2018 Outlook: 75% of institutional investors say current environment favors active management

On the other hand, allocations to passive slide for the third year in a row, according to a new study released today by Natixis Investment Managers.

• Allocations to passive strategies decline for third consecutive year; 75% believe the current market environment favors active management
• 72% are surprised volatility has been so low for so long, but geopolitical risks and asset bubbles are institutional investors’ the top concerns
• Alternative assets overshadow bonds as investors shift to Europe & emerging markets; Technology, healthcare, aerospace and financial sectors seen as top outperformers

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.

The survey found 59% believe that volatility has been artificially suppressed by flows into passive investment strategies. More than half (57%) believe the increase in passive investing is distorting relative stock prices and creating systemic market risks (63%), of which 72% believe individual investors aren’t yet aware.

Jean-François Baralon, Head of Distribution for France, French-speaking Switzerland and Monaco at Natixis Investment Managers, comments, “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.”

Navigating active markets

Comparing passive and active approaches directly, a 57% majority say active managers outperform passive in the long run. Three-quarters of institutions (75%) say active managers are better at accessing emerging market opportunities – and a similar proportion (74%) say active managers provide better exposure to non-correlated asset classes.

Jean-François Baralon continues, “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.”

Asset bubbles and equity volatility

An overwhelming three-quarters of institutions (77%) believe a prolonged period of low interest rates has led to the creation of asset bubbles. Moreover, looking ahead, 62% 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 74% following recent events – and asset bubbles rank ahead of interest rate increases (61%) as the factor institutions believe will have the most negative impact on their investment performance in 2018.

Yet renewed volatility (rather than a sustained correction) is set to be the main feature for equities in 2018: an overwhelming 78% of institutions expect an increase in equity volatility next year. Looking back on the absence of volatility this year, a majority of institutional investors (59%) believe this is unsustainable and is in fact a cause for serious concern.

The hunt for diversification

Institutional investors are placing greater faith in both equities and uncorrelated, alternative investments to help them ride out such market challenges. Almost two-thirds (64%) say fixed income is no longer providing its traditional risk management role in portfolios, while 60% of institutions now believe traditional assets in general are too highly correlated to provide distinctive sources of return.

By contrast 78% say increasing the use of alternatives is an effective way to manage risk. Within alternatives, there is also an appetite for illiquidity, as 74% believe potential returns make such investments worth the risk associated with fixed timeframes. Private equity is the most popular example with 39% of institutions increasing their private equity investments – and two-thirds (67%) are satisfied with the performance of private equity investments in their portfolio.

In terms of sector picks: more institutions (45%) expect the technology sector to outperform the market in 2018 above any other sector, followed by healthcare (44%), defense/aerospace (43%) and financials (41%).

In direct competition to fixed income, more than three quarters of institutional investors now say that private debt provides higher risk-adjusted returns than fixed income vehicles – and 36% of institutions are currently increasing their private debt holdings.

A longer-term view on the sustainability of returns is also emerging. Three-in-five (60%) institutions 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; a similar majority (59%) say there is alpha to be found in ESG investing.

Jean-François Baralon concludes, “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.”