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Thursday, 18th April 2024
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Irish managed funds are over-invested in Irish equities Back  
There’s no doubt about it – Irish equities have been the ‘good thing’ in terms of equity investment over the last ten years. In that period, our little market has managed to outperform global equities by a massive 13 per cent per annum, with out-performance registered in nine of the last ten years, writes Grainne Alexander. However, she believes that pension managed funds have reached the stage where they have become ‘unbalanced’, with allocation to Irish equities back up towards the 20 per cent level, and she recommends a broader geographical approach to investing.
IIIIIn a time of poor equity market returns, the strong performance by the Irish domestic market has made a very considerable contribution to the overall returns achieved on pension managed funds.
However, this out- performance of the market as well as proactive allocation to Irish equities by the investment managers has meant that Irish equities now account for a fifth of our standard managed pension fund investment. For pension fund trustees, who shoulder the responsibility of dictating the all-important investment strategy, it is certainly time to review the risks in this type of allocation and to ask the serious question: Have we got too much of a good thing?

Irish equity allocation
Prior to the introduction of the euro, Irish equities held a hallowed place in Irish pension funds given the need to link the currency of the assets with that of the liabilities. Post-euro, the percentage held has been coming down steadily from the 30 per cent level in 1998 to as low as 15 per cent in 2002. With the out-performance of the market, particularly in 2004, when it produced a staggering 29 per cent return, the percentage invested in managed funds in Irish equities is back up towards the 20 per cent level. Some managers have been more active in the market, increasing the percentage allocation to almost a quarter of the assets.

This fondness for the Irish market is well illustrated by the comparison of its allocation within the overall equity component of the average managed fund. The Irish market only represents 0.3 per cent of the world index and just 2.2 per cent of Eurobloc, yet ‘balanced’ managed funds manage to allocate 25 per cent of total equity to this minnow market.

Figure 1 shows an allocation to Irish equities that is greater than that to the entire US market (which accounts for more than half the global market capitalisation), almost twice the allocation to the UK and multiples of that allocated to Japan and Asia.

Should we be concerned about this – after all having a high allocation has not hurt us in the past?
I would certainly argue that with this allocation we are now breaching one of the basic tenets of investment, i.e. maintaining adequate diversification. The particular stock and sector concentration issues of the Irish market, which are detailed below, mean undue risk is being taken with a significant proportion of managed pension funds. However, with the bright lights of past performance shining brightly and with the prospect of another good year or two in the Irish economy, these risk issues are being played down by investment managers who are in pressured pursuit of higher returns.

So what are these risk issues?
1. Stock concentration: It has been well documented that the Irish market is a concentrated market in terms of stockholdings. The top five companies make up 60 per cent of the index and the top 10, 80 per cent. Figure
2 demonstrates the concentration of the market versus the other regional blocs in which Irish pension funds invest.

This stock concentration translates into the fact that 15 per cent of the pension managed fund is in the Top 10 Irish stocks. But it is the sector concentration within this Top 10 that poses the real risk issue.

2. Sector concentration: In the Irish market, there is a marked concentration in the Financial sector (accounting for 44 per cent of the index) with the heavyweights of AIB, Bank of Ireland, Irish L&P and Anglo Irish Bank. The heavy allocation to Irish equities in pension managed funds means that over 8 per cent of the total assets are in just these four stocks. An equivalent exposure in managed funds is allocated to the entire UK market, yet it is more than 50 times the market cap of the Irish banks!

Given its weighting in the index, if the financial sector is delivering good returns, the market will generally do well. One could also postulate that given the financial sector’s link with the residential property sector, if the latter is performing well, the index should remain in reasonable health. Of course if this segment gets into difficulty, then pension fund members, whose wealth already depends significantly on the residential property sector, will likely face a further source of loss in their pension fund.

These stock and sector concentration issues would not present a difficulty per se – one can find other country indices that have similar issues – however, with such a large chunk of the pension fund dedicated to this one market, the risks are blown up to a bigger scale and need to be understood and addressed by the trustees who have committed their pension fund members’ funds to this type of strategy.

