Professional fund buyers seek alpha, diversification — and defense
by Dave Goodsell
While nobody could have predicted the historic levels of volatility experienced in markets across the globe since February, more than half (54%) of professional fund buyers surveyed around the world in Q4 2019 believed we would see a market crisis within one to three years and had already been preparing for a shift in market fortunes as they began 2020.
Whether it was concern about stratospheric stock valuations, questions about the viability of a sustained low interest rate environment, or the lingering effects of geopolitical uncertainty, professional buyers were worried that 2019’s 25% for the MSCI World Index1 market runup could not continue into the new year. One quarter into the year concerns about 2020 proved to be well founded.
Results from Natixis Professional Fund Buyers 2020 Outlook show that these professionals, who choose investments for financial institutions’ recommended lists, discretionary portfolios, multi-manager funds and the like, knew they were facing a difficult position, worried that the market environment was largely the product of previously unprecedented central bank policies and exploding equity valuations and were worried about what would come next – even if they didn’t know what would trigger a downfall or when it would happen.
When surveyed, eight in ten (79%) expected greater equity volatility, but it wasn’t the only risk on their minds. Pro buyers also worried about how individual investors would respond if and when risk reared its head. More than eight in ten (82%) said individual investors don’t understand their own risk tolerance.
Facing this environment, professional fund buyers were already looking to diversify and build downside protection into portfolios – even as they were seeking sources of growth and yield. To those ends, results show they were upping allocations to alternatives and favoring the active managers they think can truly add alpha.2
Historically, buyers’ long-term return assumptions tend to be fairly stable and built to account for the ebbs and flows of market cycles. This year had been no exception, and the vast majority of buyers (85%) thought their organization's current return assumptions were realistically achievable.
That said, many buyers had anticipated some reversion to the mean after a strong 2019, with 38% more respondents expecting to lower return assumptions than to raise them. Anxiety about an uncertain future may have colored these responses, as buyers also foresaw the potential for market troubles that would call for downgraded return expectations.
Equities: Repositioning already under way Fund buyers’ allocation plans reveal that they had expected equity-market leadership to shift from the US to emerging markets and Europe. More than one-third of buyers anticipated upping allocations to emerging market equities (38%) in order to capitalize on relatively appealing valuations. The same held true for one-third (34%) of professional buyers who planned increased allocations to European equities. Given the severity of the global downturn this clearly isn’t unfolding now, but it’s likely buyers will return to strategy at some point in the future and may find even more attractive valuations than they had anticipated in 2019.
Buyers had intended to fund these shifts by trimming US stock positions. More than four in ten (44%) planned to decrease their allocations to US equities, which already looked overvalued following a decade-long bull market driven by low interest rates, a 29% 2019 return in the S&P 500,3 and corporate debt levels near all-time peaks.
Fixed income: A dearth of yield leads buyers to EM debt Similar trends had informed plans for the fixed income side of the portfolio. With developed market sovereign bonds paying low to negative yields and credit spreads compressed, the yields on EM debt likely looked attractive by comparison. This is especially true now, given that central bankers are making rate cuts a critical first line of defense in shoring up markets – as the US Federal Reserve has done twice since the start of March. This at a time when half of buyers (49%) already said the low yield environment would have a negative impact on investment performance.
Those dynamics help explain why 28% of buyers planned to increase allocations to emerging market debt, 37% anticipated reduced allocations to government-related securities, and 34% anticipated reduced allocations to high yield corporate debt. Given the severity of the crisis it’s likely these shifts has been put on hold for the time being rather than abandoned altogether.
Interest in alternatives grows Alternatives are expected to make up 15.2% of buyers’ portfolios in 2020, an increase of about one percentage point from 2019. Sentiment was consistent across all geographic regions, as buyers look for sources of return and yield with the potential to improve their portfolios’ diversification. (See “Alternatives: Seeking a more efficient frontier,” below.)
Discover fund buyers' moves for 2020
Sector outlook Buyers’ sector preferences already reflected expectations for weak economic growth. Few saw the pro-cyclical materials and industrials sectors outperforming. Buyers were most sanguine about sectors with strong secular growth drivers: information technology, in which cloud computing, artificial intelligence, the internet of things, big data, 5G and other breakthroughs can create fast-growing new markets; and healthcare, which stands to benefit by applying advances in biotechnology and other new treatments across an aging global population.
Sector preferences reveal muted outlook
Outperform the market
Underperform the market
Buyers’ market outlook: More nervous than hopeful In the absence of strong economic growth, what did buyers think will drive market performance? Their answers showed greater concern for negative factors than optimism about positive drivers (below).
