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ROUGH GUIDE TO EQUITIES
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It is an exhilarating time to be invested in the stock markets. In
May 2007 the index of the UK’s 100 largest companies, the
FTSE 100, was at its peak. It then started falling, in what
became one of the most savage plunges since the early 1980s,
and only bottomed out in March this year. It has since partially
recovered, but the direction of its next large movement remains
impossible to guess.
In fact, shares (also termed equities) have underperformed
property, bonds and cash as investments since 1997, with the
bursting of the technology bubble in the early years of the
millennium and the recent credit crunch both taking their toll.
That is bad news for pension schemes, who are traditionally
huge investors in shares. The poor performance of equities has
been one of the main factors behind ballooning pension deficits.
However, many schemes have shied away from investing in
shares in recent years. According to a survey from Mercer a third
of pension schemes plan to cut their investments in UK equities
over the next year and a further fifth plan to cut their involvement
in overseas equities, despite the fact that doing so will give them
no chance to claw back the losses caused by last year’s falling
stock markets. Just 2 per cent plan to increase the percentage of
shares in their portfolios this year.
But trustees can’t afford to ignore shares. After all, the average
UK pension scheme still has 54 per cent of its assets in equities,
albeit down from 58 per cent a year ago. And there is significant
evidence to suggest that shares will still outperform other
investments over the long term.
WHAT ARE SHARES?
A ‘share’ of a company refers to the ownership of a part of that
business. Its value changes with the success of the company and
how highly it is rated by investors. In addition, shareholders
usually receive a share dividend, which is a proportion of the
company’s profits.
Dividends are decided by the company’s directors and usually
paid every six months, although some companies pay quarterly
dividends. Businesses that are focusing on reinvesting in their
business, or are loss-making, will pay nothing at all.
Share prices are driven by the company’s performance and
expectation of its future performance. If expectations rise the share
will be in demand, leading to its price increasing.
Shareholders have important governance rights. They elect the
company’s board of directors, including the chief executive and
chairman and, in the UK, vote on the company’s pay policy.
Although the decisions of shareholders are not legally binding,
few corporations would ignore consistent objections from
shareholders. Large investors can expect to be consulted on major
decisions. This aspect of share ownership has been very much in
the news recently.
WHAT ARE THE BENEFITS?
Shares essentially contain a claim to a portion of a company’s
future profits. This means they often protect an investor against
inflation. Even moderate inflation can have a corrosive effect –
inflation of 3 per cent would mean £100 would be worth just £86
in five years’ time. Shares that maintain a dividend above the rate
of inflation can protect a portfolio from this effect.
While past performance gives no guarantee of future benefits,
there is strong evidence to show that pension schemes should
invest in equities over the long term.
The Barclays Equity Gilt Study, which collates investment
returns going back to 1899, shows that over the last 40 years,
shares have returned 4.38 per cent a year compared with 3.3 per
cent for gilts (government bonds) and 2 per cent for cash.
WHAT ARE THE DRAWBACKS?
Shares can underperform for long periods, as we have seen over
the last decade. Equities produce an average return of 7 per cent
but, such is the fluctuation in their performance that the index of
the largest US companies, the S&P 500, only achieves that return
16 per cent of the time.
In the event of a company failure, bondholders and others
creditors get paid back before shareholders and are likely to
recoup at least a portion of their investment. Shareholders got
nothing when Lehman Brothers collapsed last year, for example.
Shareholders can also find that their investment is ‘diluted’ if
the company runs into trouble and if the board responds by
deciding to raise money by issuing more shares. These issues of
more shares are termed ‘rights issues’ – several of the banks,
58 SEPTEMBER/OCTOBER 2009 WWW.ENGAGEDINVESTOR.CO.UK ENGAGED INVESTOR

ROUGH GUIDE TO EQUITIES
Shares can provide good
levels of income, but
investing in them can be a
wild ride, says Tim Sharp
EXPERT VIEW
A strategy for
all seasons
Legal & General Investment Management’s (LGIM)
Shalin Bhagwan explains how a holistic risk
management approach can reduce risk and
maximise returns through all market conditions.
including HSBC, have carried out rights issues this year for
example.
Shares tend to be unpredictable compared to other asset
classes, such as property or bonds, with the price over and
undershooting the level that is ‘rational’ given the performance of
the company. Individual share prices can also move quickly on
news or rumours. For example, when rumours of a share issue by
the Royal Bank of Scotland circulated in April last year, its shares
swung 8 per cent in just over an hour.
Although returns from shares depend on future profits, if you
jump on the bandwagon too late, the prospects of these future
profits would already be “priced in” to the value of the shares,
meaning returns could be less impressive.
WHAT ARE THE CHOICES?
There are various strategies for investing in shares that will provide
quite different returns.
So-called ‘blue chip’ stocks are the big names familiar to most
people. Named after a high value gambling chip, they will have
very substantial assets, a consistent growth and dividend record
and stable management. However, because of their size, returns
from these companies might be less than from younger more
dynamic firms.
