Blog: What can pension funds learn from BP crisis?

The Gulf of Mexico oil spill crisis may not only prove a wake-up call for BP but for UK pension funds too.

BP announced last night it will scrap its dividend for 2010 as it has to put $20bn (£13.5bn) in a compensation fund for victims of the spill.

This is a major blow for DC and DB pension schemes invested in a typical FTSE 100 UK equities mandate. They hold as much as 8% of their portfolio in the oil giant's shares - and are estimated to receive as much as £1 in £6 of their UK equity dividend income from the company.

Yet, rather than blaming US president Barack Obama for hurting UK pensioners through his attacks on BP, we should instead be thinking about why so many pension schemes have so much risk concentrated in so few stocks.

Indeed, those schemes investing in passive FTSE100 portfolios held at the end of April will have had about 46% of their portfolio in just nine firms (BP, HSBC Holdings, Vodafone, Royal Dutch Shell, GlaxoSmithKline, Rio Tinto, BHP Billiton, British American Tobacco and Barclays).

Two oil firms, two banks, two mining firms, a telecoms company, a pharmaceutical manufacturer, and a tobacco firm doesn't sound like a risk-balanced portfolio by any standard.

There are alternatives for schemes however - such as fundamental approaches, which base indices on sales, profits, book value or dividends rather than market capitalisation.

Such approaches would do more than simply reduce the concentration of risk in scheme portfolios - they could also boost returns as smaller companies and those with a higher accounting value relative to their market value can often offer higher returns with a lower volatility.

In its 1995 paper, Fundamental Indexation, Research Affiliates' Robert Arnott, Jason Hsu, and Philip Moore argued a trillion-dollar industry was based on investing in or benchmarking to capitalization-weighted indexes, even though the finance literature rejects the mean-variance efficiency of such indices.

Their study found these fundamental indices delivered consistent, significant benefits relative to standard cap-weighted indexes - both outperforming standard market-cap based indices and delivering this return with either less or a similar amount of risk.

Since this study came out a range of advisers and fund managers have advocated the use of these fundamental indices - including Towers Watson, which started recommending its clients invest up to half of their passive assets in fundamental indexes. earlier this year (PP Online, February 9).

Senior investment consultant Philip Tindall said such a move would "enhance returns without increasing risk".

The fundamental FTSE RAFI All World index beat the market-cap weighted FTSE All World index on an annualised basis over the one, three, five and ten year periods ending December 31, 2009.

Yet, while investors like the Merseyside Pension Fund and the California Public Employees' Retirement System have already incorporated investment strategy indexes into their portfolios, many other consultants, schemes and investors are holding back.

Indeed, there are disadvantages of these kind of indices. Fundamental index funds can be more expensive to run than traditional market cap index trackers and fundamental funds can overweight value firms when they see a rapid fall in their fortunes.

There is also a fear that investors could miss out on other growth factors that could affect returns by focusing on just a handful of fundamentals.

Even though fundamental investing may have its weakness, the Gulf of Mexico oil spill disaster has highlighted the flaws of traditional approaches to indexation.

Perhaps it is now time to give some of these alternatives a chance.