As the environment changes, so must strategy
October was a rather hectic month for international securities markets, leaving major stock markets in the red as in September. The Euro Stoxx 50 index that reflects Europe’s largest companies lost 7.3% of its value during the month and the value of German companies even fell by 9.4%. The US stock market (S&P 500 index) fell by 2.1% measured in euros.
At the end of October, the global stock market was still 5% lower (including dividends) than at the beginning of the year, and even the S&P 500 index, which includes major US technology companies, yielded –1.4% when measured in euros, including dividends.
Compared to the stock markets, the value of LHV’s largest pension funds fell minimally in both September and October and stand out for their stable performance and positive return in the year of the coronavirus pandemic. As LHV’s pension funds were conservatively positioned before the coronavirus crisis, this made it possible to take advantage of the March decline quickly and relatively vigorously.
Bonds that swallow investor money
In a changing investment environment, it is worth analysing the distribution of portfolio assets on a regular basis and considering whether the risks are sufficiently hedged or diversified. If the coupon rate of a bond is 0% and the price of the bond has risen above its redemption value, a loss is guaranteed if the bond is held to maturity.
The expected return on assets and the level of risk are not constant. Although they do not fluctuate on a daily basis, changes can be quite significant over time. Therefore, when looking at our investment portfolio, it is worth asking ourselves from time to time what our expectations are for different asset classes and which asset classes we should indeed prefer. Should we adjust our former expectations, opinions and also our prejudices?
Just ten years ago, I couldn’t have imagined a situation that would force me to buy gold – it seemed that there were always better alternatives. At the end of October, however, the share of gold-related investments in LHV largest pension fund L was approximately 7%, and we are likely to increase this position further in the future.
I remember that in the mid-1990s, the yield on risk-free long-term bonds was estimated to be around 4 to 5% and the equity risk premium to be almost constant at 7%, so that the expected return on equities was around 11 to 12%. If we now invest 1,000 euros in ten-year German government bonds, then in ten years’ time we would get back 950 euros, which makes a guaranteed loss of 0.5% a year.
I suspect that if we invest in stocks at the current price level, the average annual return of stock indexes over the next five years will not be significantly higher than a few percent. Those who invested in the MSCI World Index of Developed Countries’ Equity Markets in March 2000 did not reach zero until six years later. It is worth noting that the equity price drop in the spring of 2000 was not caused by any particular event. Stock markets fell because prices had risen to unreasonably high levels relative to profits.
Equities are not the only asset class worth investing in
In recent years, it has become increasingly popular in Estonia to believe that global stock markets are the only place to invest and that an index fund is the best and only instrument for making such investments. An index fund is indeed a great financial instrument for investing in global markets, but equities are just one of many asset classes. It should be noted that equities are not even the largest or always the most profitable asset class.
The view of the Yale University Endowment has increasingly served as an example for me in recent years. They aim for a quick inflation-adjusted return while considering the risk. The investment team at Yale University has allocated their endowment into eight asset classes. At the end of 2019, US equities accounted for 2.7% and international equities for 13.7% of their investment portfolio. The shares of real estate and mineral resources were 10.1% and 4.9% of the portfolio, respectively.
Allocation of Yale University Endowment assets. Source: Yale University
The graph shows how the distribution of Yale University’s investment portfolio has changed over time. Yale has not invested all its money in the stock markets. An investment review recalled how they reduced their equity holdings during the dot.com boom as markets continued to rise at an accelerating pace. However, it’s unlikely that anyone would accuse Yale’s investment team of naivety or ignoring the academy.
In recent years, we have also significantly expanded the asset classes in LHV pension funds, investing in forest land with renewable natural resources and making a return on investments in the rental apartment buildings and office buildings respectively established and acquired by us (Valge Maja and Microsoft building). We are looking for high-potential but low-leveraged private equity funds and help finance local companies (Peetri Keskus, Sunly, Alexela, Ekspress Grupp) through bonds that offer a better return for pension fund investors than international bond markets.
A retail investor operating outside the pension scheme does not have easy access to such alternative assets. We believe that adding alternative asset classes to a traditional portfolio of equities and bonds will help increase returns and reduce risks.
Encouraging consumption rather than investment
Until the end of 2018, LHV pension funds had two main goals: to preserve investors’ assets and to beat the pace of inflation. The third goal was to outperform competitors. In our opinion, we have always succeeded in achieving these three goals.
Following an amendment to the Investment Funds Act at the end of 2018, the legislator set a new goal for fund managers to exceed the growth rate of Estonian social tax receipts (the social tax amounts paid out as first pillar pensions). This encouraged fund managers to take more risks to achieve the goal. While at the time of the establishment of the pension system, the concern was about the preservation and protection of pension assets, the 2018 amendment effectively guided fund managers to take more risks in order to earn a return.
Wages in Estonia have grown faster in some years and slower in others, while the average wage growth has been more than 5% per year. In our view, taking into account the limitations of pension funds and the risk profiles of the funds, it is possible to achieve a long-term average return in excess of 6%. This is what we strive for in our daily work.
In some years, our performance may be slightly lower, but we do everything in our power to exceed this target. We also choose our investments based on that goal. In essence, it is no longer reasonable for LHV’s riskier actively managed pension funds to make any new longer-term investments with an expected return of under 6%.
Amendments to the Funded Pensions Act, which entered into force in October, make it much more difficult to invest in less liquid private Estonian companies, private equity funds and real estate. However, our team has not given up and we will continue pursuing our chosen mission – to develop Estonian capital markets. We believe that by developing the local capital market and contributing to the growth of Estonian companies, we can earn a better return than by investing in listed shares and negative-yield bonds.
It is embarrassing that many Estonian politicians do not understand the role of capital in the economy and encourage consumption rather than saving. By spending the assets saved for retirement, the economy can be stimulated in the short run, while sacrificing the long-term development and growth of the country’s economy.
You can’t get rich by borrowing and spending. Capital accrues only when expenses are less than revenues. When you have capital, you can leverage it through borrowing. When you have no capital, you have no other financing options besides high-cost consumer loans.
