Pension funds are unlikely to be part of any big equity push

The so-called “great rotation” back into equities from bonds is unlikely to be seen in 2013 among most defined benefit pension funds in major markets, including the U.S., U.K. and Netherlands.

However, institutions have taken their foot off the bond-buying pedal, as equities are outpacing government bonds from a relative valuation perspective, according to consultants, managers and plan executives. Also, investors are taking short-term tactical advantage of the rising equity premium by, for example, allowing multiasset managers to drift toward the higher end of the equity allocation range.

In addition, while many pension funds are moving out of investment-grade bonds, alternative asset classes, like hedge funds, real estate and private equity, are a more popular destination than traditional long-only equities.

“I don't think many people think that bonds represent screaming good value, but if you think equities represent relatively better value, the question is what do you do about it?” said Carl Hess, global head of investment consulting at Towers Watson & Co. in New York.

In the six months ended Jan. 31, the Russell 3000 index rose 11.23% compared with -0.29% for the Barclays Capital U.S. Aggregate Bond index. Worldwide, the MSCI All Country World index returned 13.74% during the same period, compared with a 0.68% gain for the Barclays Capital Global Aggregate Bond index. The long-term equity risk premium is typically between 4.5% and 5%.

Separately, the ratio between the earnings yield of the Standard & Poor's 500 index and 10-year U.S. Treasury bond yields reached 4.0 at the end of 2012, suggesting that the gap between the rate of return that stockholders require and that of bondholders has widened to unprecedented levels, according to data going back to Dec. 31, 1980 and compiled by Russell Investments. Between 1980 and 2002, the ratio rarely rose above 1.0 but has since been climbing.

A 30-year bull run in bonds amid ultra-low interest rates — coupled with recent government stimulus actions in the U.S., the eurozone and Japan that lifted investor confidence — led to arguments that a "great rotation' from bonds into equities is under way.

“Historically institutions haven't really had to be concerned about bond market risk, because historically institutions haven't had much bond market risk” relative to equity risk, said Michael Mendelson, principal at AQR Capital Management LLC, Greenwich, Conn. “Now you do have to worry about bond market risk.”

While some institutional investors with below-average equity exposures are gradually ratcheting up their exposures to publicly held stocks, they represent a minority rather than a majority, consultants said.

“As spreads come in, they're shifting back into equities, using swaps and other tools to manage their liability related risks so they have to worry less about their physical bond allocation,” said Richard Dowell, head of clients at fiduciary manager and investment consultant Cardano , London. “But it's a very gradual shift rather than a rotation.”

In other cases, as the outlook for high-yield bonds becomes less attractive, some clients are trimming their high-yield allocation and tilting towards equities “in order to benefit from the potential growth in the economy,” Mr. Dowell said.

Corporate defined benefit funds, for the most part, are continuing to reduce risk in the overall portfolio, consultants said.

“There is a recognition that bonds represent minimal-risk assets, so it's difficult for (plan executives) to abandon bonds in favor of equities,” Mr. Hess said. “They're slowing down their plan to buy more bonds, but they're not abandoning them.”

For example, one particular client who is targeting a long-term 7% reallocation of total assets into bonds from stocks is reconsidering the short-term goal, Mr. Hess said. “They're not sure that bonds represent good value right now, so instead of targeting a 7% shift, they're looking at maybe about 3%. They're still keeping an eye on that (7%) target but lessening the pace” in the short term and keeping assets in equities in the meantime. Mr. Hess would not name the client.

Paul Trickett, managing director and head of global portfolio solutions for Europe, the Middle East and Africa at Goldman Sachs Asset Management, London, added: “While it may truly make sense for pension funds to move into equities (from bonds), the regulatory environment makes it much more difficult to do so in reality.”

In the Netherlands, for example, the average funding level among Dutch defined benefit pension funds is about 102%, which is below the minimum requirement of 105%.

“A lot of funds have not yet reached the 105% level, which implicitly means that they're not supposed to increase risk” in their investment portfolios, said Jelle Beenen, head of investment consulting in the Benelux region at Mercer in Amsterdam. “As long as funds have not reached the objectives of their recovery plan, they're not allowed to increase the risk profile, and moving into equities is, in most cases, increasing risk.”

However, government bonds are also viewed as being “more risky than they used to be,” Mr. Beenen said. “To some extent, the relative valuation (of equities vs. bonds) means that funds don't necessarily want to sell equities.”

Corporate pension funds have come under pressure from regulators and corporate parents to lower investment risk, which has led to a boom in liability-driven investment in the U.S. and U.K. However, among public DB funds, which aren't under the same regulatory pressure as corporate plans are to better match assets and liabilities, the move out of bonds has generally been in favor of alternatives and not necessarily equities, consultants said.

Ricardo Duran, spokesman for the $154.3 billion California State Teachers' Retirement System, West Sacramento, said in an e-mail: “On the downside, equities and bonds have acted in correlation (as 2008 showed), so we've actually reduced our allocation to both asset classes.”

In 2012, global equities accounted for 51% of CalSTRS' total assets compared to 60% in 2007. Fixed income decreased to 18% from 21% of the portfolio during the same period. CalSTRS is currently conducting an asset allocation review, which is expected to be completed in the second quarter. “If we do shift assets out of fixed income due to the historic risk, they will likely wind up elsewhere other than equities,” Mr. Duran added.

“The role of equities has diminished” in the past decade and will likely continue, said James Ind, managing director and multiasset fund manager at Russell Investments, London. As a result, “the role of non-equities — not just fixed income but also a range of alternatives — have played a much more important role in the overall asset allocation” of a typical pension fund.

DB pension funds generally already hold too much equity risk compared to their long-term targets, consultants added. But in the short term, one way of benefitting from the favorable equities outlook is through multiasset mandates, in which consultants or fund managers have the freedom to make small asset allocation adjustments.

Asha B. Cryan, London-based vice president and portfolio manager in the global multiasset group at J.P. Morgan Asset Management, said within equities, “fundamentals are beginning to matter more for the first time in years.”

As a result, JPMAM's global balanced flagship strategy is about six percentage points overweight in equities at the expense of bonds, compared to its custom benchmark. Fund managers began notching up the equities weighting in the summer of 2012 and with greater conviction in the third quarter. At the beginning of the fourth quarter, the strategy was about four percentage points overweight in equities.

GSAM also holds an overweight position in equities within several multiasset mandates. The overweight level varies according to controls set by pension fund clients, and is usually not more than 10. “We don't expect to stop worrying about liability hedging, but we're also trying to find prospects for some additional returns,” Mr. Trickett said. n

Data Editor Timothy Pollard contributed to this story.