Pension funds should allocate more to small caps, according to Nick Dixon, head of pensions at Avon Pension Fund, who expects smaller UK companies will outperform S&P 500 companies in the next 20 years.
Speaking at the Pensions and Lifetime Savings Association’s (PLSA) Local Authority Conference, Dixon said he was initially sceptical of the asset class.
He pointed out that equity allocations of Local Government Pension Schemes (LGPS) varies between 40-60%. Of that, he said that only about 5% is allocated to UK companies, and of that 5% only 0.1% is allocated to smaller companies.
He added that AME index is worth about $7bn (€6.5bn) and AstraZaneca alone is worth more than £170bn (€201.2bn).
He said: “The London market is an unloved sector of an unloved UK market and one should proceed with caution. And if you add to that the illiquidity in these stocks and the wide pricing spreads – what’s not to like about it?”
However, building a case for small caps he said that “unloved often means good value” and “modest price earnings ratios with good growth implies decent value”.
“The biggest driver of future returns is the price we pay today. The low value is actually a catalyst for action,” Dixon explained to conference delegates.
He acknowledged that this is a “very poorly” researched segment of the market, which means that there’s a lot of price discontinuity and mispricing of stocks.
Active asset management can “add to the overall equation” around understanding things like the value chain, competitive advantages, barriers to entry and depth and quality of franchise and as result the pricing resilience and future cash flows”, he contninued.
He added that small caps also have “low correlation to global equities” so in terms of equity holdings and from an asset allocation perspective it can be “quite good”.
“My perspective, despite my scepticism, is that this sector has massively underperformed the S&P 500 in the last 20 years, but in the next 20 years, my prediction is the AME index and UK smaller companies will outperform the S&P,” he said, adding UK local authority pension funds shoudl be allocating more than 0.1% to UK small caps.
Catalyst
Victoria Stevens, fund manager at Liontrust Asset Management, pointed out that the UK government has been gradually stepping up the rhetoric for supporting UK capital markets over the last year or two setting out two primary overriding objectives: boosting returns and improving outcomes for pension fund investors; and simultaneously increasing funding and support for UK high growth domestic companies.
Stevens noted that as pension funds hold over £1trn worth of assets, if there was “just a 1% move” into small caps across pension funds, it could prove to be a “powerful catalyst”.
She said: “I can’t tell you if that’s going to happen in a month or six months, or 12 months or longer, but I do know that it’s very likely that value tends to outperform and markets tend to, over the long term, recognise that.”
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