Being a large equity investor in a relatively small domestic market can have advantages as well as drawbacks. Proximity to the market and its infrastructure, good knowledge of corporates and corporate leaders, and the ability to exercise strong influence as an owner, potentially a stable long-term one, all count among the advantages. The need to avoid concentration – in terms of position, sizing and overall allocations – and idiosyncratic sector exposure are among the challenges. 

June 2023 Editor's Letter

In 2022, slightly better performance across regional European markets has helped investors with local or regional market overweights to offset the poor performance of global equities. This has persisted. Overall, European equities, up around 15% for the year to end-April, have significantly outpaced global equities, which rose 10%. 

Many smaller regional equity markets include large-cap liquid companies with globally diverse revenue streams.

This comes at the cost of some concentration. Phamaceutical Novo Nordisk, for example, dominates the Danish equity market on a capitalisation basis, which has driven the market’s year-to-date returns (as of end-April) to more than double those of the MSCI World index.

While Switzerland’s equity market is dominated by global players like Nestlé, Novartis and Roche, the market cap distribution is relatively even. Sweden’s market has some global players with a relatively even distribution at a much lower market cap.

For AMF in Sweden, six of the top 20 return drivers across the whole portfolio in 2022 were domestic firms, including healthcare specialist Essity and forestry company CSA. Novo Nordisk was a leading performer in ATP’s equity portfolio in 2022.

Stakeholders are more likely to be forgiving of local losses than with stakes in overseas companies. Would criticism of Alecta have been so intense if Silicon Valley Bank had been a local company? There would have been greater public understanding and knowledge of the investment case, as well as greater sharing of the downside pain as many other parties would also have been invested.

In countries like the UK, there has been a steady shift away from pension fund exposure to the domestic equity market. According to Schroders, UK equity allocations by pension funds have declined from 50% of overall assets in the 1990s to less than 2% now. 

In tandem with the tide of globalisation, the standard advice from consultants was to shift away from local markets and towards global equities mandates. As schemes’ liability profiles have matured there has been a natural shift away from equities and towards bonds, credit and illiquid alternatives. With a sector bias in favour of unsexy industries like insurance, mining and oil in the large-cap segment, and without tech-focused growth stocks, the UK market has often appeared dowdy and unexciting. 

In 2012, the Kay Review of UK Equity Markets and Long-term Decision Making highlighted the short-termism of UK corporates, including underinvestment in areas such as research and staff development. Better engagement by long-term investors was to be part of the solution, but engagement cannot happen without ownership.

There may be many reasons to diversify away from concentrated markets and liquid investments. There are also strong reasons for pension funds in markets like the UK to consider a structural reallocation to domestic equities. Others, like UK discretionary private wealth managers, have retained a larger weighting to domestic stocks.

From a human capital perspective, local markets can provide an opportunity to develop in-house investment talent. A bottom-up equity strategy in a local market can provide thematic, alpha-generation possibilities. 

Greater involvement creates opportunities to shape the market. Denmark’s ATP has recently called for changes on prospectus rules in relation to local IPOs. Without significant ownership, institutional investors lose the ability to protect the interests of long-term investors either in capital-raising practices or in corporate governance codes.

UK fund management chiefs have recently called for higher board pay to boost the attractiveness of London as a corporate listings venue. This goes against the grain of much engagement activity by institutional investors, but without a stake, their voice will go unheeded. 

At the same time, a greater allocation to domestic markets is more in tune with contemporary political thinking in a world focused on deglobalisation.

It’s now more than two years since Rob Arnott of Research Affiliates named UK equities as a trade of the decade. With a P/E ratio of less than half of some developed markets, it continues to look attractive on a pure valuation basis. It might be time for pension funds to reconsider their domestic equity allocation policies. 

Liam Kennedy, Editor