Return to equities not a sign of volatility ending, consultants say

But equity investors could be at risk if the US-China trade war triggers a recession, commentators say, amid fears the global economic cycle is entering its later stages.

Over the past decade, equity markets have witnessed a massive exodus of pension funds, with investors consolidating previous years’ gains and derisking into assets such as fixed income, infrastructure and private debt. However, Q1 recorded net inflows to equities among European investors at £12bn, reversing net outflows of £2bn in Q4 of 2018.

This reversal was not a wholesale return of confidence, but was prompted by investors attempting to capitalise on the fall in markets in late 2018, says Karen Shackleton, senior adviser at MJ Hudson Allenbridge.

“I think there were some tactical buying opportunities following the falls in the markets in Q4.”

Analysis of inflows also revealed that the majority of new mandates were awarded by public sector pension funds, as the eight Local Government Pension Scheme pools begin to allocate to their chosen new equity managers.

My advice has been to expect lower returns from equities than in the past five years

Karen Shackleton, MJ Hudson Allenbridge

The inflows to equities, despite being modest, do raise questions about risk at the late stage of the cycle. Louis-Paul Hill, public sector investment consultant at Aon, says: “We're towards the end of the economic cycle. There is a risk that risk assets such as equities suffer severe falls, which is going to hurt clients that have a large allocation to them.”

The US-China trade war kicked up a gear this month, as US President Donald Trump imposed billions of dollars in new tariffs on Chinese goods. The trade war could be a potential trigger for recession, Mr Hill says, and the onset of recession could see equity markets fall across the board.

However, fears that the end of the cycle is nigh are far from consensus. “Investor confidence has remained steady” so far, says Laith Khalaf, senior analyst at Hargreaves Lansdown.

Keeping it global

What is clear is that investors favoured global equities to UK equities in Q1. International stocks saw net inflows of £746bn, whereas UK equities saw net inflows of £24.5bn in the first quarter.

Preference for global over UK equities is nothing new. “Sentiment towards global markets is still more robust than towards the domestic market,” says Mr Khalaf.

This is because UK equities are associated with a number of risks, such as a no-deal Brexit. With uncertainty over the UK's departure from the EU unlikely to be resolved anytime soon, investors are likely to continue opting for global over domestic equities.

Carbon-heavy investing is another risk associated with UK equities, says Ms Shackleton, especially for investors looking to update their investment principles ahead of Department for Work and Pensions regulations arriving in October.

She says shifting from UK to global equities can dramatically reduce an investor’s carbon footprint: “The FTSE 100 index has a higher carbon footprint than global equities, so there are some easy wins if you move from UK to global.”

What can trustees do?

With the US-China trade war rumbling on and Brexit uncertainty continuing to plague equity markets, what should trustees be doing to protect their scheme’s value?

I wouldn't advise any knee-jerk reactions

Louis-Paul Hill, AON

Well, not much, according to Mr Hill. He advises that pension schemes with high equity exposure should be able to weather short-term volatility, and urges them to stick to their long-term strategies. “I wouldn't advise any knee-jerk reactions,” he says.

Investors should be prepared to collect significantly lower gains from equities as in previous years, says Ms Shackleton. “My advice has been to expect lower returns from equities than in the past five years.”

Equities will continue to play a vital role in asset allocations, wherever a pension scheme is in its funding journey. “[Equities] still, over the long term, represent a good investment with inflation-linking for a pension fund,” Ms Shackleton notes.

Active over passive

Quantitative easing in the wake of the global financial crisis unleashed years of stable growth in equity markets. Those upwards trends boosted the possibility of passive equity funds, while schemes became increasingly sceptical of active managers’ ability to beat benchmarks net of fees.

But with volatility seemingly here to stay the trend appears to be slowing, with pension funds taking a bet on active management to steer them through safely. While passive managers simply track a benchmark up and down, active managers can attempt to soften the edges as markets rise and fall.

UK-based equity investors preferred active to passive management in Q1, the figures show. Active management saw net inflows of £746bn, whereas passive management recorded net outflows of £3.4bn in the first quarter.

“Particularly with things like some of the geopolitical risks, an active manager can – as long as they can get those calls right, and I'm not saying that's easy – be a little bit more nimble and try to avoid the sharp falls,” Ms Shackleton says. 

This is all very well in theory, notes Mr Hill, but it ultimately depends on the skill of the individual manager. “If you pick a good manager and you outperform [benchmark] performance, then an active manager is going to be better than a passive manager,” he says.

Overall, the question of active or passive management depends largely on the preference of trustees, he adds.

Interested in LGPS? Register now to attend the Pensions Expert Local Government Pension Scheme Forum on September 12 2019 live.ft.com/LGPS