30 November 2020
To paraphrase Charles Swindoll “life is 10% what happens to me and 90% how I react”.
In a world recovering from the Covid-19 pandemic there is a lot to be drawn from Charles’s view on life. In the last 11 months we have witnessed some of the biggest falls in equity markets followed by an incredible recovery and abnormal volatility in almost all asset classes. How should Trustees view this extreme period, and how should they ‘react’?
Background – DC equity allocations
To steal another quote “get the basics right and the rest will follow”. When thinking about the DC equity allocation, most of my clients have different equity profiles; some have an allocation to active equities, some different investment styles, some have clearly justifiable overweight positions to regions or sectors. But I always start at the same starting point; regional equity diversification.
Historically, UK pension schemes favoured a significant overweight to the UK, often as much as half of the fund compared to a broad market cap index. There was some rationale for this position; better governance and regulation of companies, the same currency as members will take their benefits and a developed economy that was performing better than peers. However, over time, I think these benefits have been diluted.
Over the last few years most schemes have subsequently reduced this overweight significantly, although some still retain a slight bias. Many of my clients have now moved to a global market weighted allocation, which means less than 5% allocation to the UK. To some this may seem drastic shift – and they could be right. But the important aspect I think to note here is that the starting point has changed. No longer are we consciously first discussing how much to hold in the UK; we’re instead talking about a global weighting and where to allocate from this point. Holding an overweight position to any region should be an active decision. If the recent market experience has taught us anything, it’s that you should be well aware of the risks you are exposed to.
The Covid-19 pandemic – predictable themes impacted regions differently
As consultants, we often use modelling to predict the impact on portfolios from market events. After all, we haven’t had a pronounced global market shock since 2008. Covid-19 provided a proxy market cycle in just a few months (albeit it was a biological rather than financial catalyst).
When considering equity performance, some obvious themes played out from a regional perspective. For example, predictability in regional equity market slumps. As the virus spread from Asia into Europe initially via Italy and a lockdown was imposed on 21 February, the Italian financial markets collapsed before those countries further west in Europe (for example the UK, who went into lockdown a month later).
But one thing is clear, it’s wasn’t a great period for UK equities, who had the worst or second worst performing month across the globe in 80% of the 2020 months so far.
However, what these regional charts mask is the impact on sectors, the impact of which was also just as predictable. Those regions reliant on energy sectors underperformed due to lower manufacturing and travel whilst those regions with a large technology presence naturally performed stronger with more people at home either working or with more leisure time.
Things could have been very different, I imagine if that catalyst to financial market slumps was technological or global cybercrime, the US would have been the poorest performing region.
Indeed, despite US equity market performance throughout the year having been buoyed by the large tech companies within the index, the month of September saw the US as the lowest performing region (4.5% less than Asia Pacific) as a result of valuation scares on some of these stocks the index is so reliant on, notably technology.
Differences in sector allocation within regional equity indices
Therefore, what I take from the volatility and rollercoaster ride that has been 2020 is, now as much as ever, diversification is king. This message is not new and is not innovative, but 2020 has provided market context to justify the theoretical models.
A diversified portfolio would have returned 3% for the calendar year to 31 October 2020, with much lower volatility than many of the regional equity markets in isolation. Not the US equity market’s 14%, but also certainly not as bad as Europe (-4%) or even the UK (-18%).
What does the future bring?
Looking forward, there are reasons to be optimistic and pessimistic about UK equities; optimists point to strong recent performance (at the time of writing UK equities are up 11% in November), low relative valuations, improving market conditions if a Brexit trade deal is agreed and currency hedging considerations. Pessimists point to the uncertainty following Brexit and potential long-term decline of the traditional energy companies as the world transitions to be reliant on greener energy sources.
However, in a world where a smooth journey and member engagement is paramount, I think recent market conditions have demonstrated that when thinking about equity portfolios there are worse places to start discussions than a passive market cap index regional weighting. I would advocate any deviations to be a positive decision, designed to add value for members over the longer term, rather than a legacy position that hasn’t been recently reviewed.
LCP DC Quarterly Update
What's on the horizon for defined contribution pensions? In this edition of our DC update we look at key industry and market updates from the past quarter, as well as Covid-19 updates and the latest within Responsible Investment drawing attention to climate risk.Read the update