Institutional investors anticipate a year of dramatic change in 2017: A global wave of populism is upending conventional thinking about politics and economics. Central bank policies, which have driven investment performance for nearly a decade, are beginning to diverge. The U.S. Federal Reserve is likely to raise rates, while other central banks are challenged to scale their asset purchase programs.
Market volatility is the likely outcome as political, economic and monetary forces converge, according to the 500 decision makers included in our 2016 Global Survey of Institutional Investors.* Recognizing the role geopolitical events could play in the year ahead, we split our pool of respondents to reach 340 respondents prior to the U.S. presidential election and 160 after. In many cases, the results have had a significant effect on their outlook.
Active management and alternatives key to investment strategy
In anticipation of higher volatility and greater dispersion,1 institutional investors have strong investment opinions. Decision makers say they will apply a one-two punch to portfolio construction by implementing actively managed strategies in pursuit of returns and alternative investments2 in search of diversification.3
Looking ahead to the new year, institutions have clear preferences for both active management and alternatives:
- Almost three-quarters of institutional investors say the current market environment is more favorable to active management.
- Investment plans call for increased allocations to alternatives with decreased exposures to fixed-income.
Posing pointed questions to institutions about their opinions on risk, predictions on asset allocation, and views on market performance, our survey finds that institutions are ready to hit the reset button in order to address a more volatile market and uncertain landscape globally.
Economics and politics add up to volatility
After seven years marked by only sporadic bouts of volatility, economic and geopolitical forces are converging to make volatility the top risk concern for institutions in 2017.
On the economic front, central bank monetary policies have kept volatility artificially low for close to a decade, but it is now poised for a change, at least in the U.S., as the Federal Reserve looks to increase interest rates. Simply put: Volatility may actually be the byproduct of the market perception that central banks are no longer delivering the so-called Yellen/Bernanke “put option” on assets, in which accommodative monetary policy has resulted in the perception of downside protection for risk assets.
On the geopolitical side, the Brexit, a Trump presidency, and Italy’s no vote on constitutional reforms are emblematic of the forces of change that could contribute to heightened volatility. But these events do not mark the end of geopolitical volatility; they are more likely just the start. Still to come are elections in France, Germany, and the Netherlands, where populist sentiments are running high, and the outcomes of political upheaval in South Korea and Brazil, as well as Britain’s plan for invoking Article 50; all add to uncertainty across the globe. While they see volatility as their top risk concern, institutional decision makers also see it as an opportunity for asset growth. With the likelihood of a policy-driven market shifting to one driven by earnings growth, institutional professionals are once again returning to active management in pursuit of returns.
The shift is reflected in changes to what institutions see as their primary investment objectives for the year. As expected, the number one objective among institutions is achieving the highest risk-adjusted returns, but post-election the number who listed growth of capital as their primary objective increased by 9%, moving from 15% to 24%. At the same time the number citing capital preservation as their primary objective declined from 16% to just 8%.
A market for active management
Higher volatility is likely to lead to greater dispersion within equity markets, and institutions believe the tide is turning in favor of active management. Looking back at past performance, half say passive investments distort relative stock prices and risk-return tradeoffs. Almost three-quarters also say current market conditions are more favorable to active management. More than eight in ten institutions choose active management over passive for generating alpha, and three-quarters say they are willing to pay a higher fee for potential outperformance. Of course, all investing, whether actively or passively managed, is subject to risk, including risk of loss.
Long-term views on passive beginning to change
Over the longer term, institutions project they will be less reliant on passive investments than they previously believed.
Current portfolio projections show passive allocations have decreased by 3.3% in the past year. Institutions anticipate adding just 1% to current passive allocations over the next three years, a figure that’s considerably less than the 7% they projected for the same time frame in 2015. This underscores the need to evaluate passive investments on both their merits and their limitations.
Institutions say they implement passive investments for two clear reasons: to manage fees and to avoid closet indexers among active managers. While both issues are important considerations, closet indexers have become a pervasive problem. Managers who charge an active fee for an investment strategy that mimics their benchmark challenge institutions’ ability to maximize returns. Even though they say they are willing to pay a higher fee for potential outperformance, the institutional motto for 2017 is likely to be “get what you pay for.”
A word of caution for individual investors
While institutional investors have specific objectives for passive investments, they see potential problems for individual investors who have come to rely heavily on indexing.
- 75% say individuals are unaware of the risks of indexing.
- 75% say individuals have a false sense of security about indexing.
In essence, it’s important to avoid transferring greater benefits from the index feature of market exposure at a lower cost. Index funds still leave investors exposed to market risks.
Alternatives for diversification
While they see an opportunity to pursue alpha, or returns above the benchmark, with actively managed strategies, institutions are also taking action to diversify portfolios with increased alternative allocations. Looking at a market that could be marked with a double-hit of increased volatility and rising interest rates (at least in the U.S.), institutions say they will dial back on fixed-income allocations, and two-thirds of institutional investors globally say it is essential to invest in alternatives in order to diversify portfolio risk.4
Increased allocations to alternatives
One reason for the shift in allocations is the current low-yield environment, which ranks as the top risk ma nagement concern for institutions. To better position portfolios, they are looking to increase diversification by implementing a range of strategies. Increasing alternative allocations (50%) is the most frequently cited approach, followed by diversifying by sector and geography (38%) and integrating absolute return strategies (36%).
Three-quarters of institutions believe investors may be taking on too much risk in the pursuit of yield. Based on their own allocation decisions, some may think they are guilty of the same behavior.
Confidence shaken by election surprise
U.S. election results have struck a blow to institutional confidence. Prior to the election, two-thirds of respondents expressed confidence in their organization’s ability to handle the risks associated with investment performance. Among those surveyed after the election, only 53% had confidence in their abilities, a clear sign that the potential for policy changes and