With stock markets becoming increasingly concentrated, could thinking outside the box become a more prudent choice for pension schemes?
Legends in investment management tend to be spun around contrarian investors, people who had the courage not to follow the herd and position themselves against the market.
Michael Burry is one such investor whose courage to think differently has seen him immortalised on film. The Big Short portrayed the hedge fund manager’s decision in 2005 to make a $1bn (£774.7m) bet against the US housing market. The rest, as they say, is history.
In contrast, despite the media attention devoted to the investment strategies of Warren Buffet, George Soros and Bill Ackman, Hollywood is unlikely to spend tens of millions of dollars making a film about a pension scheme which invests all its assets passively at a reasonable management fee to replicate the performance of the MSCI Global index.
Yet this is precisely what is on the minds of most pension scheme managers. Institutional investment can be boring, and most trustees and scheme executives are happy to be so. Their priorities are typically long-term returns, risk management and affordability, rather than dramatic out-performance and Hollywood status. But with stock markets becoming increasingly concentrated and volatility rising, could taking a stance against dominant market views sometimes become a safer bet?
Shrinking universe
Over the past two decades, stock markets in the developed world have become more concentrated in terms of the volume of new listings and which stocks are attracting the bulk of shareholders’ cash. While the number of listed companies globally has increased in the past few decades, it has fallen sharply in developed markets such as the US, Europe and the UK. In the US, the number of publicly-traded firms has dropped from a peak in the mid-90s, when more than 8,000 firms were listed, to around 4,400 in 2018, according to the World Bank. Similarly, in the UK, the number of companies trading in London fell to 1,858 in 2015 from its 2,913 peak in 2006.
The shrinking membership of Western stock markets is driven by a combination of factors, including the rise of private equity, mergers and acquisition and, in particular, the abundance of alternative financing models born out of a zero-interest rate environment.
It also coincides with the emergence of index investing. And with most leading stock market indices being market-cap based, a handful of firms have grown to dominate global stock market indices. For example, a scheme might hold an ETF designed to mirror the performance of the MSCI World in combination with US equity ETFs. But due to the market cap-based nature of both indices, the scheme will be largely invested in the same handful of firms across both funds. In each case, the FAANG stocks are likely to account for the top five positions in the fund’s portfolio.
More than 66% of MSCI World is held in US stocks and some 12% are invested in the FAANGs, hardly making it a globally diversified portfolio. In the aftermath of the global financial crisis, the money managed by the global fund industry has skyrocketed to more than $51trn (£39.5trn) from $12trn (£9.2trn) in 2009, according to EFAMA. In other words, a rapidly growing amount of investor cash is chasing the profits of a dwindling number of companies.
Pension schemes, which are increasingly invested in passive funds, are part and parcel of this trend. More than half of all equity assets held by UK schemes are managed passively, while defined contribution (DC) schemes hold virtually all their assets in passive funds.
The trend towards concentration has been accelerated by the Covid pandemic, argues Daniel Booth, chief investment officer at Border to Coast. “When you look at the concentration of markets by top stocks, you’ll see that the top 10 stocks, countries or sectors, vary over time. But what we are seeing in the recent period is that the top stocks have outperformed the market, which is quite an unusual thing because usually the top 10 stocks would face headwinds of regulation from above and competition from below. So effectively overtime you tend to see quite a lot of turnover at the top 10 stocks.
“What we’ve seen recently is the top 10 stocks outperform the index, and that applies especially to the top five stocks in the S&P500, the FAANG stocks, this year they have outperformed the other 495 stocks by around a third. So that has driven an increase in concentration in the US,” he argues.
The reasons for the dominance of tech stocks are complex, he says. “Partly that is due to the regulatory environment catching up on the evolving tech sector and also some of the competitive behaviours and acquisition activity of some tech companies. You do get periodic concentration in stock market indices overtime (Japan accounted for almost 50% of the world index in 1980s) and we have seen that particularly in 2020, as the Covid related market environment is hitting some sectors (such as hospitality and travel) and benefiting companies with an online presence. So, a trend that was already in place has been accelerated by the Covid crisis,” Booth explains.
Potential for a turnaround
So far, the gamble has paid off for many equity investors, with FAANG stocks recouping most of their losses from earlier this year. But as stock market volatility and warnings of a tech bubble are mounting, could it be time for pension schemes to think outside the box? At its recent peak valuation, Apple’s market cap exceeded that of the FTSE, while Tesla’s market value grew bigger than all other car manufacturers combined.
Booth acknowledges that valuations have reached extreme levels. “The relative valuations of growth versus value are quite extreme today. When we look at the beginning of the year, according to Research Affiliates, we were at the 95th percentile and that means the ratio of more expensive growth stocks to cheaper value stocks, was more expensive than 95% of the history, and we’re now at a 100%. So, the divergence between the expensive stocks and the cheap stocks is at record levels. That is partly because of the Covid market environment that has benefited online large-cap tech companies and been disadvantageous for cyclical, leveraged value sectors,” he warns.
