Local Government Pension Scheme funds are approaching their actuarial valuations next year (2023 in Scotland) and beginning to reconsider their investment strategies. I provide some food for thought on some areas of portfolios I believe should be addressed. These are my personal views and not necessarily those of Hymans Robertson as a whole: other opinions are available!

1. Stop overweighting the UK

Many LGPS Funds have been slow to reduce historic positions where all assets were invested in the UK; they now hold significant overweights relative to the UK’s allocation in standard global markets of c. 4%.

Overweighting the UK should only be there to reflect a strong belief that the UK will outperform, something that is very difficult to forecast.

The common defences for these positions are that it is an investment in the local economy and reduces currency risk. However, the UK represents a very concentrated allocation of a stock and sector perspective. Significant overweights to financials and energy and very little exposure to technology stocks mean it is challenging to be overly optimistic about the future prospects for the market.

The FTSE All Share has underperformed global markets significantly over recent years. Any concerns around the timing of a reduction can be reduced by spreading it out over time.

2. Plenty of juice left in private markets

We’ve been told for years that the opportunity in private markets is gone as “dry powder” amasses. Yet private markets continue to perform well, and opportunities continue to arise. They can also be an effective way of implementing RI beliefs and achieving diversification.

The complexity and illiquidity of these investments mean that many investors are unable or unwilling to allocate to them, meaning these markets may actually be undersubscribed. As long-term investors, LGPS funds may be better placed to look here for higher returns.

So, continue to allocate to private markets, as rumours of their death are greatly exaggerated.

3. Get out of gilts

Many LGPS funds invest in gilts as part of their protection assets. However, gilts currently offer negative yields and can be very volatile. 

There is better value in other assets that are less volatile and offer a better return, such as Asset Backed Securities. At the right point in the market, these offer attractive characteristics to replace gilts, such as being very highly-rated and liquid.

4. Change how you find “value”

Historic methods of finding value stocks, using metrics of financial data about companies, are no longer fit for purpose.

Accounting rules mean intangible assets (e.g. data, software and quality of staff) are not accurately captured, or captured at all, within these metrics. Unsurprisingly, this affects particular types of companies more than others, with the obvious candidates being tech companies.  

Tech stocks have contributed significantly to market gains over recent years, and traditional value investors have missed this due to these companies looking expensive on these outdated metrics.  

Ensure your value managers and indices are not using outdated methods to find you stocks.

5. Climate change is not priced into markets

Climate change poses a humungous risk to investors. 

However, some believe that markets are efficient and the risks are adequately priced in to markets, and hence your investment strategy.

I don’t believe this is the case, given the uncertainty of the impacts and timescales of climate change. I think it is just too difficult to accurately factor all these into any assessment of an investment’s fair value.

An example of the underappreciation of the risks in the market is set out by carbon pricing. Currently, only around 20% of global emissions are covered by carbon pricing. Importantly, China’s pricing is very low and the US has no nationwide system. This means that the global average for a tonne of carbon has been estimated to be about $3. To put this into context, the IMF estimates that pricing needs to increase to $75 per tonne to keep global warming to 1.5C whilst other studies price it at over double that. It is not difficult to imagine the impact on share prices of large emitters if carbon pricing is taken more seriously.

This creates opportunities for truly long-term investors such as the LGPS. Funds can take a long-term view of companies, and invest capital today in the solution providers of tomorrow. If you can find the climate equivalents of Google and Amazon, your funding levels will definitely see the benefit.

If you would like to discuss any of the above, please get in touch.