Defensive stocks are those companies, such as pharmaceutical
companies, utilities and telecoms firms whose profits usually
don’t change much with the economic cycle. They usually pay
relatively large consistent dividends and often operate in highly
regulated markets, so profits are predictable.
If you want a riskier bet, smaller companies can provide higher
returns than bigger firms because they grow faster; the flipside is
that they are more likely to go bust.
Emerging market equities move more dramatically than
developed world equities. In 2008, the MSCI Brazil, Russia, India
and China (Bric) index fell 54.8 per cent, against a 37.6 per cent
fall in the S&P 500. But in the first four months of 2009, the
same index rose 21.4 per cent, outperforming developed markets.
A key drawback of investing overseas as a UK investor is that
fluctuations in the relative value of currencies can have a massive
impact on the returns.
DIVERSIFICATION
It is understandable that some investors are put off by the recent
ups and downs of equity performance. However, pension schemes
can reduce risk while still reaping the benefits of equity investment
by varying the mix of equities they hold – termed diversification.
Investing in a mixture of shares means you are less reliant on ➔
Like the seasoned traveller who
prepares for all types of weather
conditions, a robust LDI process
aims to strike a balance between
adopting a strategy that copes
with only the worst market
conditions and one that
anticipates only the most
optimistic scenarios.
Given the extreme volatility
experienced by equity and credit
markets in recent times, pension
schemes must consider the use
of both risk-reducing and return
seeking assets if they are to fulfil
their main objective of paying
their liabilities in full. By applying
a variety of risk management and
tactical strategies it even possible
to exploit perceived market
dislocations and optimise the
risk-reward trade off.
Umbrellas and sunscreen
Bonds and swaps are the
“umbrellas” in the world of interest
rate risk; offering pension schemes
protection against unexpected
interest rate changes. The
choice of whether to extend
duration using bonds or swaps
depends on a variety of factors
including the scheme’s ability to
fund the purchase of any physical
bonds as well as the relative value
offered by each.
However, the LDI framework
can be applied to more than
simply bonds and swaps. Equities
continue to be a significant portion
of the average pension scheme’s
investment strategy. Many scheme
sponsors hope to benefit from their
higher expected returns when the
sun is shining on equity markets.
With brighter days likely to be
accompanied by harmful UV
rays (volatility), equity protection
strategies are essentially the
“sunscreen” protecting against
equity risk, helping create
more stable funding level
outcomes. Different combinations
of different types of equity options
can be bought or sold, providing
protection from equity market
falls while simultaneously
allowing participation in equity
market gains sufficient to meet
pension scheme’s expected rate
of returns on their equity assets.
Furthermore, in some cases
this can be achieved with no
initial outlay. Perhaps surprisingly,
some of these strategies can
appear more attractive under
current volatile market conditions
than when equity markets are
more stable.
In essence LDI participants
need to retain an open mind in
approaching the design of an LDI
strategy, permitting the use of a
wide range of instruments; from
vanilla fixed income securities and
equities to sophisticated derivativebased
swap overlay and equity
protection strategies. Like packing
both an umbrella and sunscreen
to provide protection against both
rainy and sunny weather
respectively, a robust LDI
framework should be designed
to cope with an ever changing
environment. An LDI provider
adopting this holistic approach
offers pension schemes a one-stop
shop for the implementation of a
flexible and customised investment
strategy; a strategy designed to not
only reduce risk, but also
maximise returns by capturing
market opportunities. ■
Shalin Bhagwan,
Legal & General
Investment
Management
ENGAGED INVESTOR WWW.ENGAGEDINVESTOR.CO.UK SEPTEMBER/OCTOBER 2009 59

ROUGH GUIDE TO EQUITIES
EXPERT VIEW
Recognise the risks
David Schofield and Howard Nowell explain
the importance of risk management statistics
in the search for alpha
Institutional investors are facing a
number of challenges, from the
moderation of high returns to an
under-funding conundrum. Riskmanaged
strategies may offer a
potential solution. However,
properly evaluating the risk
characteristics of a manager is
crucial, particularly if a scheme is
attempting to replace a passive
investment that carries virtually no
relative risk. Metrics such as
information ratios, t-statistics and
one tail significance can help
sponsors evaluate the risks of a
strategy from a statistical and
probabilistic standpoint.
Passive returns may not be
enough: the 1 per cent difference
Pension schemes can leave their
passive allocations alone and hope
that market returns will be
sufficient to generate returns in this
new market reality. Risk-managed
products aim to provide alpha
while managing downside risk,
allowing a scheme to participate in
the market and potentially realise
excess returns, with little additional
relative risk.
Some pension schemes may find
themselves under whelmed by
excess returns of 1 per cent or 2
per cent net of fees above the
benchmark. However, to write off
such an amount is to ignore the
power of compounding.
