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ANALYSIS

Is the Great Rotation passing pension funds by?

The prospect of a seismic shift from bond to equity investments looks set to pass most of the world’s pension funds by, argue experts. The concept of a ‘Great Rotation’ rose to prominence following its use by Bank of America Merrill Lynch in October. It argued in a note that “the era of bond outperformance has ended” and advised investors to instead position themselves for strong long-term equity returns.

Some six months later, the idea has come under a sally of attack from a host of skeptics denouncing it as a myth. While stock markets have continued to rally and the Dow Jones industrial average has set new all-time highs, data from both BlackRock and Lipper suggest that investments into bond funds have remained steady in the first quarter of 2013.

Nick Sykes, European director of consulting at Mercer, says recent market upswings do not change the fact that he has seen no interest in three years from institutional clients to significantly acquire equities. The primary reason for this, he believes, is the “one-way ratchet of de-risking” that so many of the world’s defined benefit funds are constrained in. Sykes argues that “there is no desire to rebalance by selling bonds when they do well and buying equities”. Instead, pension funds will “only ever step up bond purchases as time goes on to cover liabilities”, he reckons.

Speaking about the UK, Sykes says that “a lot of the funds probably still have more equities than they want”.Sykes_N_115x150

Rather than future equity-market rises being something pension funds are desperate to take advantage of, Sykes (pictured right) argues they could actually further steer closed defined benefit schemes away from equities. He says that a continued rally might see funding-level targets breached and “by the logic of their de-risking strategies”, funds might seek to withdraw further from equities and pile even more heavily into bonds.

Great Rotation skeptics stress that the closure of many large defined benefit funds in the US and UK over the last decade means de-risking is likely to remain a priority for the distant future. Added to that is the assumption that bonds are likely to become even more attractive to institutional investors as fund memberships slowly age.

Then there is the prospect in Europe of insurance-style regulation from the European Commission that may limit the amount of risk-seeking assets – such as equities – a fund can hold.

Laith Khalaf, from financial services provider Hargreaves Lansdown, says that as a consequence there is little prospect of UK pension funds’ equity allocations recovering from current historic lows. The prospect of UK funds returning to the 80-per-cent equity weighting common in the 1990s, roughly double the present situation, certainly looks unlikely.

Off the mark?

For anyone rushing to rubbish the very existence of a Great Rotation, it is perhaps worth reading the Bank of America Merrill Lynch note that launched the debate. It mentioned merely that the phenomenon “could start” in 2013 “if the US successfully navigates the fiscal cliff, Europe continues to stabilise and Chinese growth re-accelerates”.

Without needing to delve into that trio of weighty issues, should funds at least be positioning themselves to take as much advantage as they are able to from a possible rotation if the global economy does decisively turn a corner?

Not even, says Sykes. He points out that the established theory of de-risking implies that interest rate risk should not be rewarded. By this thinking, any move from the mass of defined benefit funds to take more risk would likely wait until there is some upward trajectory in interest rate rises.

Various commentators agree that the shock of the world’s central banks unwinding their ultra-loose monetary policy in the future could send interest rates spiraling upwards over a short period. While Khalaf (pictured right)  says investors “could be in for a rude awakening”, Sykes advises funds not to second-guess the world’s central bankers. He says “we just don’t know when and where interest rates will go. Many people were predicting interest rate rises three years ago, but that has been very wrong. The conditions we are in are new to everyone and investors don’t know how the policy will play out”. Laith-Khalaf-140x140

Khalaf adds that predictions of a future spike in bond yields neglect to consider that a swell of downward pressure is being maintained on yields by regulation that has created large institutional buyers of government debt. As defined benefit funds are protected from rising interest rates by linked reductions in liabilities, the threat of interest rate spikes should arguably not concern them in any case.

Diverse appetites

Investors unconstrained by liabilities such as sovereign wealth funds and endowment funds seemingly have more scope for swapping bonds for equities should they be convinced the bond boom’s days are numbered.

There are also pension funds freer than others to benefit from a possible Great Rotation. Sykes points to open public sector funds that “have more appetite for risk assets” and in the UK are subject to less stringent regulation than their private counterparts. The relatively high existing risk profiles of those public sector funds (which Sykes estimates to be 10 to 20 percentage points more of risk-seeking assets) means that their appetite for more equity might be limited though.

