It’s that time of year again when we ask ourselves – just what investment policies and strategic asset allocation decisions make sense in today’s market? The problem is that we are asking ourselves that question rather too often lately.
Unfortunately, we don’t appear to have much in the way of an answer. The biggest problem is knowing whether the bear market in equities is yet at an end. After what must be, for most people, the biggest bull market in living memory, we appear to have experienced the worse bear market most investment managers have ever experienced. But is it over yet? What will 2003 have in prospect? It was difficult for most pension schemes to imagine three bad years in a row but four years – the prospect is all too difficult to contemplate.
As markets tend to overshoot on the way up they also tend to overshoot on the way down and according to many commentators we have not yet reached fair value. If this is correct then not only are we still in the middle of a bear market but we may well have some way left to drop.
Luckily, I don’t have to forecast the level of the index but as I write the S&P 500 stands at just over 900 and has already come down from an all time high of about 1550. If you believe in reversion to mean then a drop to about 650 would be your forecast and if you think that what has happened in every previous cycle will be repeated in the next few years, that is the market overshoots, then don’t be surprised if the S&P drops a lot further. As the American market is still the most important market for most investors and has an influence on stock-markets around the world, can funds do anything about this potential disaster?
Well actually, there are many other influences in play for pension funds. Compared to previous market cycles pension funds are now much more constrained by other factors. I can see four main determinants of behaviour at this point – maturity, solvency, regulation and of course existing asset allocation.
Looking at the latter point first, we have to remember that many pension funds were holding their highest ever equity exposure just as the market peaked. This of course means that there is likely to be very little surplus cash to put back into equities as the market reaches fair value.
In addition, regulations have recently tightened in places like the Netherlands such that an investment in equity merely leads to higher solvency requirements as a fund has to build in a capacity to withstand a fall in equity prices. If prices fall, the solvency margin stays the same but if prices rise the solvency margin requirement rises. This does not provide much of an incentive to hold equities.
For readers with a technical bent I am indebted to Martin de Gelder at Hewitt Heijnis and Koelman for advising me that: the Dutch regulator, the PVK, now require the following solvency margin for equities. That a pension fund must be able to meet a depreciation of its equities and that the depreciation to be taken into account is equal to the maximum of 40% of ‘all time high’ of the benchmark in the last 48 months, and, 10% of ‘all time low’ of the benchmark in the last 12 months.
In addition, as pension funds become more mature their natural matching asset changes from equities to bonds. Both UK and Dutch pension funds are reaching maturity and this is clearly being reflected in asset liability studies.
As I indicated last month we already have evidence that the proposed International Accounting Standard IAS19 is also affecting behaviour before it is clear what it will finally say.
All things considered, it is going to be difficult to see how European pension funds can become anything other than net sellers of equities over the next few years. Insurance companies are probably under even more pressure than pension funds to reduce equity exposure from historic levels. Although European equity markets are closer to fair value than the US, it is difficult to see what will hold them up.
I listened to a talk from Jeremy Graham the guru of value investors the other day. Graham, an Englishman, is chairman of leading US value investors GMO, who lost a lot of business but built a tremendous reputation by sticking to their value beliefs whilst the US market went into TNT growth overdrive. Graham, like a number of great minds, tries to distil his beliefs into a few simple truths. They seem all too obvious but are clearly ignored by the majority of investors.
Let me summarise his five main conclusions: Firstly, markets are inefficient; second, markets are overly influenced by comfort and confidence; third, we extrapolate recent experience; fourth, all markets tend to revert to mean in the long term and fifth, for most institutional investors, the risk that matters most is career and business risk.
Very simply stated but needing many words of explanation. I think they can be summarised even more succinctly as ‘herd instinct’ and I can’t help thinking of the word slaughter when I think of herds!

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