Earlier this year, Nick Fitzpatrick, a partner at UK consultants Bacon & Woodrow, silenced a crowd of UK pension fund and asset managers at a London conference run by SPS on indexing and passive fund management. He pointed out to them their slavish index weightings in so-called UK domestic stocks, which in fact behaved like global 'mega companies', bore little correlation to the UK economy at all.
Most UK pension funds have greater exposure to BP/Amoco stocks, which represent almost 6% of the FTSE All-Share Index, than they do to the whole of the US equity market. And in fact these stocks are just UK domiciled, because many have vast trading operations worldwide, core business overseas and do their reporting in dollars. So, in effect what UK funds are saying is that they believe BP/Amoco is a much better bet than, say, Exxon, or that Glaxo Wellcome is worth many times more than Pfizer", he told the audience.
The discussion, he felt, was one which needed to be brought out into the open.
"Are we merely looking for returns with UK pension fund investment, or potential diversification and prudent investment principles - because at the the moment statistics show the US and Japan only receiving on average about 2% each of total fund assets.
"What is being sought through benchmarks,or is is that indices are actually just being selected blindly these days?, " he asked.
"And do trustees realise how much of their own performance is at stake should any of these companies experience a downturn in fortune."
Fitzpatrick then announced that his firm was working with Barclays Global Investors (BGI) on the development of a multinationals index to deal with the increasing integration of world stock markets and the advent of these diversified, previously unclassifiable 'mega stocks'. Fitzpatrick commented: "The implications of building a portfolio using a new asset class are profound and still need careful consideration. However, we believe strongly that the result will be a much more robust and relevant investment policy for pension funds worldwide."
Breaking down companies worldwide on a multinationals basis within the MSCI index in terms of capitalisation, he indicated, showed the US to have 19% of the market, the UK 41%, Europe 38%, and the rest spread globally. So the UK has the lion's share of the listed multinational operations. Therefore, he pointed out, a large proportion of the 'UK' equity market could disappear into such a new index. "This is all on based on past information though," he explained,"and as yet there are no projections for the future, which will obviously be important."
Next, he said it would be essential to examine the characteristics of multinationals - predominately one of high returns with low volatility- and decide whether the investment effect of multinationals was due to their size or their behaviour as a group of diverse, but stylistically homogeneous stocks.
" Our statistics show that this has not been a question of largesse, but research needs to be done into what the true drivers of their performance are. We must also consider volatility, after all, what will currency effects begin to be on multinationals, should they be in a single index together?" Another issue he asked fund managers to consider was what would be the effects on UK trustees if mixed portfolios of 'multinationals' along with UK stocks traditionally favoured because of domestic market knowledge, became the norm.
"There are questions of education and unfamiliarity which need to be addressed, because any new approach will almost certainly surprise and confuse trustees." Fitzpatrick added that factors such asthe imminent arrival of three or four South African companies on to the UK stock exchange, had really begun to change the rules of the UK index weighting game, because their size would dictate that UK pension funds have them in their portfolios, yet their relevance to the UK economy was negligeable.
"Companies such as Glaxo Wellcome and Diageo are already looking at things on a more global competitive basis and comparing themselves to a basket of currencies, so I definitely believe we are moving in the right direction. What we must ensure though is that we are not walking into a minefield, and this is difficult because the evidence for our research is scant , the work is tough and consultancy help is minimal."
Fitzpatrick offered an example of how such an index could affect a UK pension fund portfolio: p Stage 1 - A UK pension fund pre-multinational index with split equity portfolio of around 72% in the UK predominately but with significant European weighting, but with no multinational stocks. p Stage 2 - The same pension fund post multinational index would now have UK 55% (Ex-multinationals) 30% multinationals and other equities at 5%.
The stock position: In the original portfolio BP/Amoco would be around 4% of the equity component. However, if bought as a multinational stock, BP/Amoco would be reduced to about 1% of the portfolio.
l British Telecom - not a multinational - is also reduced in line with the reduction in the UK portfolio from 72 to 55% overall.
l Large UK multinational company representation would follow the same trend.
l For European multinationationals, some stocks would rise considerably because proportions this shift to a multinationals index , for example, Novartis on the chemicals.
l Shell would rise from an average of 0.3% to 0.8%.
l Roche from an average of 0.2% to 0.8%.
l But Daimler Chrysler which is not listed as a multinational would fall.
l In the US - Intel and Exxon would take off, rising from 0.1% of the portfolio to 1.2%.
Fitzpatrick added: "Then you have to start asking questions about companies such as Microsoft, which operate very much on a multinational basis."
Some weeks later and the game had moved on, with the announcement by Bacon & Woodrow and BGI last month, that they had entered into discussion with FTSE International regarding the creation of a multinationals index, after their research revealed cross-border companies could be treated as a single asset class.
Mark Makepiece, managing director at FTSE International, adds: "There is sure to be a debate in the industry around this issue and we are aiming to provide the necessary tools for those wishing to analyse the market in a different way."
However, Lorig Maranjian, marketing director of Robeco Institutional Asset Management in London, questions the effect such an index could also have on the asset management industry.
"Will this mean that pension funds look at multinationals as a separate asset class and so have to hire specialist managers?" she asks.
"Such an index could certainly have widespread international repercussions, for instance global specialist stock managers will no doubt be rubbing their hands with glee at the prospect, but what will happen to the smaller specialist players?" But Gordon Phillingson of the UK Motor Industry Pension Scheme wonders why it has taken so long for the industry to arrive at this conclusion: "Issues of non currency risk in apparently 'UK' company stocks currently driving their demand, have been bogus for years, with BP/ Amoco already giving out US style investment expectations - so the sooner this question is addressed the better." "

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