Global Investment Review

Global Investment Review

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Continental Drift - US pension funds look internationally

US pension funds have been relatively recent converts to the gospel of international diversification - and it's not hard to see why. With such a large and prosperous home market, they were slow to accept the argument that greater international investment leads to greater risk diversification with the potential for higher returns.

Over the last decade or so, US funds' allocation to international equities has gradually increased. By last year, the average US pension fund had between 10% and 15% of its total assets invested in non-US equities.

Even so, their appetite still lags that of UK pension funds, whose average allocation to international equities has remained high - 16% to as much as 25% during the past five years, according to CAPS.

Strength of US market

A key factor keeping the lid on US funds' international equity allocation at the policy level is the strength of their domestic market, which has had an unprecedented run of spectacular returns. By contrast, international equities have had several periods of relative underperformance. The euro's plunge against the dollar has further limited returns and reinforced pension funds' wariness.

So, though US pension funds may accept the diversification argument in terms of risk reduction, they are finding it harder to make the case for increasing their international equity allocations in the face of disappointing performance. As a result, international allocations may even have shrunk recently, simply because funds are not rebalancing their portfolios.

But while international investing is not gaining masses of new converts, there is a fair amount of movement going on at the margin. Some of this is being driven by small and medium-sized funds, which have been slower to accept the value of international diversification than their bigger counterparts.

Some small public funds, for instance, have recently had longstanding overseas investment restrictions lifted and so have some catching up to do. Small corporate pension funds are also dipping a toe into overseas investing for the first time. In general, however, these types of funds are putting only small amounts into non-US equities while they keep an eye on returns.

New trends to diversify

The new trend among bigger US funds, meanwhile, is that they are starting to diversify their international mandates in terms of style. The catalyst was last year's huge divergence in performance between growth and value. This led to the discovery that funds were not as diversified as they had thought in their international manager line-ups. In fact, they realised that they were using mostly value managers.

They are now trying to offset some of this value bias by bringing growth managers into their line-ups. This, in turn, has led to new types of managers being considered in addition to the established players. Some are domestically-based US growth investors who are taking their strategies overseas; others are newer boutique-type managers. In general, there is no longer any cachet attached to having an international manager with a foreign accent. Funds are increasingly comfortable with the idea of using domestic managers, particularly if they have already worked with the manager.

Though style diversification has begun, it is still in the very early stages and with funds trying to limit the numbers of managers they use, there is not much scope for expansion. Few $500 million funds will have more than two international managers.

Also, some styles of management don't travel well overseas - at least in the opinion of US pension plans. They have very little interest in passive managers because they view most international markets as inefficient. They therefore choose active managers, who should be able to exploit the inefficiencies to add value.

They are highly sceptical, too, about the composition of many of the international indices. For example, until recently, Japan formed the lion's share of many of these indices. Yet for some years, Japan's banking system was in deep trouble and any active manager worth his salt knew that all he had to do was to underweight the banks to beat the index.

Other asset classes

International small cap investing has never really caught on with US plans either. The lack of established benchmarks is a major problem. Another is that in the US, small cap investors expect a bit of excitement in that they are looking to buy the growth companies of tomorrow. Outside the US, by contrast, small companies tend to be in very dull sectors such as retailing or auto parts supply.

A word about international bonds: US funds are happy to have their fixed-income managers invest in non-US bonds with a small portion of their portfolios in order to boost their performance against a domestic benchmark. But they have resisted making dedicated allocations to non-US bonds on the grounds that they lack the vital link with liabilities.

To sum up, there is no wall of US pension money heading for international equity markets. It is more a gentle drift with some shifting of assets at the margin.

For more information on US investment managers, contact Jeff Nipp in our Atlanta office on +1 770 290 8500.