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The Actuary The magazine of the Institute & Faculty of Actuaries

The case for global equities

P ension funds have two types of accrued liabi-
lities: those you can match and those that you cannot match. Some people would have you believe that it is possible to match all accrued liabilities, whether they be in respect of 80-year-old pensioners or 20-year-old members in active service. With a large enough population, it is possible to genuinely match benefit outgo for pensioners by holding a portfolio of fixed-interest and index-linked bonds.
For longer-term liabilities, this is clearly not possible. Apart from the fact that there are no bonds available with a long enough term, the liabilities for active members are unknown in either nominal or real terms, due to salary increases.
Under the minimum funding requirement, a ‘matched’ asset strategy would involve holding mainly UK equities for members who had not yet retired. This could be given as a reason for basing a performance benchmark on UK equities. In most cases, however, it is inappropriate to base a benchmark on what is intended to be a safety net for pension schemes, especially if this adversely affects long-term performance.
A more traditional argument has been that to match UK salary increases, you should hold UK equities, as they will broadly match UK price inflation, which in turn will broadly match UK salary increases. This argument is not completely watertight. True, the long-term relationship between salary inflation and price inflation is relatively stable over time; however, it is difficult to establish any consistent relationship between equity returns and price inflation. Price inflation does impose real economic costs, through increased uncertainty. However, equities can generally be regarded as real investments, in that their returns should maintain their purchasing power for a long time. There is, though, no necessary relationship between real equity returns (which depend on real returns to capital) and real salary growth (which depends on real returns to labour) although the economic conditions which are conducive to real salary growth may also be conducive to good real returns to capital.
So, should you invest in UK equities to protect you from UK inflation? The argument is flawed in two respects, one practical and one theoretical. The practical flaw arises from the question: ‘Is it possible to define a UK equity?’ You could exclude all stocks whose non-sterling profits exceed a certain proportion this could be done using the new FT-SE multinational indices. This would, however, significantly deplete the universe of equities, especially large capitalisation stocks, available to a manager. This would be especially true in certain industries, such as pharmaceuticals, and could lead to an unbalanced performance benchmark for investment managers. Is this really a desirable route?
The theoretical flaw arises from the fact that an equity is a real investment wherever profits are earned and wherever it happens to be quoted. This link between foreign equity returns and UK price inflation comes from the purchasing power parity argument. This is unconvincing as an explanation for exchange rate movement in the short run but, given the investment time horizon of a pension fund, this does not matter. So, instead of trying to exclude multinationals from the UK index in some vain attempt to create a genuinely UK portfolio, it would be better to move in the opposite direction and move to a truly global equity portfolio built around a global equity benchmark. This leaves managers able to pick what they believe to be the best stocks from around the world. For instance, if a manager wants to balance a portfolio by having some exposure to pharmaceuticals but does not like any of the UK-domiciled options, he could instead hold a Swiss or a US stock.
One argument against such an approach is that a global benchmark may encourage managers to invest too heavily in a market that is overpriced relative to the UK. However, this is no different from saying that an FT-A All-Share benchmark may encourage managers to invest too heavily in an overpriced sector. The degree to which either of these assertions is true depends on the degree by which a manager is allowed to deviate from the stock allocation benchmark and, if appropriate, the split between the passive core and active satellite. In any event, such an approach is not yet the norm, so opportunities for outperformance by active managers, should, in theory, be greater than for UK mandates.
There is no need for such a strategy to be confined to large pension schemes; smaller investors could follow this route if appropriate collective investment vehicles were freely available. A global approach to equities could stretch the resources of some smaller managers. However, as many industries become more global and it will inevitably be the largest firms within each industry that spread their wings ignoring cross-border comparisons could mean ignoring some of the best-performing stocks. It is time to take a global view.