So what approach is recommended in terms of asset strategy for pension funds?

Go Eurozone!
Our recommendation to trustees is that they begin their plan to adopt a full Eurozone mandate for their euro equity assets, i.e. consider their domestic market as Eurozone in which Irish equities play a much smaller part. This is a significant change and would see the Irish equity weighting fall dramatically as a percentage of the benchmark.

Why take this action?
The main benefits of the approach are as follows:
• Achieve adequate diversification of pension assets taking advantage of a far bigger opportunity set
• Remove stock and sector concentration risks
• Invest in Irish equities in a controlled way, i.e. by merit against their European counterparts rather than being dictated by a peer group weighting

For the longer term, and as Ireland becomes more integrated into the Eurozone, this approach makes intellectual sense. However, for trustees who currently have a typical managed fund mandate, there are some pertinent issues and concerns that need to be addressed. These generally fall into the following categories:
• Timing – With the Irish economic outlook superior to Eurozone in the short - medium term; is now the right time to switch?
• Growth prospects - Reducing the Irish market exposure will mean a certain loss of ‘dynamism’ achievable by the smaller economy
• Local economy link - Reducing the Irish market exposure will mean we lose the link with the local economy and local inflation (relevant for salary linked liabilities)

Timing
In terms of addressing the timing issues, trustees can elect to implement a staged reduction in moving to the Eurozone approach. So a period of two to three years may be set over which the allocation to the Irish market is gradually wound down. The investment manager is given the discretion in terms of timing so that if the view is that the Irish market will outperform in the short term, a higher allocation is maintained for longer. In this way, the fund reaches its destination point by ‘averaging’ in over a pre defined period, allowing for market timing in the interim. It is also worth noting that the valuation of the Irish market has now caught up with that of international markets in terms of price/earnings multiples and relative dividend yields. Hence, in terms of timing, it might be an opportune time to bank the gains already made.

Small market dynamism
One of the features of world equity markets over the last number of years has been the significant out-performance of small and mid size companies over their larger counterparts. The Irish market has been a major beneficiary of this trend as evidenced in Figure 3, which shows the ISEQ performing in line with the EMU Small Cap Index. What this also shows us is that by going ‘Eurozone’, investors do not have to confine themselves to the larger cap companies only – there is a whole universe of mid to smaller sized companies available to invest in across the Eurozone that will provide that smaller market dynamism in a more diversified way than we have at present.

Link with local economy/local inflation
With pension liabilities increasing in line with salary inflation, one argument for a significant investment in Irish equities is that the local market is more likely to match Irish inflation than international markets. Intuitively, this may seem a relevant argument. However, in terms of actual outcome, the results do not accord with the theory. Figure 4 charts the annual movements in international and Irish equities over the period 1970-2004 and against these shows the annual movement in Irish CPI. The conclusion on a mathematical basis is that the correlation between Irish CPI and all equity markets, whether Irish or international, is effectively zero.

In terms of Irish companies’ link to the local economy, it is worth noting that many of the leading non-financial companies now have the majority of their earnings coming from overseas activities. For the top 10 companies, the locally sourced earnings account for only 30 per cent or so of their overall earnings. Hence the link to the local economy is more diluted than perhaps realised.

In summary, I believe pension managed funds have reached the stage where they have become ‘unbalanced’ in terms of an excess allocation to Irish equities. It is time for trustees to realise their responsibility in this regard and to address the risks of their pension fund having one fifth of their assets invested in a small concentrated equity market. We recommend trustees consider investing on a broader eurozone basis which will allow for greater diversification of assets and opportunity to tap into alternative sources of growth.

Finally, it is always difficult to sell something that has performed so well and has seemingly good prospects for future returns. But perhaps it is worth recalling that’s what they said of Asia in ‘96 and Nasdaq in ‘99. Staying with the herd is not always the best policy….

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