Buyers are more concerned about negative factors
Top 5 Negative
Top 5 Positive
Interest rate movements
US presidential election
Slow economic growth
Low yield environment
High correlation between asset classes
Considering the prominence of trade disputes and forecasts for slow economic growth, high levels of concern are to be expected, but few could have expected the unlikely impact of a public health crisis first China’s manufacturing engine and then the global economy as countries implemented measures to inhibit the continued spread of the virus.
Interest rates had already topped buyers’ list of positive factors after policymakers around the world trumpeted their intention to support economic growth and implemented early in the throes of the corona selloff. Surprisingly, US markets responded to an initial 50 basis point Fed rate cut with a swift steep decline. Two weeks later, an additional 100 basis cut yielded similar results.
When asked about drivers for emerging markets, buyers’ top answers reflected concerns about the non-fundamental factors that have dominated performance in recent years: trade policy (71%), political stability (66%) and monetary policy (54%). Only 35% expected domestic economy performance to be an important driver of emerging market returns, suggesting that rather than being the best opportunity, EM looked like the least-worst scenario.
Taken together, professional fund buyers’ anxiety over potential negative market developments, middling economic growth, and unappealing yield, implied higher levels of anxiety about the year ahead and beyond. Heeding these anxieties has proved to be a good strategy for the realities of 2020.
While many buyers expected increased market risks including higher equity volatility (79%), bond volatility (72%) and currency volatility (59%) few could have foreseen a crisis in this order of magnitude.
Why the worry on risk? Many point to interest rates. With appearing to have nowhere to go but up, at the time, buyers may have worried about a replay of the December 2018 freefall, which was triggered by fears about central bank tightening. The more pessimistic professionals may have also worried that central banks had few tools left to address a crisis or economic downturn. As it turns out Central bankers have been more resourceful than originally give credit for. Whether these moves do any good remains to be seen.
The large majority (80%) of buyers believe the long period of low interest rates has created asset bubbles. They may be referring to credit, where spreads are low despite high debt levels and an uncertain economic outlook; to the trillions of dollars in sovereign bonds that pay negative yields; to inflated pockets of the private debt markets; and/or to large US tech stocks, which now have market weightings reminiscent of 1999.
More prescient buyers also cited liquidity issues as a reason for higher volatility and this has played out in spades. Post-crisis regulations have restricted liquidity in the bond and cash markets, highlighted by the spike in the rates on US repurchase agreements last fall. The rise of passive investment strategies has created a mismatch between the liquidity of the vehicles and their underlying securities; and changes to the global financial system, such as Brexit, threaten to hinder capital flows.
Looking out to the future, 54% saw a global financial crisis looming within one to three years. To most, a market crisis wasn’t a question of if but when, as three-quarters (73%) forecasted a crisis within five years. This may be an outgrowth of the central bank-driven market environment: In essence, buyers figured that yesterday’s policies would keep working until they didn’t.
When do buyers foresee the next market crisis?
Questions about interest rates revealed a similar dynamic. Buyers named interest rates both a top risk factor and the number-one positive driver of returns. They may be concerned about the bubbles inflated by low interest rates – but may figure those bubbles may keep inflating if rates stay low.
Politics and risk Buyers’ responses suggested they were already trying to anticipate and prepare for events that could disrupt markets. At the time, geopolitical crises continued to be the prime candidate. Almost all buyers (95%) say their firms take steps to counter geopolitical risks, with the top tactics being scenario analysis (51%), capital buffers (45%) and increased agility (37%).
Meanwhile, they are sizing up how the US presidential election and two-thirds (66%) of professional fund buyers saw the election as a potential a major source of volatility; however, one-third (33%) believe it could have a positive impact.
Buyers around the world are less unified when asked if markets would react unfavorably if Democrats took control of both houses of the US Congress: The percentage of respondents agreeing with that statement ranged from 70% in North America to 36% in Latin America.
Two-thirds of professional fund buyers globally believe that the US presidential race will result in market turbulence.
Buyers: We’re ready for risk — are you? Fund buyers are confident their own organizations are prepared to meet their return assumptions, but they’re less sure about their peers. Only about half (52%) say fund buyers on the whole are prepared to handle risks related to investment performance.
Meanwhile, buyers overwhelmingly express concern that individual investors are underprepared for risk.
Investors may not be prepared for risk
When investors don’t understand and prepare for risk, they can panic when markets get volatile. This can lead to emotional decisions that damage the progress they’ve made against their long-term financial goals.
They’re not wrong. Our survey of individual investors4 around the world found that they expected returns of 10.7% above inflation, on average — but more than three-quarters (77%) said they preferred safety over investment performance.
