Lothian to reduce 'suboptimal' market cap exposure

Institutional investors are increasingly questioning the value of the market-cap weighted index, supported by a Cass Business School study published in April showing the approach was outperformed by the majority of 10m randomly-weighted indices.

Following a review of its investment approach after a drop in scheme funding, the £4.1bn scheme concluded there was scope to reduce overall portfolio risk over the next few years and found a reliance on market cap equity indices was "suboptimal".

The scheme will reduce both its overall allocation to equities and the amount of this exposure that is managed in dedicated regional portfolios, in favour of global mandates, according to a spokesperson. It intends to increase the allocation to funds with a strategy based on income and stability.

Lothian has already terminated one external global equity mandate that the scheme concluded did not fit with its aim of lowering absolute volatility. These assets were moved into an existing internally managed global high income equity fund and a new fund run by asset manager Nordea.

"Both [funds] invest in companies with low volatility compared with the global equity benchmark and are expected to perform relatively well when equity markets are weak and produce positive absolute returns in rising equity markets," said the scheme spokesperson.

A number of schemes have sought to move away from using market capitalisation as a benchmark. Gavin Orpin, head of trustee investment at consultancy LCP, said a lot of its clients have decided that it is not the right approach for passive mandates, for example.

“They are looking at what is known as fundamental indexation. It is a similar sort of mechanical process, but it is selecting stocks based on their fundamentals rather than [on] what proportion of the market are they,” he said.

For some schemes looking at different criteria such as earnings, rather than relying on market capitalisation was the preferred approach, Orpin added.

Battling its funding drop

In its 2012/2013 annual report and accounts, Lothian said despite strong investment returns in excess of expectations, the scheme’s funding level fell from 96 per cent at the last actuarial valuation in March 2011 to 87 per cent in March 2013.

The investment and funding outlook for the fund remained exceptionally challenging as government bond yields remained “stubbornly low”, the spokesperson said.

“The strategy involves a small increase in index-linked gilt exposure, which provides diversification, some insurance against an unexpected rise in inflation and a return broadly in line with the fund’s liabilities."

The new approach, which was approved in October 2012, is to be implemented at a steady pace, with some changes already in progress, towards the following end:

• In March, the scheme's asset allocation stood at 64 per cent equities; 5 per cent index-linked gilts; 30 per cent alternatives; and 1 per cent cash.

• The strategy shift will see the scheme move to 65 per cent equities, including private equity; 7 per cent in index-linked gilts; and 28 per cent in alternatives.

Lothian also revealed plans to increase allocation to alternative investments, but said any changes in this area would be relatively modest.

The scheme has been investing in infrastructure for a number of years and planned to continue to do so if attractive opportunities were to arise, added the spokesperson. 

Peter Martin, head of manager research at consultancy JLT Employee Benefits, said a lot of schemes were looking to be more nimble with their strategies.

"A lot of schemes are looking to take advantage of medium-term prospects, rather than having a strategy in place for 10 years and just sticking with that approach," he said.