Structural changes to stock markets have made it increasingly challenging to put an accurate price tag on a company’s shares. Popular methods such as the Shiller PE struggle to capture the potential effect of the Covid pandemic on future earnings. Meanwhile, negative interest rates on bonds have posed a serious challenge to the discounted cash-flow model, as portfolio institutional explored in our previous issue.
Added to that is the gradual decline of analyst coverage for individual stocks, partly as an unintended side effect of Mifid II. Since the introduction of the new rules unbundling research and trading costs, investment banks have cut back on their research departments. Over the past year alone, analyst coverage of UK-listed firms has dropped by 52%, according to Citigate Dewe Rogerson. Across Europe, analyst coverage fell by 38%. One consequence of this decline in research output could be that high-quality SME companies might fall off the radar for institutional investors, the firms warns.
Most schemes might be reluctant to describe themselves as contrarian investors and are careful to avoid the impression of banking on short-term, tactical trades. But neither do they wish to stand accused of simply replicating what everybody else does. As valuations of a handful of stocks have reached increasingly extreme levels, could a move away from indices start to become a more prudent approach?
Thinking outside the box
There are, of course, multiple ways of doing so, from allocating a growing proportion of assets into actively-managed strategies to implementing a factor tilt across portfolios. Or, at the most fundamental level, being comfortable with having a relatively higher active share compared to benchmark indices.
Less mature final salary schemes with an in-house investment capacity might find it easier to develop a strategy that is to some degree independent of indices. One example is Railpen. The £30bn Railways Pension Scheme manages the bulk of its equity assets itself.
As part of that, the scheme has employed a blend of factor exposures, as Craig Heron, head of public markets for the scheme, explains. “We have about a decade of experience with exposures to different factor investments, which have evolved over time. Most of that was done externally 10 years ago, but now the vast majority of our strategy is internally managed by a nine-person team dedicated to running quantitative equity strategies.
“We’ve expanded the range of factors we invest in, the first one was low volatility. We now have four individual strategies: low volatility, quality, momentum and value. We construct our portfolios using a combination of portfolio blending and signal blending. The basic idea is that by taking on this exposure from the start, we are harvesting premia above the equity risk premium,” he adds.
Taking risks does not always pay out in the short-term, Heron says. For example, the scheme continues to hold about £2bn of its assets in an internally managed value-strategy, despite value as a factor having consistently underperformed growth assets during the past decade. But Heron insists that the strategy should be judged within the entirety of the portfolio and over the long term.
Year to date, the MSCI All Country Enhanced Value index has performed -14.3% below the MSCI All Country. Heron points out that the scheme’s strategy has declined 13% throughout that period, somewhat less than the index, at an active share of up to 90%. Combined with other strategies the scheme runs, such as a high conviction equity strategy, the active share is still in the range of 40% to 50%.
Border to Coast’s Booth also stresses that long-term investors should not dismiss the potential for a turnaround in stock markets. The £45bn LGPS pool manages a large proportion of its equity assets in-house, with three internal equity funds and two external equity funds.
“The predictive power of stock valuations is quite strong over a 10-year period but over a year it is quite weak. So, there is not much predictive power in those valuations for the next one-year returns. When you’re looking over a 10-year horizon and you are at extreme valuations that you are seeing there should be a benefit to investing in value over growth stocks,” Booth argues.
While Booth is keen to stress that the pool has not placed any significant bets on underdogs, he says that the scheme is balancing risk neutral positions out of over-performing growth companies and into underperforming value companies. “We don’t have a huge factor exposure within funds, but we are cognisant of the market environment. Within our internally managed funds, we are taking profits on outperforming stocks and rotating them back into cheaper stocks. As part of that, the scheme has taken profits out of some large cap tech stocks. In contrast, financials could be an area to increase exposure to in 2021, with many banks having improved their Tier I funding levels substantially and not having immediate refinancing requirements they had during the last crises, he predicts.
Meanwhile, many DC schemes which invest predominantly in passive strategies might find it more challenging to position themselves independently from mainstream market views. Indeed, the default funds in their growth phase are positioned similarly to mainstream equity indices.
However, Nest says that as the scheme has grown rapidly, it has increasingly been able to integrate different risk factors into its investment strategy, explains Katharina Lindmeier, responsible investment manager at Nest. Earlier this year, the scheme shifted £5.5bn, it’s entire global equity exposure, into a climate aware fund, which overweights low carbon emitters.
Overall, schemes continue to remain cautious about embracing the label of contrarian investor. But stretched market valuations and increased levels of concentration might drive them to new perspectives. “As CIO or asset manager, you need to be an independent thinker, which means you should not always follow the herd or be a contrarian,” Heron says.
“Perhaps, in our case, thinking outside the box means trying not to pay too much attention to the short-term noise and actually sticking to the long-term plan,” he adds.
While the strategy is unlikely to feature in a Hollywood blockbuster, it might help pay secure member’s benefits over the long term.
