Investment strategy: Equities are the new bonds


Peter Koh
Published on:

Just as Schroders Investment Management joins the ranks of company pension funds to dramatically cut equity exposure, the debate about the merits of such moves is heating up.

In particular, a recent joint Standard & Poor’s-HSBC study argues that equities might be the best match for pension liabilities after all.

Schroders announced in December that it was looking to reduce the weighting of equities in its staff pension fund, but would not confirm precise levels. Instead, the fund manager said that it intended to invest 35% of its £465 million ($826 million) staff pension fund in liability-driven investments and the remaining 65% in a diversified growth portfolio of alternative asset classes, which might include some equities from emerging markets.

Schroders’ announcement came just two months after UK retailer WH Smith announced that it was allocating 94% of its £837 million pension scheme to liability-driven investments. UK pension schemes typically allocate about two-thirds of their assets to equities but more are rethinking their equity weightings. Pension fund consultancy Hymans Robertson expects equity allocations to more than halve over the next 10 years.

Pension funds first began rethinking the orthodoxy of holding most of their assets in equities after the dot com bubble burst and equity markets began a prolonged bearish phase, punctuated by devastating corporate scandals. Disillusioned equity holders scrambled to replace their holdings with corporate bonds, which seemed a safer bet that better matched their liabilities.

The pension fund of UK retailer Boots was the first high-profile fund to make the break when, in 2000, it began replacing its entire equity holdings with high-quality, long-dated corporate bonds.

But just as more funds come around to the idea that corporate bonds might be a better match for pension fund liabilities, the debate appears to be moving on. A study by Standard & Poor’s index strategist Srikant Dash and HSBC’s head of global equity strategy, Kevin Gardiner, released in December, argues that equities are actually long-duration assets that ought not to be written off.

The duration of a security is the weighted sum of the times at which payments, including any principal repayment, are made to investors, where the weights used are the present values of the cashflows. A security’s duration is the period in years around which the weighted present value is distributed.

Normally used in fixed income investing, the concept can also be applied to equities. An investment with a long duration will be a better match for a long-term liability than an investment with a short duration, because the cashflow characteristics of both the asset and the liability will coincide more closely.

Although there is no universally agreed way to calculate equity duration, what Dash and Gardiner argue is that equities are intuitively the “ultimate duration play”. This is because there is no explicit repayment of capital – investors own the business, which in theory could last perpetually. Meanwhile, in theory, dividends can also continue to grow in perpetuity. Using a variety of techniques, Dash and Gardiner estimate the duration of US and European equities to be between 15 and 40 years, substantially greater than the duration of most government bonds.

Dash and Gardiner aren’t the only ones to question the new orthodoxy. Earlier in 2005 Prudential announced that it was increasing its equity weighting at the expense of corporate bonds.

Before following in Boots’s early footsteps, pension fund schemes would do well to look at that company’s experience. In May 2004, Boots announced that it was switching 15% of its all-bond pension fund assets back into other asset classes to better match long-term liabilities. According to the fund, the about-turn was because it found that some risks simply could not be matched. The fund estimates that investment risk alone resulted in losses to the scheme of more than £100 million over three years.