Almost two-thirds of institutional investors in the UK (64 per cent) expect asset bubbles to negatively impact performance in 2018 and more than three out of every four (78 per cent) believe the current market environment favours active management, as allocations to passive slide for the third year in a row.
That’s according to a new study released by Natixis Investment Managers.
To position their portfolios for the volatility they expect as central banks gradually remove the monetary life support system in place since the financial crisis, they are also increasing allocations to non-traditional assets, including private equity, private debt, infrastructure and real estate, as they seek alternatives to bonds and hunt for higher returns in a crowded market.
Oliver Bilal (pictured), Head of International Sales and Marketing at Natixis Investment Managers, says, “Institutional investors around the globe are wary of fragile market conditions, distorted asset prices and systemic risks caused by central bank interventions and the growing popularity of passive investments, and they continue to turn to active management to manage current market conditions. They are confident their own portfolios are built to weather future market conditions, but warn that individual investors are not aware of the systemic market risks posed by passive investing.”
Natixis surveyed decision makers at 500 institutional investment firms who, in sum, manage more than USD19 trillion in assets for retirees, governments, insurance companies and other institutions worldwide. In the UK, the survey found 66 per cent believe that volatility has been artificially suppressed by flows into passive investment strategies. More than half (53 per cent) believe the increase in passive investing is distorting relative stock prices and creating systemic market risks (73 per cent), of which 82 per cent believe individual investors aren’t yet aware.
Active strategies are in favour among institutions, with 78 per cent who now believe the current market environment is likely to be favourable for active portfolio management.
Comparing passive and active approaches directly, a 62 per cent majority say active managers outperform passive in the long run. Almost three-quarters of UK institutions (73 per cent) say active managers are better at accessing emerging market opportunities – and a similar proportion (78 per cent) say active managers provide better exposure to non-correlated asset classes.
Bilal says: “Managing downside risks will be more of a challenge in 2018 – but the New Year should also be seen as an opportunity. Volatility can boost returns for those able to take advantage; however institutions without a truly diverse and durable portfolio risk reacting to market corrections and volatility – rather than profiting from such movements. Markets look set for a more lively and volatile 2018, and active markets will therefore demand far more active thinking.”
An overwhelming three-quarters of UK institutions (76 per cent) believe a prolonged period of low interest rates has led to the creation of asset bubbles. Moreover, looking ahead, 64 per cent of institutional investors see interest rate rises as the top portfolio concern for 2018 – a potential trigger for a correction in fixed income values.
The survey also found asset bubbles rival geopolitical events – a concern for 76 per cent following recent events – and asset bubbles rank ahead of interest rate increases (48 per cent) as the factor institutions believe will have the most negative impact on their investment performance in 2018.
Institutional investors believe the bond market is the traditional asset class most likely to be entering a bubble. With 60 per cent of institutional investors in the UK now expecting a ‘bond market bubble’, this represents four times the proportion who expect a property bubble (15 per cent) – and is even comparable to the 82 per cent who see a bubble in Bitcoin.
Oliver Bilal adds, “With all fixed income investments now subject to the growing possibility of sustained global rate rises, many institutional investors are starting to view current bond market valuations with suspicion. Consequently, investors are increasingly looking for alternatives and uncorrelated investment solutions that can help them to ride out market challenges in 2018”.
A substantial proportion of institutional investors (24 per cent) also observe a ‘bubble’ in equity markets. Yet renewed volatility (rather than a sustained correction) is set to be the main feature for equities in 2018: an overwhelming 85 per cent of UK institutions expect an increase in equity volatility next year. Looking back on the absence of volatility this year, 42 per cent believe this is unsustainable and is in fact a cause for serious concern.
Institutional investors are placing greater faith in both equities and uncorrelated, alternative investments to help them ride out such market challenges.
Equity exposures in the UK stand at 40.7 per cent, while UK institutions’ fixed income allocations are now 32.2 per cent.
Potentially reflecting fears of a bubble in fixed-income valuations, over a quarter of institutional investors (27 per cent) are decreasing the amount of high yield corporate debt they hold, while a third (33 per cent) are decreasing their exposure to hedge fund strategies.
A 57 per cent majority say fixed income is no longer providing its traditional risk management role in portfolios, while 58 per cent of UK institutions now believe traditional assets in general are too highly correlated to provide distinctive sources of return.
By contrast 79 per cent say increasing the use of alternatives is an effective way to manage risk – and two-thirds (67 per cent) of UK institutions go further, believing alternative investments are in fact essential to diversify portfolio risk.
Within alternatives, there is also an appetite for illiquidity, as 78 per cent believe potential returns make such investments worth the risk associated with fixed timeframes. Private equity is the most popular example with 51 per cent of institutions increasing their private equity investments – and two-thirds (69 per cent) are satisfied with the performance of private equity investments in their portfolio.
In terms of sector picks: more UK institutions (51 per cent) expect the technology sector to outperform the market in 2018 above any other sector, followed by defence/aerospace (49 per cent), healthcare (48 per cent), and consumer discretionary (40 per cent).
In direct competition to fixed income, almost three quarters of UK institutional investors (73 per cent) now say that private debt provides higher risk-adjusted returns than fixed income vehicles – and 55 per cent are currently increasing their private debt holdings.
A longer-term view on the sustainability of returns is also emerging. A majority of UK institutions (51 per cent) now say incorporating Environmental and Social Governance (ESG) practices will be standard for all managers within the next five years. This appears to be for practical purposes as much as moral; an overwhelming majority (64 per cent) say there is alpha to be found in ESG investing.
Bilal says: “Institutional investors worldwide are steeling themselves for the possible emergence – and correction – of asset bubbles, alongside interest rate hikes and increased volatility. Beyond the traditional interplay of fixed income and equities, we’re also seeing many institutional investors seek refuge in alternative investment strategies, as they look to protect and diversify their portfolios while also generating satisfactory returns. Instead of the long-standing hunt for yield, we are seeing an emerging scrutiny of portfolios – and a new hunt for diversification.”
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