Buyers’ concern: To quote our Individual Investors Survey report,5 “Overly optimistic expectations and extreme caution on risk is a combination that can lead to bad decisions.” Investors’ failure to understand, appreciate and prepare for risk could lead them to panic when the markets hit a rough patch. Six in ten buyers (60%) say recession worries will lead individual investors to liquidate their investments prematurely.
Fund buyers’ conundrum: How can they guard investors from downturns and their individual reactions, while satisfying investors’ inflated return expectations? They are starting with defense. Nearly three-quarters of buyers (73%) are willing to underperform their peers in exchange for greater downside protection.
Meanwhile, they’re looking to wring growth and yield out of their portfolios in ways that are consistent with a greater emphasis on protection. One solution they see is alternatives, which have the potential to deliver investment returns and income with low correlations to traditional assets. Six in ten buyers (61%) say an allocation to alternatives is a must in the current market environment. Clearly, after current losses, buyers will have a new found appreciation for strategies that will help produce un-correlated returns and offer greater potential for risk management.
Eight in ten buyers (82%) say low yields from bonds will trigger a shift toward alternatives. That hunt for yield likely explains the interest in income-related alternative assets such as infrastructure, real estate and private debt.
Fund buyers who will maintain or increase allocations to alternatives
Buyers express some concerns about alternative investments, including liquidity issues (66%), high fees (65%), transparency and diligence challenges (62%) and complexity (52%). Yet buyers generally think the benefits are worth the tradeoffs, particularly in the case of private investments. Half (49%) say private assets will play a more prominent role in their portfolio strategy going forward. The growing popularity can present a challenge in and of itself, as nine in ten buyers (89%) worry that too much money is chasing too few private equity deals.
Buyers think the climate they projected for will favor active management, likely because they think greater dispersion and volatility will give active managers opportunities to find value. They also identify the popularity of passive investments as a potential source of systemic risk and volatility, which may exacerbate the effects of the current downturn just as it may have amplified the previous run-up.
Buyers’ survey responses show that they don’t think just any manager will be able to capitalize on the coming environment. More than three-quarters (77%) of respondents say alpha has become harder to obtain, so 75% are willing to pay higher fees for potential outperformance.
Professional fund buyers see a market primed for active management
agree that the market is favorable for active management
* Spread between security prices.
Percent of fund buyers expecting increases in:
When asked about their firms’ take on environmental, social and governance-related investing, buyers’ responses suggest they increasingly see the investment case for ESG.
The investment case for ESG is clearer to more buyers
There is alpha to be found in ESG investing
Incorporating ESG will be standard practice for all managers in five years
ESG investing mitigates risk
*Natixis Investment Managers, Global Survey of Professional Fund Buyers conducted by CoreDataResearch in September and October 2017. Survey included 200 respondents in 23 countries.
In addition, one in five say ESG can help minimize headline risk (22%), generate high risk-adjusted returns over the long term (21%) and benefit from new sources of diversification (19%). And buyers are feeling demand from clients and want to align their investment strategies with investor values (62%).
Europe has pioneered the implementation of ESG and continues to take the lead, with higher rates of implementation and active ownership, in which investment firms enter into a dialogue with companies around ESG issues, exercising both ownership rights and voice to effect change.
The age of anxiety seems to have had professional fund buyers prepared for market disruptions. Those surveyed wonder how long market gains driven by central bank policies could last, expected increasing risk, and saw few appealing sources of yield or return.
Their responses to our survey suggest that buyers are trying to protect clients – both from market losses and from individuals’ reactions to them – by emphasizing defense. At the same time, they plan to seek alpha, yield and diversification through the use of high-quality, opportunistic active managers and a shift toward alternative investments. And they’ll be watching conditions vigilantly, looking for clarity on the direction of the global economy and markets as they try to navigate this unprecedented era of financial history. And this looks to be a solid strategy for where markets are in early 2020.
1 MSCI World Index (Net) is an unmanaged index that is designed to measure the equity market performance of developed markets. It is composed of common stocks of companies representative of the market structure of developed market countries in North America, Europe, and the Asia/Pacific Region. The index is calculated without dividends, with net or with gross dividends reinvested, in both US dollars and local currencies.
2 Alpha is a measure of the difference between a portfolio's actual returns and its expected performance, given its level of systematic market risk. A positive alpha indicates outperformance and negative alpha indicates underperformance relative to the portfolio's level of systematic risk.
3 S&P 500® Index is a widely recognized measure of US stock market performance. It is an unmanaged index of 500 common stocks chosen for market size, liquidity, and industry group representation, among other factors. It also measures the performance of the large-cap segment of the US equities market.
4 Natixis Investment Managers Global Survey of Individual Investors, conducted by CoreData Research in February and March 2019. Survey included 9,100 investors in 25 countries.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of January 20, 2020 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
All investing involves risk, including the risk of loss. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.
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