Today Natixis Global Asset Management (AUM $887 Billion) released the findings of its annual global survey of 500 institutional investors, including public and corporate pensions, insurance funds, foundations, endowments and sovereign wealth funds. Collectively, they oversee $15.5 trillion in assets.
2016 Hedge Fund Letters
According to the survey, market volatility is the biggest risk to managers’ investment performance this year, but avoiding risk is not an option, given their mandates. Instead institutions are embracing risk in pursuit of better returns and much needed yield. Key strategies include growing use of private investments, illiquid assets and increased exposure to alternatives in the year ahead. For example:
- 56% say their organizations are embracing illiquid assets more than they were three years ago
- 55% believe private equity provides better diversification than traditional asset classes
- 73% say private debt provides higher risk adjusted returns than traditional fixed income vehicles
- 34% report that they are planning to increase allocations to real assets, including real estate, infrastructure and aircraft financing, this year
- 77% say alternatives have a role in liability-driven investing
The results also reveal:
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- Growth in outsourced management: More diversified portfolios are driving an uptick for specialist capabilities
- Potential changes in return assumptions: 50% say their organization is expecting to decrease return assumptions in the next 12 months
- Few relying on traditional strategies: Reliance on risk budgeting, diversification across sectors and increasing use of alternative investments seen as most effective in managing portfolio risk
Double down – Faced with increased volatility, institutions embrace the risk
Following a year of political volatility that brought Brexit, a Trump presidency, the resignation of the Italian Prime Minster Renzi and the impeachment of both Brazil’s Dilma Rousseff and Korea’s Park Geun-hye, institutional investors see geopolitical upheaval continuing through 2017 and they are betting it will lead to increased market volatility across the globe.
Beyond politics, institutional investors are feeling the added pressure that a decade of accommodative monetary policy places on their ability to manage long-term liabilities. An anticipated policy shift in the U.S. may help to moderate yield concerns in the long run, but it could double the short-term challenge by putting downward pressure on the value of current bond holdings.
Faced with greater volatility and continued rate pressures, the 500 decision makers included in this, our fifth annual Global Survey of Institutional Investors, appear to be doubling down on their bets by increasing allocations to equities, private equities, and other high-risk assets seeking to generate returns. Institutional investors will have their hands full balancing three critical objectives:
- Managing risk – Navigating higher volatility and low yields is a risk management challenge which is compounded by more stringent solvency requirements, which 71% of respondents say creates too much bias for shorter time horizons and more liquid assets.
- Generating returns – Institutions are not shying from volatility and will look to active management to help capitalize on opportunity. Nearly three-quarters (73%) say today’s market favors active managers and 86% say it’s the better choice for generating alpha. Alternative investments and private assets also feature prominently in institutional return plans.
- Managing the portfolio – A large number of respondents see the need for outside help in managing more complex portfolio strategies. Four in ten (41%) report turning to outsourced CIOs or fiduciary managers; most frequently they are looking to outside managers for specialized capabilities.
Volatility and uncertainty may be the cards institutions are dealt in 2017, but they are willing to bet on positive investment outcomes. They are coming to the table with a strategy for managing the risks and have clear asset preferences. How well they play their hand will determine their success in meeting their number one goal: delivering higher risk-adjusted returns.
Introduction – Double Down
Faced with increased volatility, institutions embrace the risk
On January 26, 2016, with the Dow Jones in the throes of the worst New Year’s slump in history, if you had been given one-million-to-one odds that, one year later, the Dow would be at 20,000, the U.K. would be navigating its exit from the European Union, and a former reality television personality would be the president of the United States, would you have taken the bet?
These are the table stakes with which institutional investors, often considered the “smart money,” are playing as they look to manage assets earmarked for pension payouts, insurance settlements, and funding for endowments over the next 40 years. Faced with prospects for increased market volatility and rising interest rates (at least in the U.S.), institutions are doubling down on risk in pursuit of better returns and much-needed yield.
Our 2016 Global Survey of Institutional Investors provides a view into the reality of those responsible for managing assets on behalf of public and private pensions, foundations and endowments, insurance companies and sovereign wealth funds, and finds the smart money anticipating increased volatility as a by-product of a world in tumultuous change. Faced with greater risk, institutional decision makers say they will increase allocations to equities, private equities and other higher risk assets in the year ahead – seeking to better position themselves to meet their three most important objectives: delivering the highest risk-adjusted returns (28%), growing capital (18%) and effectively managing return volatility (17%).
The tables have turned, maybe
While nearly a decade of accommodative monetary policies has helped to buoy market returns for institutional investors, it has also stymied their need to address long-term liabilities. Policies implemented nine years ago to stave off a global credit crisis have kept interest rates artificially low, making it increasingly difficult to find yield. Rates have also had an equalizing effect on equity markets, keeping dispersion1 low and equally rewarding the companies with middling results alongside the companies that could demonstrate meaningful earnings growth. Topping off the challenge are regulatory and liquidity requirements that have limited the choices for professional investors as they look to make up the difference.