The heightened investor sentiment in North America, along with looser accounting rules, might also leave more scope for ‘rotating’ there, Sykes adds.

There is some data suggesting that moves in this direction are already afoot. Towers Watson’s latest global studies of pension asset allocations indicate that US pension funds’ equity allocations surged from 44 per cent to 52 per cent in 2012, with bond holdings dropping from 31 per cent to 27 per cent. Other figures paint a different picture, though, with a recent study from top1000funds.com and Casey Quirk suggesting that a large proportion of global fund chief investment officers, 35.7 per cent, plan to reduce their domestic equity holdings in 2013.

A US consultancy, NEPC, suggested at the turn of the year “valuations might suggest an opportunistic overweight” in emerging market and non-US equities, but warned about the potential for volatility. At the end of January, $255-billion fund CalPERS was overweight its policy target on public equity, with 52 per cent of its giant asset base in the class, and underweight on ‘income’.

Meanwhile, bond-heavy Swiss pension funds are showing signs of wanting to take more risk to counter low bond yields, says Stephan Skaanes of the PPC Metrics consultancy in Zurich (pictured below right). He thinks that a desire to meet return targets is driving increased equity, corporate bond and emerging market debt investment among funds that can convert a higher share of active members into a higher risk profile. A new survey from Credit Suisse supports Skaanes’ assessment by finding average overseas equities allocations to be at an historic high of 17.9 per cent in (non-EU) Switzerland.SKAANES Stephan

Risk appetites also seem to be have changed somewhat in pension systems where defined contribution arrangements are predominant. Consultants in Denmark, for instance, talk about equity holdings being increased at the end of 2012 – albeit from relatively low bases. The $50-billion Danish fund PFA recently announced a desire to sell some of its “traditional bonds” in exchange for US equities – as part of a DKK5-billion ($900-million) purchase that puts it overweight on equities.

The funds of the future in Denmark look certain to have greater equity investments as existing funds are due to be phased out in favour of unguaranteed lifestyle products. In 2009 PFA launched a new lifecycle product that has a “much higher” allocation to equities (some 65 per cent of the $3.75 billion in assets) than its existing funds. In its 2012 report, PFA argued that “the future-oriented potential for return [from bonds] is estimated to be extremely limited as the absolute interest rate level is now at a historic low. In actual fact, there is a considerable risk of a negative return on both government and mortgage credit bonds in the coming year”.

The largely defined-contribution group of Australian super funds also managed to up their equity holdings from 50 per cent to 54 per cent in 2012, according to the Towers Watson survey.

Sykes agrees that defined contribution schemes are better positioned to take advantage of a sustained equity rally, should that occur. In addition to their freedom from liabilities, he says that there are signs defined contribution designs are becoming more equity-friendly. “We are seeing some reconsideration of the asset mix at the risk-averse life-stlying stage of DC pension plans,” he argues, with an allocation in purely defensive assets in later stages “possibly looking unappealing”.

The sum of it

Given the small proportion of global assets in defined contribution or risk-hungry plans, skeptics still have good reason to doubt that a Great Rotation could ever occur across the world’s pension assets. The prospect of new regulation in Europe also means the great reservoirs of bonds in continental Europe – where a bond weighting above 50 per cent is a rarely challenged norm – are unlikely to be depleted for the foreseeable future.

Possibly the most likely rotating here will be a continued interest in alternatives and a reshuffling of bond assets. For instance, the $9-billion Vita Sammelstiftung in Switzerland began selling domestic bonds in the second half of 2012, while launching an infrastructure portfolio and exploring further real estate opportunities.

Sykes adds that low yields on corporate debt have intensified interest in “more exotic credit assets” such as emerging market debt, high yield and private debt.

While he admits there “has been a rotation in sentiment”, there appears good reason to believe that pension asset allocation fundamentals won’t be revolutionised any time soon. Should the current equity rally continue, funds able to take advantage no doubt will, but liability headaches and regulation will likely keep many away from the party.

 

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