|
The trm Report - June 2006 A lot of effort has been spent providing fund managers with tools to identify high risk situations and to help them deal with those situations. Trustees are in much the same boat, and need to be able to understand the risks they run. Sir David Scholey famously said, on being asked when he thought financial markets would return to normal in the early 1990s: “What is normality? Maybe this is normality.” His comment was made even more pertinent by the fact that, several years after he said it, we still do not know if those circumstances were normal or abnormal. From 1990 to 1993, UK equities averaged 10% return, which is pretty close to the 9% they have averaged since 1985. This means that amidst one of the biggest economic crises of the past twenty years UK equities actually behaved ‘normally’ and produced averagely good returns. Conversely, during a three year period of decent economic growth, low inflation and low unemployment at the start of the new millennium, UK equities lost on average 17% a year. It is also worth noting that in 1994, the year that Britain seemed finally to have emerged from the havoc done by the Sterling crisis, the FTSE100 lost 10%. It is clear that the economy and the stock market do not always march in step. There are basically, two schools of thought as to how you can approach this. The first is to assume that equity performance is random. The second is to assume some sort of mean reversion or “umbrella behaviour” (what goes up, eventually comes down). Let us assume for the moment that markets are indeed random. Over the past twenty years, UK equities have had an average annual performance of 9% with a standard deviation of 15%. Assuming a normal distribution, this means in any given year there is a 27% chance of the market declining. (The reality is a startlingly close 25% occurrence). Furthermore, there is a 10% chance of the market falling 10% of more. Now, let us assume for a second that it doesn’t matter too much to a pension fund if the equity market is down the odd year, the problem comes when it is down, say, three years in a row, like 2000 - 2002. Now the good news is that, statistically, the chance of something with a 27% probability happening three times in a row is just 2%, which seems acceptably low. Unfortunately, that 2% is simply the odds for any given year. A trustee that is on the board of a fund for ten years is playing against those odds ten times, in what becomes a form of Russian roulette. The chance of the market being down three years running in any ten year period is actually closer to 20%, assuming complete randomness. One in fifty may be acceptable odds, one in five is probably not. Assuming markets are random, there is not a lot that you can do about this except either not take on the role of trustee for very long and hope that your stewardship does not occur during interesting times, as the Chinese curse has it, or accept that there is a sufficiently large chance for it to happen and to be prepared to deal with the situation when it arises. If we assume for the moment that the markets are not random, then the current situation for trustees is even worse. Our own research and that of Professor Shiller at Yale University indicate that both the US and the UK markets are substantially over valued. For example, according to our own methodology (based on Tobin’s ‘q’, as at 21st September 2005, US equities were 44% overvalued. The cyclically adjusted PE ratio used by Professor Shiller indicated an excess valuation of 72%. The two methods have historically tracked each other quite closely. The graph below (where 0 equals fair value, points below 0 indicate that equities are cheap, and points above 0 that they are expensive) shows relative value since the beginning of the last century for the US market. Either index shows that the US market is significantly over-valued in historical terms, and that even after the stock market falls at the beginning of the 21st Century shares are still as about as over valued as they were in the mid sixties
Whether the performance of equities is random or not, the position of a trustee is also a difficult one. Market pressures mean that even those intuitively inclined to favour the mean reversion argument often end up operating an investment policy pretty close to the random behaviour view, such are the asymmetric risks of non-conformity (in hindsight, UBS’s Tony Dye was right, but not soon enough to satisfy those looking for outperformance over a much shorter time horizon). The situation is rather similar to winning the toss in test cricket. The mantra on winning the toss is: “If you win the toss, bat first. Unless the conditions are very unfavourable for batting, then have a long hard think… before batting first”. A corollary of this is that over time, investment policies are likely to become even more uniform than they already are, as the Myners Review identified. One reason for this is that the trend towards uniformity creates a weight of money argument in favour of the majority’s decision. As a case in point, if over a period of time the percentage of pension funds that invested heavily in equities went from 60% to 70%, there is a greater likelihood that the performance of equities over that time would be good because of the amount