Now, the effects of historic global geopolitical change may be amplified by divergent global monetary policy, and institutions anticipate the likely outcome will be increased market volatility. Facing this new gambit, institutional decision makers must manage three critical factors that could determine their long-term success:
- Assessing and managing risk: Volatility may be the biggest risk concern for institutions in the year ahead, and from the aftermath of the U.S. election to a hard Brexit, a softening market in China, and interest rates, they see many potential sources. While they believe it’s within their abilities to handle the risk, many may be second-guessing the strategies they’ll deploy to manage it.
- Generating returns: Global populism has not only upset political convention, it’s also sparked volatility in markets around the globe. Reignited market performance in the U.S., coupled with interest rate concerns globally, has institutions returning to active management and delving into private markets for return potential, while upping alternative investment 2 allocations for diversification.
- Portfolio management: Given the challenges of today’s market, the mechanics of managing institutional portfolios goes well beyond traditional asset allocation considerations. In-house investment capabilities may not be enough as institutions report an uptick in outsourced management for at least a portion of assets. Adding to the challenge is the need to manage long-term liabilities and sustainability mandates alongside market risk.
Increased risk and volatility are the cards institutional investors have been dealt as they look to generate returns in a low-yield world. Seeking to beat the odds, many are reassessing risk parameters, resetting investment priorities and revisiting strategy. In the end, the risk factors may change, but the goal for institutional investors remains the same: deliver long-term results while navigating short-term market pressures.
Section One – Volatility On A Hot Streak
From the surprise results of Brexit and Trump, to the rejection of constitutional reform in Italy, to rising populism in the Netherlands, France and Germany, volatility continues to be a dominant theme in world politics. Many institutions believe that political volatility has the potential to jump to investment markets in the next 12 months.
Faced with prospects of increased volatility, six in ten institutional decision makers believe they are prepared to handle the risks in 2017, but given the economic complexities, coupled with ongoing political upheaval, only 2% offer up strong convictions in their ability to succeed in this critical endeavor.
If they have any reservations about their ability to navigate markets, it may come from the change, uncertainty and potential instability looming over the investment landscape. On one hand, new political leadership could result in decreased regulation, which could spur business growth. On the other, it could dramatically alter the trade and security alliances that have been the backbone of global market expansion. Divergent monetary policy may reset interest rate expectations in some regions, but could hamper currency valuations in others. Low yields, which rank as the top organizational concerns among our survey base, are likely to persist even as interest rates, whether stagnant or rising, will continue challenging institutions to fulfill their long-term liabilities.
Buckle up for a bumpy ride
The effects are uncertain and, as a result, market volatility (50%) ranks as the biggest threat to investment performance for institutional investors. Not far behind in their risk concerns are geopolitical events (43%), followed by interest rates (38%). Risk and volatility are inextricably linked in the institutional mindset, and politics dominates their views on which forces will most influence market turbulence.
While 65% cite geopolitical events as the driver of greater volatility, it’s notable that fallout from the U.S. election (38%) still weighs as heavily on their minds as interest rates (37%) and even more than the potential impact of a market downturn in China (29%) and issues in the European market (23%). Given the need to generate returns, avoiding risk is not an option for institutional investors. But a majority of respondents (75%) wonder if investors are taking on too much risk in pursuit of yield.
The unintended consequences of reform
Some risks are out in the open; others may lurk in the shadows. One of the stealthier risks institutions must manage is the unintended consequences of regulation and reform. Many institutional decision makers (71%) believe more stringent solvency and liquidity requirements established by regulators around the world have resulted in a greater bias for shorter time horizons and more liquid assets. This can be a significant challenge for investment teams that must prioritize meeting liabilities that stretch out over multiple decades. In the aftermath of a collapse in oil prices, the pressure appears to be greater for sovereign wealth fund managers, eight in ten of whom identify the bias, an increase of 9% over 2015.3
Given the prospects for greater volatility and the persistence of low interest rates, regulatory pressures have the potential to result in sub-optimal decisions, as they limit the ability of money managers to access alternative investments and private markets in pursuit of their investment objectives. Circumstances may call for investments with longer time horizons and lower levels of liquidity to shore up an income stream needed to meet long-term liabilities that is not readily available within traditional markets.
Growth, liquidity and risk in the balance
This same challenge is evident in what respondents cite as their top risk management concern: balancing long-term growth objectives with long-term liquidity needs. The risks are many and managing exposures is complicated. Forty-six percent report that one of their biggest challenges is simply getting a consolidated view of risk across the portfolio.
In their efforts to manage risks, institutions have a number of strategies at their disposal. But where yields remain low, few say they will rely on the traditional risk management strategy of increasing fixed-income allocations. Instead, they believe the more effective techniques include risk budgeting (87%), diversifying holdings across sectors (86%), currency hedging (75%), and increasing their use of alternative investments (76%). It is interesting to note that sentiment for alternatives has grown significantly from a lukewarm 53% in 2015.3 This may be partly the result of frustration with the limitations of traditional assets and partly the result of greater dispersion of returns brought on by more volatile markets.
The pressure to manage risk cannot be underestimated, and institutional managers are hedging their bets. Nearly seven in ten report they are willing to underperform their peers to ensure downside protection. As they consider their options, institutions may be second-guessing the efficacy of long-standing portfolio strategies. Just 54% of those surveyed believe that diversifying across traditional asset classes can provide adequate downside protection. Just 3% say they strongly believe that strategy will be enough to protect portfolios in the coming year.
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