Damon Hambly

Volatility finally roared back to abnormally tame markets, but most institutional investors were already bracing for impact; their efforts to diversify and build durable portfolios should now pay off, according to new survey findings released by Natixis Investment Managers.

78% of institutional investors expected stock market volatility to spike in 2018, and they are making opportunistic allocations to active management and alternative investments in order to meet average long-term return assumptions of 7.2% this year.

Natixis’ Centre for Investor Insight surveyed 500 institutional investors around the world to gain insight about how they are balancing long-term objectives with short-term opportunities and pressures. Seven in 10 investors agreed that the addition of alternatives is important for diversifying portfolio risk. Yet, they see a number of alternative strategies playing distinct roles in their portfolios.

Alternatives to diversify, manage mounting risks, and pursue returns

The survey found that investors continue to turn to alternative investments with 70% of them saying that it is essential to invest in alternatives to diversify portfolio risk and over half (57%) think investing in alternatives is necessary to outperform the broader market.

Damon Hambly, Australian CEO, Natixis Investment Managers, said: “The ‘lower for longer’ environment means we are seeing institutional investors favouring alternative assets as a means of risk mitigation, and accounting for around 20% of the average institutional portfolio. Looking at the Asia Pacific market specifically, institutions were mostly expecting to increase their allocation to all alternatives, with the most popular being private equity, REITs and real estate and infrastructure.”

When asked to match the best alternative strategies with specific portfolio objectives, institutional investors indicated the following:

• Diversification: Institutional investors most commonly cite global macro strategies (47%), commodities (41%) and infrastructure (40%) investments as best for diversification.
• Fixed-income replacement: Top choices for providing a source of stable income as interest rates rise and the 30-year bond bull market ends include infrastructure (55%) and private debt (47%).
• Volatility management: Institutions cite managed futures (46%) and hedged equity (45%) as best suited to manage volatility risk.
• Alpha generation: Traditional markets have generated attractive returns, but institutions see opportunity to outperform. Seven in 10 (72%) cite private equity as their top choice among alternatives for generating alpha. They also see hedged equity (45%) as useful in meeting this objective.
• Inflation hedge: Institutions view commodities (56%) and real estate (46%) as best for inflation hedging strategies.

Damon Hambly, Australian CEO, Natixis Investment Managers said the challenges faced by local institutional investors were consistent with their global peers.

“The return of market volatility is a timely reminder for institutional investors of the need for a consistent approach to portfolio diversification. As allocations decline for the third consecutive year, investors are questioning the benefits of passive strategies, with nearly 60% saying passive investing artificially suppresses volatility and distorts relative stock prices, 57% fearing it creates risk/return trade-offs, and 63% believing it increases systemic risks (63%). As a result, investors are increasingly turning to active managers and alternatives for the tools and flexibility to diversify their portfolios and mitigate risk,” said Mr Hambly.

And while alternative investments can present a range of portfolio risks, 74% say the potential returns of illiquid investments are worth the risk. That said, two-thirds report that solvency and liquidity requirements has created a strong bias for shorter time horizons and highly liquid assets, and hidden risks lurking with the dynamic macroeconomic and regulatory market makes it even more challenging for institutions to balance short-term opportunities and long-term objectives.

Active allocations continue to rise

Over three quarters (76%) of institutional investors say the current market environment is likely to be favourable to active management in 2018. In 2015, the survey found that institutions expected that 43% of total assets would be invested in passive strategies by 2018, but in reality the figure has been far lower, at 32% by 2017, with institutional investors projecting just a 1% increase in the next three years. More than half (57%) of those surveyed also said they expect active to outperform passive over the long term, despite three quarters (76%) saying alpha is becoming harder to obtain as markets become more efficient.

Nine in 10 institutional investors say minimizing management fees is one of the strongest drivers for passive investment strategies, but three quarters (75%) said they were willing to pay higher fees for potential outperformance.

The survey also highlighted a preference for active strategies in order to gain exposure to non-correlated asset classes, with three quarters (75%) citing it as one of the foremost reasons for a preference for active over passive instruments. Similarly, three quarters (75%) prefer active over passive to access emerging market opportunities, while 69% favour active strategies for providing risk-adjusted returns and more than seven in 10 (73%) for providing downside protection.

Damon Hambly commented, “The ‘active versus passive’ debate doesn’t look set to disappear, as institutions have signalled a gradual shift towards active strategies. The traditional arguments about the cost-saving potential of passive products are being challenged. For example, many institutions already see the long-term value of active management, and the access it brings to a broader range of asset classes.”

New attitudes toward ESG investing

Institutional investors have also signalled a more active approach to managing environmental, social and governance (ESG) issues, with three in five (60%) now integrating ESG investing into their approach.

The number of institutions that see alpha to be found in ESG now outweighs the number focused chiefly on risk mitigation, and their convictions about the efficacy of this approach are strong with the vast majority saying that incorporating ESG into investment strategy will become a standard practice within the next five years.

• 59% say there is alpha to be found in ESG investing
• 56% believe ESG investing mitigates risks (e.g. loss of assets due to law suits, social discord or environmental harm)
• 61% agree incorporating ESG into investment strategy will become a standard practice within the next five years

Whereas a year ago, the top reason institutional investors were integrating ESG was because of their firm’s mandate or investment policy, almost half (47%) say the incorporation of ESG is now driven by the need to align investment strategies with organizational values, while two fifths (41%) say the primary driver has been the need to minimize headline risk, a 21% increase on 2016.

“Attitudes towards ESG investing are changing dramatically, with the vast majority of institutions now saying that ESG leads to alpha generation and will become standard practice in less than 5 years,” said Dave Goodsell, Executive Director of Natixis’ Center for Investor Insight. “Institutional investors have witnessed the impact of environmental, social and governance events at numerous companies in recent years and watched as stock values declined right along with corporate reputations.”

Lower rates mean higher liabilities

One of the long-term challenges cited by institutional investors is longevity, with 85% of insurance companies, 78% of corporate pension plans and 76% of public pension plans all challenged to meet their longevity risk.

Institutional investors have had to perform a balancing act over the past 10 years, navigating low interest rates, while facing rising liabilities and an increasingly regulated environment. While in the short term the majority feel equipped to meet their return expectations, there is an acute awareness that finding returns over the long term will be challenging. In light of this, institutions have adopted a long term investment approach, with few making radical defensive moves today.

“Low rates may have helped to boost returns by increasing the value of bond assets held in institutional portfolios, but – at the same time – the low-rate environment has increased the present value of liabilities, exacerbating the pressure to effectively manage liabilities. The prospect of rising interest rates presents a bright spot for a number of institutions, as it would decrease the present value of their liabilities. This is one of the reasons why institutions cite managing duration as their top strategy for navigating a rising rate environment^[1]”, said Damon Hambly.

However, liability management strategies are not a straightforward solution for institutions. Seven out of ten (70%) said they are incorporating liability management into their portfolio strategy and yet three in five still think organizations will fail to meet their long term liabilities despite adopting LDI techniques. Despite the rising popularity of strategies such as cashflow-driven investing, six in ten (60%) say there is a lack of innovation within LDI solutions, while almost two thirds (63%) say decision makers are placing greater importance on achieving short-term performance results, over meeting long-term liability matching objectives.

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