Struggle ahead for active U.K. equity managers

Active long-only U.K. equity managers are taking stock of their business plans as British pension funds continue to look overseas for better risk-adjusted returns.

At least one — Martin Currie Investment Management Ltd., Edinburgh — has pulled the plug on its open-end U.K. equity strategies altogether. In a signal of the potential struggle ahead for other long-only managers, CEO Willie Watt said of the reason for closing the institutional U.K. active equity strategy this year: “Investors are focusing on global equities, so we saw that the future of U.K. equity as an institutional product was going to be very limited.”

Once the anchor of almost all U.K. institutional portfolios, U.K. equity is gradually being relegated to the sidelines, leaving many active managers struggling to hang on to assets even amid strong performance. Craig Gillespie, senior investment consultant at Towers Watson & Co., Reigate, England, said the move out of U.K. equity reached “a tipping point within the past several years and then just began to snowball.”

U.K. pension funds are reducing their total exposure — active and passive — to U.K. equity, although active managers have been hit hardest, according to consultants. A 2010 survey that included 331 U.K. pension fund professionals with aggregate assets of about £909 billion ($1.45 trillion) revealed only 2% of the respondents were planning to search for a U.K. equity manager in the following year, according to Greenwich Associates LLC. That figure was 8% just two years earlier.

“I think opportunities to gain new business in domestic equity are very few and far between,” said Marc Haynes, vice president and consultant at Greenwich Associates in London.

What's happening in the U.K. has implications for the U.S., where pension funds also are reducing active domestic equity holdings in favor of a more global approach. Udo Frank, global CEO for RCM Capital Management LLC in San Francisco, said U.K. pension funds have been gradually reducing their home bias for at least the past 10 years. “The U.S. is starting on that journey now,” Mr. Frank said.

According to data from Greenwich Associates, 23% of U.S. corporate pension funds and 27% of U.S. public funds plan to significantly reduce active domestic equity by 2012. Only 7% of U.S. corporate funds and 5% of U.S. public funds are planning to increase exposure to domestic equity.

“U.K. pension funds are further ahead ... in moving their U.K. equity strategies from core to satellite,” said Mr. Frank, whose firm manages about $146 billion in global assets.

Managers and consultants don't believe the pace of domestic equity reduction will happen as quickly in the U.S. because of its much larger market capitalization — estimated to be 24.5% of the global economy measured in U.S. dollar terms, according to the latest data from The World Bank, Washington. In comparison, the U.K. accounts for about 3.7%.

The average U.K. pension fund's exposure to domestic stocks is 50% of the total equity portfolio in 2010 vs. about 63% five years ago, according to figures from Mercer LLC, which compared data from the firm's annual European asset allocation surveys. However, some pension funds have reduced their domestic equity exposure to as low as 10% of total equity assets from as high as 70% a decade ago, according to estimates from several consultants.

“It's really an inevitable trend that's set to continue,” said Fiona Dunsire, Mercer's head of the U.K. investment consulting business based in London. “Pension funds' U.K. equity exposure could ultimately go as low as market cap, but I think some domestic equity bias will remain.”

Officials at the £3.2 billion Lothian Pension Fund, Edinburgh, reduced the fund's U.K. equity exposure to 15% from 18% in the latest asset allocation review that is now being implemented. Since 2006, the fund's U.K. equity portfolio has been more than halved from 36.5% of total assets. Allocations to both alternatives and global equities increased as a result.

In the first round of Lothian's portfolio restructuring in 2006, Baillie Gifford and UBS both lost their active U.K. equity mandates, which totaled about £245 million and £220 million, respectively, at the time. Martin Currie, which was Lothian's only remaining external active U.K. equity manager, returned money to clients when it shut down its active U.K. equity institutional strategy. Lothian's entire U.K. equity portfolio is now managed internally, said Geik Drever, the fund's head of investment and pensions.

The fund's shift from externally managed active U.K. equity reflects both a reduction in overall equity exposure and a deliberate move to diversify globally, she said. “The move toward a more international strategy increases the investment opportunity set to gain exposure to sectors and themes that are not well represented in the U.K. market with the benefit of improved diversification.” For the year ended March 31, the latest data available, Lothian's investments returned 34.5%.

Martin Currie, which has £11 billion in assets under management, was running about £500 million in active open-end U.K. equity strategies that were closed in the third quarter. Jeff Saunders and John Monnelly, senior directors who managed the strategy, have both left the company.

“Through the strategic review, we had identified a requirement to invest more of the firm's resources in emerging markets, where there is strong potential for inflows,” Mr. Watt said.

Martin Currie hired a six-member emerging markets equity team led by Kim Catechis from Edinburgh rival Scottish Widows Investment Partnership and separately acquired a European long/short team along with about $200 million in related assets from hedge fund manager Sofaer Capital. The acquisition brings the firm's total long/short assets under management to £1.3 billion.

Hugh Cutler, head of distribution at Legal & General Investment Management Ltd., based in London, said there are several factors “conspiring against active U.K. equity managers.” A maturing defined benefit pension market in the U.K. has resulted in a sharper focus on risk, and a shift from equity in general. Within equity, investors are demanding more — not less — overseas exposures, particularly in higher-growth sectors such as emerging markets. A third factor is an increase in passive investing in developed market equity, Mr. Cutler said.

LGIM, which is one of the largest passive equity managers in the U.K. with £342 billion in total assets under management, reported a decrease of about 13% in total U.K. equity assets even as firmwide assets grew about 27% in the three years ended Sept. 30. U.K. passive equity slightly increased after adjusting for market movements, and the firm also manages about £5.5 billion in active U.K. equity assets.

Mr. Cutler said the firm is not concentrating on pushing domestic equities. “We're very much in the game of selling people what they want, and that's not what clients are asking for.”

But according to Mr. Cutler and others, opportunities to add alpha in U.K. equity might be increasing just as many investors are exiting the strategy. LGIM's PMC Small Cap Active fund, which invests in the bottom 10% of the U.K. equity market, returned 21.6% —22.2 percentage points above the FTSE Small Cap (ex-IT) index for the year ended Sept. 30.

At RCM, officials are counting on alpha to lure clients to active U.K. equity strategies. Assets in those strategies shrank about 25% in the past three years after adjusting for market movements, even as the company's overall assets under management remained relatively stable during the same period. In July, RCM appointed a new chief investment officer — Jeremy Thomas — to help expand its U.K. high-alpha equity range of products. The firm likely will launch a long/short U.K. equity strategy in the first quarter of 2011.

The U.K.'s market capitalization is about £1.9 trillion, said Mr. Thomas, who is based in London. “There's still bound to be demand for U.K. equity by domestic life (insurance) and pensions clients. ... But they are looking at products that are much more differentiated from the index and they're prepared to be much more unconstrained.”

As with some other managers, RCM's active U.K. equity assets have decreased among institutional clients even amid strong performance. For example, RCM's high-alpha U.K. equity strategy returned 13.9%, topping the FTSE All-Share index by 1.4 percentage points, in the year ended Sept. 30.

“As the pool (of active U.K. equity investors) gets less crowded, there are better opportunities for alpha,” said Ms. Dunsire of Mercer. “Pension funds need to be careful that when they go global, they don't miss these pockets of expertise in their home markets.”