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Why a market correction might help some investment managers

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A market correction could provide some longer-term benefits, says Nathan Flanders, managing director, Fitch Ratings…

Mention the words ‘market correction’ and reactions range from mild worry to outright concern among most market participants. However, a number of different types of investment managers may actually welcome hearing those words, as a market correction could provide some longer-term benefits.

Why is it that a market correction, which we define as a temporary decline in asset values of approximately 10 per cent, could benefit a business model primarily predicated on delivering positive returns to investors? The answer is that despite the short-term performance pain a market correction would cause, it could also counter current industry challenges including growing investor appetite for passive strategies, the potentially distortive effects of widespread Central Bank intervention and higher asset valuations after an extended bull market run.

Active-oriented traditional investment managers, for example, have endured an extended period of underperformance relative to their passive brethren, particularly in developed markets. These managers argue that underperformance has been driven by the benign post-crisis economic backdrop and extensive Central Bank intervention, which have led virtually all asset classes to move in a more correlated fashion, diminishing active managers’ ability to outperform. Reflecting these dynamics, US long-term passive funds attracted USD501.8 billion of inflows in 2016, while US long-term active funds experienced USD315.2 billion of outflows over the same time period, according to Morningstar. Not surprisingly, two of the largest players in the passive space, BlackRock and Vanguard, reported strong 2016 ETF inflows of USD140 billion and USD93 billion, respectively.

In the event of a market correction, passive funds would follow their respective benchmarks down, while those active-oriented traditional investment managers able to better navigate the stress could see better results and attract asset inflows thereafter. Active-oriented traditional investment managers may benefit from a correction even absent material outperformance, as it would provide a reminder to investors that passive strategies do not always move upwards.

For most hedge fund managers, their value proposition to investors centres around providing returns uncorrelated to broader markets, particularly in downturns. As the last financial crisis recedes from the market’s collective memory, however, hedge fund investors are increasingly focused on underperformance relative to broader benchmarks. For example, 2016 marked the eighth consecutive year that the S&P 500 outperformed Hedge Fund Research Inc’s Fund Weighted Hedge Fund Composite Index.

Recent underperformance along with elevated management fees have led a number of large hedge fund investors to reduce or curtail their hedge fund investments including certain public pension funds, insurance companies and university endowments. A market correction that evidences the downside protection that hedge funds purport to offer could create renewed appreciation for the asset class and stem outflows and fee pressure. A correction could also pressure smaller hedge fund managers to close, reducing competition and the amount of capital chasing a somewhat finite number of hedge fund investment strategies.

Private equity, credit and real estate fund managers have taken advantage of improving market valuations post-crisis to realise significant gains on investments made in recent years. This has driven strong returns for limited partners (LPs) and allowed these managers to fundraise record amounts of committed capital for future deployment, commonly referred to as dry powder. At Sept. 30, 2016, the seven largest Fitch-rated diversified alternative investment managers had USD273.5 billion of aggregate dry powder committed from LPs but not yet invested. Unfortunately, the same market valuations that enabled private equity, credit and real estate fund managers to be such active sellers of assets are now making it more difficult to invest sizeable amounts of capital without challenging future returns. While a market correction would at least temporarily depress valuations on existing investments, it would also reduce the values of investable assets, improving return prospects on new investments based solely on their lower cost basis.

Investment managers do not necessarily need a market correction in order to invest, and in fact, the outcome of the recent US presidential election has increased market volatility, bond yields and asset performance dispersion, offering investment managers some reprieve. At the same time, a correction could initially exacerbate asset outflows for open-ended fund structures if investors responded by temporarily migrating to cash or other low-risk investments. It is also unclear whether the potential benefits of a cyclical correction could head off broader secular changes in investor appetite and fee sensitivity.

Nevertheless, we see the current environment offering many investment managers two sub-optimal paths. First, risk appetite can be expanded in order to achieve incremental returns. This may defend against near-term underperformance but leaves funds exposed to valuation declines in the event of a re-pricing of risk and could cause franchise damage to investment managers if performance volatility exceeds investor expectations. The second option is for investment managers to expend more investment resources to identify fewer suitable investment opportunities, while right-sizing funds and holding larger balances in cash or lower risk securities in the interim, in effect holding out for improved risk-adjusted investment opportunities. This approach would pressure funds’ short-term returns and investment managers’ near-term profitability, but would presumably defend against the downside risk of a market correction while maintaining the flexibility to invest at lower asset values thereafter.

The longer the current market dynamics persist, the more likely it is that investment managers will expand, rather than moderate, their risk appetite, an outcome perhaps more concerning than a market correction itself.

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