October proved to be relatively calm on international securities markets, leaving the S&P 500 index, which comprises the stocks of the largest US companies, with a decline of 0.2%, measured in euros. However, there were also considerably more outstanding results: the German and Swedish stock markets grew by 3.5% and 4.9%, respectively.
Even though almost no days have gone by without the tariff war or the global weakening of economic growth making the news, 2019, which is now nearing the finish line, has turned out to be an unexpectedly good year for international securities markets. European stock markets have grown by 20%, on average, compared to the beginning of the year, and US markets by nearly 30%, when measured in euros.
The same can be said about bonds. Even though an ever increasing segment of the European bond market offers a negative rate of return when held until maturity, the prices of bonds have increased due to the continuing decline in interest rates. This may seem absurd at first, but even bonds with a negative interest rate may provide a positive rate of return if interest rates continue to drop. Specifically due to the decline in interest rates, the European bond market has offered a rate of return exceeding 7% this year.
An especially curious example is the Austrian 100-year government bond, issued in September 2017 at a price of EUR 99.50 and a coupon of 2.1%. Right now, investors are content with a rate of return of 1.08% per year, and thanks to this, the bond’s price has risen to EUR 162.50. This kind of growth in value has not been witnessed in any stock market in the past two years. On 15 August of this year, investors were even willing to pay EUR 210 for this bond.
The stock exchange is not the whole story
If we were to live by the belief that stock markets are the only proper place where money grows, many fruitful investment opportunities would go unnoticed due to looking only in one direction. This is also the case with the glorification of passive investing.
There is no doubt that over the past ten years the passive investment strategy has beaten the active strategy. However, when approaching investing only through the active-passive lens, a major part of the investing universe, which has also shown very good rates of return, would go unobserved. Not all businesses are listed on the stock exchange, and there are other asset classes besides stocks and bonds, such as real estate and natural resources.
When we look at successful pension funds in Canada, Denmark and Finland, we can see that a significant part of their portfolio is placed in assets that are not listed on the stock exchange and that cannot be defined on the active-passive or stocks-bonds scale.
Studying the investment strategies of funds that invest the assets of major and well-known US universities is also highly informative. For example, in 2018, only 3.5% of the assets of Yale University were placed in US listed stocks; at the same time, 14.1% of investments were made in private capital funds. A total of 19% of assets were invested in risk capital funds, which allocate money into start-ups (mainly in the technology sector).
Several winners of the Nobel Prize in Economics are from Yale University, such as James Tobin, Robert J. Shiller and, most recently, William D. Nordhaus, who won in 2018. I believe that no one suspects the Yale University investment team of naivety or of not having heard of the triumph of index funds.
Increasing pension assets in a more predictable way
LHV Pension Funds have increasingly focused their attention on alternative investments over the past three years. This is not a field where it is possible or reasonable to enter in a hurry. For about four years already, I have been very sceptical of the price levels of listed securities. This is why I have been looking for an alternative means of investing in pension fund assets with a moderate risk, but nonetheless with a proper rate of return.
The amendment to the Investment Funds Act that was passed last year gives fund managers a reason to compare the rate of return of funds with the accrual of social tax, which, in turn, is comparable with the nominal economic growth of Estonia. I believe that in order to achieve and surpass this goal, it is reasonable to primarily look for investment opportunities in one’s homeland, which was also the idea of last year’s legislative amendment.
Compared to the Estonian economy, the Tallinn stock exchange is tiny, which means that most investment opportunities must be found outside of it. Over-the-counter (OTC) investments may also be called active, but not on the active-passive scale that is related to indexing.
An OTC investment generally means becoming an owner yourself, and often also participating in the decision-making process related to the company, project or asset management. This is why control over the result can be forecast better than with a stock market investment.
At the same time, making OTC investments requires somewhat different competences than choosing stocks on the stock exchange or investing in index funds. For this reason, we have strengthened our team with new members this year, who have experience in financing major companies and real estate development.
By investing in commercial real estate that has been rented out for an extended period of time, one can forecast the cash flows for the following years with a relatively high degree of confidence, compared to forecasting changes in stock markets. Indeed, their value is not protected from changes in outside factors (such as interest rates), but the contractual cash flows are still known. This is also the case with bonds issued by local businesses: our team will think through the different risk scenarios before making an investment, and consider these when finalising the contracts.
A downside of OTC investments is their lower liquidity compared to major securities listed on international stock exchanges. However, this does not mean that a buyer cannot be found for them. It is highly likely that a EUR 10 million office building located in the heart of Tallinn would be easier to sell than a EUR 10 million shareholding in a smaller company that is listed on the Tallinn stock exchange.
In addition, due to the long-term nature of the money, pension funds are able to take steps that are more complicated for other investors. Pension funds have the capacity to act contrary to the cycle. For example, when making a real estate investment, improvements to buildings can be scheduled for periods where construction prices fall, i.e. a period of time when the rest of the market is not investing because banks have shut off loans.
We will continue investing in Estonia
Even though Helir-Valdor Seeder and the Isamaa party are trying to destroy the Estonian funded pension system, and are doing everything in their power to divert as much money as possible away from pension funds, we have still not completely ceased investing in Estonia. When making new investments, we also consider how to divest, if need be, to guarantee the liquidity of pension funds.
However, it is also clear that if pension fund volumes decrease, the opportunities for local businesses to find capital also deteriorate. Isamaa’s condescending attitude that if pension funds do not invest then the gap will be filled by someone else shows their naive and flawed understanding of the economy.
Index funds sell their clients the hope of reaping a share of the rate of return of international stock markets, be it positive or negative. We at LHV, on the other hand, are trying to create a portfolio where the rate of return is related to the nominal growth of Estonia’s economy and which should have smaller increases and decreases than the rate of return of international stock indexes.
When in previous periods, the rate of return of LHV Pension Funds has surpassed the increase in the cost-of-living, then the amendment to the Investment Funds Act that was passed at the end of last year made possible an even higher goal: surpassing the nominal economic growth of Estonia. At the same time, this amendment forces us to strive for the aforementioned goal. This kind of investment portfolio cannot be created overnight. If we do not take too many risks, it will take years, but the result will hopefully pay off – both for pension collectors and the Estonian economy.
