Market commentary March 2006

Do the institutional pension funds give any clues as to how you should be structuring your portfolio?

In the 1990’s pension funds bought equities and turned their backs on bonds.  This was despite the fact that there were not just good liability-matching reasons for buying bonds, but also because the investment case for bonds in a disinflationary environment was obvious even without with the benefit of hindsight.  The attractions of bonds were overlooked, and they outperformed equities for much of the decade.

Commercial property also looked increasingly attractive in that disinflationary environment.  Again this asset class, largely overlooked by pension funds, had a great run.

This crazy lack of diversification by pension funds (and other institutions) left them very exposed in the subsequent bear market.  So after a superb period for bonds and property, what have the pension funds been doing?  Rebuilding their weightings in property and bonds, asset classes which might not be too over-stretched, yet no longer look compellingly attractive, and all this at the expense of their weightings in UK equities.

As the UK institutions turn their backs on UK equities, so the acquisitive private equity operators are moving in, and it is just a matter of time before they take out one of the household names in the FTSE 100 index.  Clearly there is value in the FTSE 100 constituents, plus greater diversification potential than is immediately apparent, with 60% of the footsie’s non-financial revenue being generated overseas.  Interestingly, oil and mining account for less than 3% of UK GDP, but over 20% of the footsie.  This makes the mining sector larger than the food and general retailers put together – so it could be argued that what is going on in China is more important to the footsie than sales on our own High Streets.

The key lesson appears to do the opposite of the myopic and regulatory-constrained institutions.  Diversification remains vital and you cannot avoid having bonds and property in a rationally structured portfolio.  You can’t diversify your equity risk much more by going overseas, at least not to other Western markets, which are highly correlated with the UK.  But there remain much lower correlations with Japan, Emerging Markets and Asia generally.

If you find the footsie a bit too boring for your tastes, you need stray no further than the UK small and mid-caps for both a bit more action and diversification.  Domestically-orientated small caps have generated returns nearly three times greater than their larger (global-facing) brethren over the last 5 years, building on their long term track record of outperformance, albeit in a more volatile manner and often requiring a bit more patience.