LHV Pensionifond S

Stock markets have been trending downward since the end of July. In October, the S&P 500 index, which reflects movements in the stock prices of the 500 largest companies in the United States, lost 2.2% of its value, while the Stoxx 50 index, which measures the performance of the 50 largest companies in Europe, lost 2.6%. Emerging markets fell even more, with the Chinese stock market losing 4.3% of its value.

Stock markets ignore geopolitical tensions

The stock market losses in October were probably primarily related to expectations concerning what the European Central Bank and the US Federal Reserve would decide at their monetary policy meetings at the end of the month, with there being a small risk that these two central banks could raise interest rates.

On 7 October, Hamas terrorists carried out a horrifying massacre in Israel that set off a renewed conflict in the Middle East. This is likely to have a far-reaching negative impact on the stability of the region as a whole. Despite the gravity of the situation, US investors reacted with relative calm: on 9 October, the US stock market opened down just 0.5% and ended the day up 0.6%.

Similar indifference was on display when Russian troops invaded Ukraine on 24 February last year. That day, the S&P 500 index initially fell by 2.5% but ended the day up 1.5% and gained 2.2% the following day.

Equity investors have thus been underestimating geopolitical risks for some time. However, not all investors have shown such indifference. For example, following the Hamas massacre and the subsequent invasion of the Gaza Strip by the Israeli army, the price of gold had risen by 8.2% by the end of October this year.

Geopolitical tensions have continued to rise in recent years, and, for some time, the monetary and fiscal policies of several major countries have been relatively extreme. Therefore, the managers of LHV pension funds have focused more on protecting capital and have, for the most part, positioned the funds conservatively. Last month, for example, we slightly increased the share of gold mining companies in our pension fund portfolios.

Diversification in stock markets is deceptive

At a time when debt levels are high around the world, and interest rates have risen rapidly over the past 18 months, there is also an increasing risk that economic growth could turn negative in both the US and Europe.

I suspect that it is far too risky in such an environment to place all bets on the stock markets. In a globalised world, it is naïve to expect that if the stock market falls in one country, it will rise in another. On the contrary, we have seen in the past that, in general, the stock markets in major countries tend to both fall together and rise together.

Moreover, global stock indices may not be as diversified as one might think. For example, a solid 70% of the MSCI World Index is made up of US equities. The share of the second largest stock market, Japan, accounts for just 6.1% of the Index, followed by the UK with 4%.

At the same time, the US stock market is currently more concentrated than ever, with the share of the ten largest companies in the S&P 500 index amounting to 32%. Historically, the share of the ten largest companies has averaged 20%, rising to 25% at the peak of the so-called dot-com boom in 2000.

Essentially, the S&P 500’s gains throughout 2023 have been driven by an increase in the value of the seven largest technology companies included in the index, while the rest of the market has stagnated.

While many investors are looking forward to a Christmas rally at the end of the year, in the longer term, the skies above them are far from cloudless. My guess is that even if central banks were to cut interest rates as the economic environment deteriorates, this may not translate into a sustained rise in stock prices. Instead, it could be a sign that the environment has worsened and that harder times lie ahead.

Experience has shown that the best protection against risks is to diversify investments between different asset classes. This is easier in theory than in practice as it requires a relatively large volume of assets and active work to establish contacts with the investors who are the best in their sector.

Individual stocks currently account for 12.4% of the portfolio of the LHV L pension fund. The fund is actively managed only in a very narrow sense. For our team, active management means, first and foremost, creating new debt instruments based on the needs of the issuer and the expected return and risk tolerance of LHV pension funds.

When it comes to real estate, LHV not only buys office buildings that have already been rented out but also invests in the improvement of the assets in its portfolio, dealing with everything from planning and applying for building permits to concluding lease agreements. In the residential real estate market, our pension funds were essentially the first to undertake large-scale development projects of rental apartment buildings, from planning the building in the first stages of development to renting out the apartments at its end.

Of course, we are not trying to do this all ourselves. Costs are an important factor. If it is possible to outsource a professional service that is cheaper than the one we would be able to provide ourselves, we will do it. However, in order to know a service in detail and evaluate its value for money, we first need to have a clear understanding of the whole process.

For LHV, the active management of investments involves much more than just building a stock portfolio, although this is, of course, a necessary part of it. It also contributes to designing an optimal risk profile for the pension fund’s portfolio as a whole.

At a time when several long-term global trends are reversing, it is more important than ever to diversify investment portfolios. Since no one can predict the future, it would be arrogant and irresponsible to concentrate the entire pension fund portfolio in a single asset class, even if that asset class has had excellent returns in the past.