However pension funds cannot easily choose not to invest at all. Schemes cannot afford to just sit on cash earning very poor returns. Money should be invested but in the present climate the important issue should be diversification and risk control. No one really knows what will happen and funds cannot really take the risk of being out of markets altogether.
However, to continue to hold a large exposure to the equity market is probably too risky and just because the market has fallen is no excuse for thinking it cannot go on falling, just look at the Japanese market which has lost 80% of its value from its peak in the late 1980s.
The US in 2003 may not be the same as Japan in 1993 but it does provide a salutary reminder of what can go wrong.
So what can pension funds do? According to Goldman Sachs Asset Management appoint a fiduciary manager. What GSAM means by this is an asset manager providing a broad range of risk management and asset allocation services to a pension fund in addition to managing all or some of its assets. As a result the fund has access to state of the art tools, gains resources to monitor managers and manager selection. Effectively, it can be seen as a step up from the more traditional tactical asset allocator. The whole procedure can also shift responsibility for overall performance to an external entity whilst the fund can still retain some control over the process.
But what options are available to the average pension fund or medium-sized insurer that simply does not have the expertise to deal with current asset management issues in-house. Obviously, they can ignore the issue and hope it goes away; they can build a larger in house capability; they can create expensive risk management systems or buy in off the shelf solutions; they can hand over responsibility to consultants, outsourcing the decision making process or, according to GSAM, they could move to a fiduciary management model.
But can you be too clever? I would like to explore how a fiduciary management model, whether offered by GSAM or any other manager, compares with the fund of funds or manager of managers solutions as well as explore the other options open to pension funds in the next Cook Column.
At the present time funds really should investigate every opportunity to increase returns.