What to buy now?

High deficits, low gilt yields, expensive equities and forecasts of further volatility on the horizon – pension fund managers have plenty to navigate. Mark Dunne looks at how they are allocating their assets.

“The only free lunch in town is probably being diversified.”

Mark Hedges, Nationwide Pension Fund

The Nationwide Pension Fund’s portfolio has evolved this year. At the end of December 2016 the closed defined benefit (DB) scheme for the Nationwide Building Society was 20% invested in equities. By mid February its allocation had fallen to 15%.This reduction is the result of chief investment officer Mark Hedges’ rotation into higher yielding assets, such as infrastructure, private equity, private credit, ground rents and property. Private market investments such as these accounted for 20% of the £4.94bn fund’s assets in the second month of 2017.Hedges is not the only pension fund manager who is increasing his exposure to long term, higher yielding assets that are less vulnerable to political and economic shocks. Others are taking similar steps to help meet their commitments in a low interest rate environment and head off a repeat of the volatility that hit the markets in 2016.The stand-off between the US and North Korea and the messy negotiations on the terms of the UK’s exit from the European Union (EU) could be catalysts for turbulence in the coming months.Church of England Pensions Board (CEPB) chief investment officer Pierre Jameson is another working to alter his portfolio to avoid the low returns and potential market volatility ahead. The assets he is looking at investing in are infrastructure and low risk equity rather than low volatility equity.“Low risk equity is very much like low volatility equity but does not carry the same connotations, shall we say,” Jameson said, speaking to portfolio institutional earlier this year. “It is a little bit more than smart beta, but there are crossovers.“Essentially, the kinds of managers we are looking to use are heavily quant-based,” he adds. “So they will be screening historic data within universes for low share price volatility, low risk exposure to the whole range of potential economic and political outcomes. That tends to narrow the universe quite a bit. Then they apply forward looking judgements about how companies might react under new circumstances.”Also pursuing a specialist strategy to protect against market turbulence is the HSBC Bank Pension Trust. Chief investment officer Mark Thompson, who is in charge of a £3bn defined contribution (DC) scheme, had an idea last year to create a better accumulation fund. This would be built around generating better risk-adjusted returns, include climate change protection and a stronger management engagement policy.Thompson approached Legal & General, FTSE and an investment consultant with the idea. “The upshot of that is FTSE launched a new Index in November, Legal & General announced a new fund for that index and I said I would put £1.85bn in it,” he says.The idea is to produce a better risk-adjusted return by moving away from a market cap index to a smart beta factor index, based on a number of factors including value, quality and low volatility. “If you look at how that index would have performed from 2000 to last year, the market cap would have gone up by 7% per annum and the index by 9.6% per annum, but for lower volatility. So a better risk-adjusted return,” he adds.NEW ORDER JLT Employee Benefits senior investment consultant David Will says that the search for yield in the current low gilt return environment has gone beyond traditional asset classes.“People have looked not just at corporate debt but have gone down the rating scale into high yield and other areas of the market,” he adds. This includes floating rate senior secured loans, which are less vulnerable to interest rate rises than fixed income bonds, and commercial property.The non-traditional and illiquid assets that Hedges has turned his attention to are what he sees as alternatives to investing in index-linked gilts. This means ground rents and property, which are hedged for inflation and generate long-term cashflows.Hedges is considering investing in insurance catastrophe bonds as part of his search for return. “This is one of the reasons why we sold down our equity position to fund investment in those,” he says.He is not just looking for higher returns, but also to reduce risk. The private market assets that the Nationwide Pension Fund is moving into are less correlated to GDP and the general economic events that affect equities and gilts. Jameson’s strategy is to have half the volatility of equities in his portfolio over a market cycle, but broadly the same return. “So 10% volatility but probably still getting 7% to 8% per annum return over time,” he says.“What you might call smart beta or low volatility strategies, these are the kind of strategies that you might expect to underperform in a rising market, but strongly outperform in falling markets.” Diversity is at the heart of Nationwide Pension Fund’s focus on long-term income streams and de-risking. And not just by asset class. The scheme has exposure to Europe, the US and Asia. “The only free lunch in town is probably being diversified,” Hedges says.PRICE IS WHAT YOU PAY… London-listed companies paid dividends totalling £33.3bn in the second quarter, a record for the period and 14.5% higher than they returned in the same quarter a year earlier. This makes certain equities attractive while 10-year gilts yield less than 1.5%.However, investors increasing their exposure to equities trading in London could be forgiven for feeling they have paid too much for what they hope will provide access to more cash and potential capital gains. The UK’s blue chip index traded on a PE of around 35% in September, compared to 33% at the end of 2016, and was more than double the 15% historical average.US valuations do not make better reading. They currently trade on around 25 times earnings, compared to an historical average of 15.6 times.Hedges’ decision to reduce the scheme’s exposure to equities was partly driven by the high valuation of company shares. “We thought the equity markets in January got quite high,” he adds. He believes that equities, and not just those in the UK, look expensive. “PE ratios look ridiculously high,” Hedges adds.