As institutional investors such as pension funds continue to reallocate their assets towards bonds, retail investors can take advantage of the opportunities that arise in equity markets.Investment trends in the institutional investor space have always influenced the behaviour of retail investors, and the current market is no different. We believe that the move among institutions to reallocate assets from equities to long-dated bonds, and how this technical demand has come to over-rule investment fundamentals, continues to create opportunities for active retail investors. Institutional investors’ shift towards bonds has been an increasingly prominent feature of the market over the past few years. The background behind this trend can be traced back to the late 1990s, when the culture of equity investment was at its peak after a decade of positive returns. By the end of 2000, institutions such as pension funds, insurers and long-term saving plans had moved away from their previously conservative approach to asset allocation, favouring equities over bonds, which had traditionally accounted for a large percentage of their investments. With hindsight, by 2000, institutions were clearly over-allocated to riskier assets, in particular equities. This became obvious as bear markets began to bite in the years that followed. Poor returns from equities put pension funds under pressure, leaving many groups with crippling deficits. However, actuarial and accounting variations, such as using over-inflated return expectations, allowed groups to mask the level of underfunding. In response to the emerging problem of pension fund shortfalls, government regulation of pension funds increased, including the introduction of a new Financial Reporting Standard: FRS 17. This meant companies had to account for pension assets and liabilities on their balance sheets. With funding deficits highlighted in this way, many groups adopted a liability matching strategy, buying assets with a specific income and value, calculated to closely correspond with payment obligations in the future. Bonds tend to have a lower risk profile than equities and, as their return structure is better defined and more predictable, this makes them, especially long-dated bonds, an ideal investment for groups seeking to match their future payment requirements. As most long-term savings schemes, pension funds and life assurers chose the liability matching route, they switched out of equities and back into bonds. Therefore, the result of the government’s move to reduce the risk of underfunded pension funds was a large and radical shift in favour of bonds, which has affected the whole institutional investment universe. This change in thinking among pension funds has already provided one example of how savvy retail investors have capitalised on institutional investing trends in the past. The early years of this decade, when institutions began to abandon their bullish asset allocations, saw a prolonged period of equity sales, which spurred on the decline in global equity markets. As shares in the world’s largest companies were the most liquid, it was the large-scale sale of these stocks that had the most dramatic effect. As shares in small and mid-cap companies were not so easy to sell, they did not come under the same pressure, and over the past few years they have been able to outperform their larger peers. Investors who were able to gain an insight into what institutional investors where doing at this time could clearly see that this was creating an opportunity, of which many took advantage. Despite a considerable improvement in the equity markets, pension fund deficits are still an issue and we continue to see institutional investors reallocating assets to bonds. Demand has been particularly high for long-dated gilts (conventional and index-linked), as their duration profile makes them a useful tool for liability matching. As supply has come under pressure over the past couple of years, investors have continued to buy them, almost without regard for their trading prices. As a result, valuations have become over-inflated (see chart), driven to levels that are unjustified by bonds’ fundamentals and the current market environment. So how should retail investors respond to this trend? The negative returns that we have seen from bonds so far this year suggest that fundamental considerations are beginning to reassert themselves and we could see a prolonged shake-out in the bond market as a result. In the current environment of global economic growth, bonds appear unattractive compared with equities and we believe the associated risks of inflationary pressures outweigh the likely benefits of investing in this asset class. This fundamental analysis suggests that bonds offer little or no value at current prices. Traditionally, bonds are seen as something of a safe haven and cautious investment products tend to rely on them, especially long-dated, high quality bonds, which are the most overvalued at the moment. We believe bonds’ low-risk reputation is currently undeserved, but naturally there is still demand for cautious products. So the challenge facing investors is finding a suitably low-risk product as an alterative. We believe that cautious investors should now be focusing on investment products that use asset allocation as a key tool in reducing risk. Investors should be looking for cautious funds with a flexible and unconstrained approach to investment – funds that offer greater diversification of assets. Until recently, there has been only limited scope to actively manage the portfolio of a cautious managed fund, but new Financial Services Authority regulation greatly increases the potential flexibility of these funds. For example, under the new non-Ucits retail scheme, fund managers can move the entire portfolio into risk-free cash positions if they feel the market warrants this level of caution. New regulations also allow funds to invest in a wider range of assets, including commercial property, investment trusts, hedge funds and absolute return products. Potentially, exposure to a greater variety of asset types means fund managers can reduce volatility, creating a more cautious product, which is great for investors in the current market, where bonds are no longer a reliable low-risk option. While we currently see little value in either corporate or government debt, relatively undemanding valuations increase the appeal of equities. Stock markets continue to be supported by encouraging earnings news and a pick-up in merger and acquisitions activity. Equities are generally assumed to be a riskier asset class, and rightly so, but in the short term it could be bonds that prove more disappointing.