Traditionally, much of the focus of UK pension fund investment has been on whether or not fund managers outperform their particular benchmark or index. However, trustees and investment consultants are turning their attention to whether the equity indices they benchmark managers against remain appropriate.
There are a number of factors driving this:
q the domination of the UK equity market by a handful of companies;
q the introduction of a single currency within continental Europe;
q the potential move towards a truly global equity market.
Historically, UK pension funds have retained a bias towards their domestic equity, and with good reason. However, to do so prudently, the UK equity market needs to demonstrate sufficient diversity, in terms of both stock-specific and sector risk. If the domestic market becomes increasingly concentrated (although it remains somewhat less so that some of the other country indices within Europe), investors need to seek ways of diversifying this risk.
With the recent spate of mergers and take-overs, the 20 largest companies now account for over 50% of the UK market. More significantly the five largest companies alone represent over 30% of the market. This has resulted in an increase in benchmark risk for UK pension funds equivalent to the level of risk in a typical actively managed portfolio.
As a result we believe the current peer group allocation towards UK equities of 70–75% of total equities is far from optimal. Our research suggests trustees should be reducing their UK bias, allocating a greater proportion of their assets to international markets. We would add one caveat to this – many trustees are constrained by the current minimum funding requirement test, which promotes the retention of a home bias.
The introduction of a single currency in Europe represents a structural change within continental Europe. There is already evidence of increased correlation of returns within sectors. However, this research also suggests that the country in which a stock is listed, at least for the time being, continues to have as much impact on the price of a share.
From a UK perspective, we believe the UK’s adoption of the euro, or indeed the emergence of a single European equity trading platform, would lead to the European, rather than UK, equity becoming the domestic asset. With this in mind we believe trustees should start preparing for the transition now. To do this, trustees need to implement a strategy to allow them to move from the traditional benchmark allocation, where assets are divided between UK and continental European equities to one where the European equity is the domestic asset class. Figure 1 sets out such a potential structure.
Under this structure the traditional continental European benchmark is replaced with a pan-European index. Trustees can then alter the balance between their UK and pan-European allocation over a predefined period of time, or by reference to pre-defined triggers along the path to the UK joining the single currency or the emergence of a single European equity market.
Widening the focus, many of us would be forgiven for thinking that we already have a truly global marketplace: it is true that technology has given companies and individuals far greater reach across the globe. However, the evidence to date does little to prove that individual stock prices are driven by global market movements, and the region of index in which a stock is listed is still the primary factor affecting price. There are exceptions to this rule, such as oil and pharmaceutical stocks, but they remain in the minority at present.
It is inevitable that there will be change, albeit we believe the pace of change is likely to be slower than that affecting European markets. We suggest, therefore, that trustees of UK pension plans can begin to take some action now by implementing a transition from the current regional approach to international investment by introducing global equity managers in addition to their regional based mandates (see Figure 2).
Typically these global mandates would be benchmarked against a world index, ie, one which includes the UK.
As with the approach to Europe described above, this method provides an easy mechanism for trustees to alter the balance from regional to a more ‘bottom up’ approach to global equity investment, as the trend towards globalisation becomes more pronounced and better defined.
We believe this provides an opportunity for capturing additional investment return from truly global fund managers, who can exploit the inefficiencies created by this transition in global markets.
There has been much coverage of an alternative to our approach, which encompasses the use of the newly created multinational range of indices. The argument in favour of this approach is predicated upon multinational companies exhibiting different characteristics from domestic or local stocks. Whilst this solution also deals with the need to diversify from an increasingly concentrated UK market, evidence suggests that the performance of multinationals is still closely correlated to their domestic market. This is backed up by analysis that the level of overseas sales by the top 100 UK companies has shown little sign of increasing over the last decade. What the multinationals approach does do is capture a large company effect, which probably explains a greater element of the difference in performance between stocks in recent years, which we do not see as desirable.
It is appropriate to challenge traditional benchmarks where there is a clear trend pointing towards the need for change. Investors normally benefit from being one of the first to change, rather than one of the followers. With this in mind we believe it is appropriate to reduce the current bias to the domestic equity market, and invest a greater proportion of equity assets internationally. We believe trustees should put in place a more European driven structure now that will facilitate the transition to a single European market, as and when this takes place. Further, we would encourage trustees to consider implementing a truly ‘bottom up’ global equity mandate, albeit not a total shift away from the current regional approach.
Andrew Green is head of strategic investment consulting at Mercer.