To put this in perspective, a
hypothetical £100m investment
will grow to £1bn if compounded
at 8 per cent for 30 years. Adding
just 1 per cent in excess return
yields £1.3bn at the end of 30
years; while 2 per cent excess
return yields £1.7bn – a
substantial £700m over the 30-
year period.
The key is to identify a manager
who has a high probability of
providing repeatable excess returns.
Evaluating historical performance:
skill vs. luck
Statistical tools that enable an
investor to gain greater confidence
in the generation of alpha do exist.
Information ratio is a measure of
how consistent a manager is at
generating alpha. An information
ratio of 1.0 implies outperformance
five out of every six years. The
higher the information ratio over the
long term the better.
Taking this analysis further, one
can gauge the probability of a
manager delivering similar results
purely by luck by computing a t-
statistic, which provides the
estimated probability that pure luck
would produce the portfolio’s
observed alpha, adjusted for time.
A low one tail significance
indicates a low probability that
luck, alone, would produce the
observed alpha.
Therefore pension schemes
should consider strategies with an
investment process that has
produced high information ratios as
well as having t-statistics and one
tail significance indicating a low
probability the results were simply
random. If that process is
understandable, theoretically
sound, consistently applied and has
produced results that mirror stated
expectations, the sponsor should be
comfortable placing even greater
faith in these quantitative
measures.
Selecting an active manager with
a credible, risk-managed
investment process is a difficult
task, However, risk-managed
strategies may be a partial solution
for plan sponsors facing today’s
challenges: The potential rewards
can be substantial as compounding
positive relative excess returns
above a benchmark offers a
powerful advantage over the long
term. ■
David Schofield, President,
Intech International
Howard Nowell, UK
Institutional sales director of
Janus Capital International
howard.nowell@janus.com
0207 410 1515
JARGON BUSTER
BEAR MARKET:
A market where share prices are falling
BULL MARKET:
A market where share prices are rising
DIVIDEND:
The distribution of company profits to
shareholders
DIVIDEND YIELD:
The dividend expressed as a percentage of
the share price
EMERGING MARKET:
A financial market of a developing country
with high growth expectations
FTSE 100 INDEX:
An index of the 100 largest UK companies
listed on the London Stock Exchange
LISTED COMPANY:
A company whose shares can be bought or
sold on a stock exchange
GROWTH INVESTING:
An investment approach that seeks to gain
from the increasing prices of selected
stocks, due to the growth of the underlying
company
INCOME INVESTING:
An investment approach that seeks a
regular income in the form of
dividends by selecting stocks judged
capable of delivering sustainable
dividends
RECOVERY SHARES:
Shares which have fallen in value but are
thought capable of returning to their
former price
RETURN:
The income made from investing in shares
TOTAL RETURN:
The return on an investment which
includes both capital appreciation
and income
UNDERVALUED STOCKS:
Shares priced below their perceived value
➔ the fortunes of one or a small number of companies.
Diversification can be achieved by investing in a mutual fund,
which will contain anything from 50 to several hundred stocks.
Investing in companies in a variety of industry sectors and in
several countries will spread that risk even further. The drawback
of this ‘diversified’ approach is that you may not gain as much as
taking the risk of investing in a single, particularly profitable, area.
But, you won’t carry as much risk either.
Investors can guard against sudden large swings in the market
by gradually feeding their money into equities, so that some
shares are bought at the lower points in the market, reducing the
risk of buying everything when it is at its peak.
SHOULD YOU INVEST NOW?
There are signs that investors are looking beyond the end of the
global recession and are beginning to put their money back into
stock markets.
In the three months to the end of July, the FTSE All Share index
which covers a selection of companies from across the Uk
economy gained 8.5 per cent. Stronger returns have only been
achieved on a handful of other occasions. Banks were the
companies that contributed most to the upswing.
This same pattern was repeated elsewhere. The US market
increased 7.6 per cent in dollar terms, and Europe excluding the
UK was up 9.7 per cent in local currencies.
Even after this recent surge, shares are regarded as good value
by many investors. A survey of fund managers by Bank of
America-Merrill Lynch published in July 2009 showed that most
believe that equities are undervalued while bonds are overvalued.
The survey found that 40 per cent of fund managers now believe
global corporate earnings can rise by more than 10 per cent over
the coming 12 months.
However, as credit is still difficult and expensive to obtain many
companies are focusing on reducing borrowings and investing
profits back into the company, rather than making pay-outs in
dividends.
In the short-term income from shares may continue to be
unexceptional. Economic forecasts predict UK GDP will fall 4 per
cent in 2009 and grow just 0.9 per cent in 2010. Unemployment
is tipped to keep rising next year. If the economy falls into another
recession, then equities could fall sharply again.
But while the short-term may be uncertain, over the longer
term equities tend to prove their worth. ■
60 SEPTEMBER/OCTOBER 2009 WWW.ENGAGEDINVESTOR.CO.UK ENGAGED INVESTOR