Volatility finally roared back to abnormally tame markets, but most institutional investors were already bracing for impact; their efforts to diversify and build durable portfolios should now pay off, according to new survey findings released by Natixis Investment Managers.
Seventy-eight per cent of institutional investors expected stock market volatility to spike in 2018, and they are making opportunistic allocations to active management and alternative investments in order to meet average long-term return assumptions of 7.2 per cent this year.
That’s according to a new survey by Natixis Investments Managers’ Centre for Investor Insight of 500 institutional investors around the world to gain insight about how they are balancing long-term objectives with short-term opportunities and pressures. Seven in 10 investors agreed that the addition of alternatives is important for diversifying portfolio risk. Yet they see a number of alternative strategies playing distinct roles in their portfolios.
The survey found that investors continue to turn to alternative investments with 70 per cent of them saying that it is essential to invest in alternatives to diversify portfolio risk and over half (57 per cent) think investing in alternatives is necessary to outperform the broader market.
When asked to match the best alternative strategies with specific portfolio objectives, institutional investors most commonly cite global macro strategies (47 per cent), commodities (41 per cent) and infrastructure (40 per cent) investments as best for diversification.
Their top choices for providing a source of stable income as interest rates rise and the 30-year bond bull market ends include infrastructure (55 per cent) and private debt (47 per cent). Institutions cite managed futures (46 per cent) and hedged equity (45 per cent) as best suited to manage volatility risk.
Traditional markets have generated attractive returns, but institutions see opportunity to outperform. Seven in 10 (72 per cent) cite private equity as their top choice among alternatives for generating alpha. They also see hedged equity (45 per cent) as useful in meeting this objective.
Institutions view commodities (56 per cent) and real estate (46 per cent) as best for inflation hedging strategies.
“The sudden return of market volatility is a healthy reminder that it’s important to take a consistent approach to portfolio diversification,” says Oliver Bilal (pictured), Head of International Sales and Marketing at Natixis Investment Managers. “Institutional investors are increasingly turning to active managers and alternatives for the tools and flexibility to diversify their portfolios and mitigate risk.”
And while alternative investments can present a range of portfolio risks, 74 per cent say the potential returns of illiquid investments are worth the risk. That said, two-thirds report that solvency and liquidity requirements has created a strong bias for shorter time horizons and highly liquid assets, and hidden risks lurking with the dynamic macroeconomic and regulatory market makes it even more challenging for institutions to balance short-term opportunities and long-term objectives.
Over three quarters (76 per cent) of institutional investors say the current market environment is likely to be favourable to active management in 2018. In 2015, the survey found that institutions expected that 43 per cent of total assets would be invested in passive strategies by 2018, but in reality the figure has been far lower, at 32 per cent by 2017, with institutional investors projecting just a 1 per cent increase in the next three years. More than half (57 per cent) of those surveyed also said they expect active to outperform passive over the long term, despite three quarters (76 per cent) saying alpha is becoming harder to obtain as markets become more efficient.
Nine in 10 institutional investors say minimising management fees is one of the strongest drivers for passive investment strategies, but three quarters (75 per cent) said they were willing to pay higher fees for potential outperformance.
The survey also highlighted a preference for active strategies in order to gain exposure to non-correlated asset classes, with three quarters (75 per cent) citing it as one of the foremost reasons for a preference for active over passive instruments. Similarly, three quarters (75 per cent) prefer active over passive to access emerging market opportunities, while 69 per cent favour active strategies for providing risk-adjusted returns and more than seven in 10 (73 per cent) for providing downside protection.
Bilal says: “The active versus passive debate doesn’t look set to disappear, as institutions have signalled a gradual shift towards active strategies. The traditional arguments about the cost saving potential of passive products are being challenged, as institutions see the long term value that can be generated by active management and the access it can grant to a broader range of asset classes.”
Institutional investors have also signalled a more active approach to managing environmental, social and governance (ESG) issues, with three in five (60 per cent) now integrating ESG investing into their approach.
The number of institutions that see alpha to be found in ESG now outweighs the number focused chiefly on risk mitigation, and their convictions about the efficacy of this approach are strong with the vast majority saying that incorporating ESG into investment strategy will become a standard practice within the next five years.
Some 59 per cent say there is alpha to be found in ESG investing, while 56 per cent believe ESG investing mitigates risks (eg loss of assets due to law suits, social discord or environmental harm), and 61 per cent agree incorporating ESG into investment strategy will become a standard practice within the next five years.
Whereas a year ago, the top reason institutional investors were integrating ESG was because of their firm’s mandate or investment policy, almost half (47 per cent) say the incorporation of ESG is now driven by the need to align investment strategies with organisational values, while two fifths (41 per cent) say the primary driver has been the need to minimise headline risk, a 21 per cent increase on 2016.
“Attitudes towards ESG investing are changing dramatically with the vast majority of institutions now saying that ESG leads to alpha generation and will become standard practice in less than fove years,” says Dave Goodsell, Executive Director of Natixis’ Centre for Investor Insight. “Institutional investors have witnessed the impact of environmental, social and governance events at numerous companies in recent years and watched as stock values declined right along with corporate reputations.”
One of the long-term challenges cited by institutional investors is longevity, with 85 per cent of insurance companies, 78 per cent of corporate pension plans and 76 per cent of public pension plans all challenged to meet their longevity risk. More than nine in ten (92 per cent) of those surveyed said they would be challenged to meet their long-term return assumptions, increasing to 97 per cent for UK based institutions.
Institutional investors have had to perform a balancing act over the past 10 years, navigating low interest rates, while facing rising liabilities and an increasingly regulated environment. While in the short term the majority feel equipped to meet their return expectations, there is an acute awareness that finding returns over the long term will be challenging. In light of this, institutions have adopted a long term investment approach, with few making radical defensive moves today.
“Low rates may have helped to boost returns by increasing the value of bond assets held in institutional portfolios, but at the same time the low rate environment has increased the present value of liabilities, exacerbating the pressure to effectively manage liabilities. The prospect of rising interest rates represents a bright spot for a number of institutions, as it would decrease the present value of their liabilities. This is one of the reasons why institutions cite managing duration as their top strategy for navigating a rising rate environment,” says Bilal.
However, liability management strategies are not a straightforward solution for institutions. Seven out of ten (70 per cent) said they are incorporating liability management into their portfolio strategy and yet three in five still think organisations will fail to meet their long term liabilities despite adopting LDI techniques. Despite the rising popularity of strategies such as cashflow-driven investing, six in ten (60 per cent) say there is a lack of innovation within LDI solutions, while almost two thirds (63 per cent) say decision makers are placing greater importance on achieving short-term performance results, over meeting long-term liability matching objectives.