“They look overpriced at the moment, but the problem has been that there aren’t any other assets to invest in because most other assets look overpriced.“The problem for investors of late is that they continue to go up,” he says. “You have had a number of record highs, but these PE ratios do not look realistic.” Jameson does not agree, believing that equities have further to go, although he does acknowledge that UK and US shares are as expensive than at any time since the mid 90s. “As always with markets it is a discounting mechanism and what you have not seen come through yet in any great strength are earnings upgrades,” he says.“The other big uncertainty is around what happens fiscally and politically in the US,” he adds. “Generally, forecasters have not embedded any new forecasts in yet because they do not have any numbers to put into their models. If I am forced to give a view, I think there is still some upside in the equity markets.” Jameson is not alone in believing that equities have further to run.“Just because something might look expensive does not mean that it can’t get even more expensive,” ponders JLT’s Will.Shoqat Bunglawala, who is responsible for Goldman Sachs Asset Management’s (GSAM) multi-asset business outside of the US, believes that European and US equities will benefit from continuing economic growth. He does, however, warn of potential headwinds related to China’s slowdown and increasing political risk in the US and Europe. “As a result, a number of asset classes are likely to be range bound and that includes equities,” he adds.“Therefore, we think it is important to be nimble and dynamic in your approach to trading the range because there can be temporary bouts of volatility in markets and we think that is going to be the case for equities.”EMERGING MARKETS RETURN For those moving up the risk curve and concerned about paying too much for developed market equities, they could always turn to the emerging markets. These regions have suffered in recent years thanks to a toxic mix of slower growth in China and lower commodity prices. Then there is the US dollar, which the emerging markets have strong links to. If the US falls into recession or its currency weakens then there will be a knock-on effect in these markets.Hedges is bullish. “In the longer term I would say you have got to expect that there are some value opportunities here, particularly in Asia where China is still growing,” he says. “If it is growing by 6% that is still pretty dramatic, even if it is not the figure it used to be.“There are a host of other Asian nations that are growing and they are creating demand,” Hedges adds. “You are seeing more wealth being created there and they are going to spend money. That is more of a longer term trend rather than an immediate one.”Nationwide Pension Fund’s exposure to the emerging markets includes infrastructure and property funds as well as investments that focus on consumer spending.“There is potential value in creating those opportunities in an area that has a growing and wealthier middle class who are going to be spending,” he says. “These countries are getting wealthier and there are a lot of people there.”Jameson has made what he describes as reasonable allocations to local currency emerging market sovereign debt and emerging market equities for the Church of England Pensions Board. “We are not currently looking to add any more funds to those areas, but we are still expecting reasonable returns from them,” he says.Jameson believes that the potential political risks from the US on emerging market sovereign debt are offset by the outlook for commodities and improvements in corporate governance and what he calls the “general situation” in some of those countries.Will adds that the emerging markets are not homogenous and that some countries in those regions are more vulnerable to economic and political shocks than others. He says that this can be quite different depending on if investors are looking at commodity exporters or countries vulnerable to movements in the US dollar.“Arguably there are some areas where there is some value to be had,” Will says, but warns that some equities in these regions are looking “fairly fully priced,” as well.But GSAM’s Bunglawala believes that while rises in US rates may pose some headwinds for emerging markets in the near term, on a medium term basis, given that “there has been a significant valuation adjustment in EM and an improvement in the macro imbalances of a range of emerging markets, their level of sensitivity to rising US policy rates has improved, particularly given higher levels of local debt issuance relative to dollar debt issuance.Overall, we expect EM outperformance relative to developed markets,” he says. This is one example of where opportunities can be found among the noise of the potential political and economic shocks ahead.Dealing with volatility is one issue; finding long term, high-yielding assets is another. Members of the above pension schemes should be content to hear that fund managers are working to achieve both.