of money being invested in equities. This in turn is likely to put pressure on the remaining 30% to change policy, whilst the likelihood is also that those that got the decision right will be tempted to continue the same strategy. At some point of course extraneous factors will take over, but increased uniformity means that you as a trustee are unlikely to be alone in this situation. Indeed, the chances are that the majority of pension schemes will be in a similar boat. This has interesting implications for you as a trustee. One positive is that you are unlikely to be singled out for fault. The negative, though, is that there is likely to be something of a scramble for the lifeboats. Although defined benefit schemes can and should look to their sponsoring employer to make up any deficit in pension funding, and can now also look to the Pension Protection Fund, there is no substitute for trustees being able to make informed judgements about investment strategy to lessen the likely need for either course of action. It is possible that a stock market decline occurs amidst general economic health – as happened in 2000 - 2002. However, it is fair to say that if the economy is not reasonably robust going into a stock market decline, then the chances are that the damage done by the market’s decline is likely to weaken it. In other words it is quite likely that it is precisely at the moment that pension funds would most need to look to their sponsoring company that the company would be least able to provide the funding needed. Whilst sponsoring companies may well act as a Dr. Jekyll when market conditions are relatively benign, the alchemy of adverse markets may turn them into their alter ego of Mr. Hyde. It is therefore more important than ever before that trustees are in a position to understand the vagaries of the markets and the economic factors which influence them. As Paul Myners pointed out in his review, the most important investment decisions made are those of asset allocation, not tactical investment, and these are the direct responsibility of the trustees . There is a vital need for trustees to be able to turn to either independent economic advisers or academic institutions or both to provide them not necessarily with advice but at least with an understanding and an insight into the key economic factors which can influence the performance of their portfolio and for trustees to educate themselves on a continuing basis. Only in this way will they be able to conduct informed discussions with their professional advisers, and properly discharge their responsibilities. Although space does not permit a detailed analysis, there has been a view among many pension fund advisers that overweighting in equities can be justified on economic grounds. It is true that equities have outperformed bonds over a very long period of time, but as the above chart shows there have been a number of occasions where equities have become so expensive it would have been a very poor decision to invest in them. Investment in US equities was not an attractive proposition in the late 60s, but had become so by the early 80’s. It is increasingly difficult to maintain that a buy and hold strategy is always an appropriate one for pension funds, and particularly for those that are becoming increasingly mature. The Japanese experience where the value of the Nikkei Index is still scarcely 40% of its 1989 level is a salutary reminder that the return on equities can remain subdued for long periods of time. Equity weighting needs to take account of volatility of the return on equities as well as the expected duration of the invested portfolio. Whatever view they ultimately take, trustees need to have a good grasp of these issues. Another factor that trustees need to consider when looking at equity investment is the matter of risk. It is patently absurd to suggest that because equities have, on average, over a long period of time provided higher returns than bonds, higher equity weightings somehow justify a lower contribution level from the plan sponsor. It implies that equities are somehow immune from the risk reward principle, and that there is a permanent indestructible arbitrage between equities and bonds. If this approach were followed to its logical conclusion pension funds investing in highly leveraged derivative instruments would be able to justify very low contribution rates. Except for those who believe in free lunches it is axiomatic that the greater potential return provided by equities is matched by a correspondingly higher risk, and a more volatile performance profile. The contribution of the plan sponsor should be the same irrespective of the investment, since all properly run portfolios will seek to maximise performance and minimise risk whilst taking into account their liability profile. Trustees, as never before, need to be aware of these issues and the key economic trends which can have an influence on their portfolios’ performance. Their actions will be judged in the unforgiving and omniscient court of hindsight, and they will be expected to show that they have mastered their economic brief and exercised their own judgement on asset allocation, rather than just having relied on the advice of others. Pelham Smithers and Madoc Batcup
|
 |
|
||||||||||||
|
||||||||||||||
