A year ago, research showed fund investors expected returns of 8%. Fiona Rintoul asks if this is possible in light of projections for a bear market.
What do fund buyers want? Surprise, surprise: they want attractive returns. To be precise, faced with a market that is metamorphosing due to the end of quantitative easing, they report an average return target of 8.4%. This is one of the key findings of a recent Natixis Investment Managers’ Global Survey of Professional Fund Buyers.
The survey was conducted by CoreData Research in September and October 2017 and covered 200 respondents in 23 countries, including private banks, funds of funds, wealth managers and defined contribution investment platform providers.
The headline result begs the questions: are these returns achievable – and if so, how?
Well, things have moved on since autumn 2017. Anticipated volatility arrived at the beginning of 2018. But professional fund buyers were expecting that. In the Natixis IM survey, they ranked rising interest rates, volatility spikes and liquidity concerns as their top three risks. Possibly excepting liquidity, these ‘risks’ are double-edged, with 30% of fund buyers viewing rising rates as a potential boost to performance and fund buyers split down the middle on whether volatility is a plus or minus for performance.
This ambivalence may help to explain the surveyed fund buyers’ optimistic return target. It’s notable that 76% of fund buyers said they found it difficult to generate alpha as markets became more efficient. They may look forward to higher return dispersions, hoping for better opportunities to generate alpha. But alpha-generation opportunities and alpha generation are two separate things, and some cast a sceptical eye on the 8% figure in the Natixis IM report. “To get an 8% return, you need to take substantial risk,” says Christian Pellis, global head of distribution at Amundi. “We question the risk/return balance in today’s market to get 8%. I’m not sure whether the client investing in the portfolio will be prepared to take those risks.”
Andrew Beer, founder of Dynamic Beta, a liquid alternatives boutique firm, is also chary of the 8% figure. “The only way to get 8% is if you gear the portfolio towards strategies that have limited equity market risk and then leverage it,” he says.
“That means taking a lot more volatility than most allocators are willing to bear.”
Matt Shafer, global head of wholesale at Natixis IM, agrees that “return expectations always depend on the level of risk that you are willing to withstand in all avenues of the market”. However, he argues that fund buyers who target 8%-plus returns are not ratcheting up the risk in their portfolios. “Some clients are making a liquidity call by going into more private market investing, but they’re not necessarily adding significantly more risk to their portfolio because in a lot of cases, they are barbelling out that risk with some lower-volatility strategies and lower standard deviation fixed income.”
For Beer, however, a more realistic target for a diversified portfolio would be cash plus 4%-5% with controlled volatility. This takes account of the long-term capital markets assumptions of investment banks. Most of their portfolios expect long-term (ten years) cash yields to be around 2%, he says, and many have sovereign debt and even high-yield corporate debt returning zero or close to zero over the next five to ten years. More conservative forecasts also expect US equity returns to be quite low “in part because valuations are at the very high end of long-term historical averages”.
Beer adds: “A number of forecasters are increasingly expecting a meaningful bear market in the next 24 months. Bear markets historically have gone down, not the 20% that people focus on, but 30%-40%. Given that most investors have most of their risk in equities, if there is a bear market in the next 24 months it will be extremely difficult to achieve those long-term returns.”
Certainly, everyone is expecting more volatility. But for Shafer, while that may mean taking a more active view of risk, it doesn’t and shouldn’t mean dramatically altering long-term return expectations – with ‘long-term’ meaning at least five years and more likely ten years or more.
“It’s a difficult recipe to cook up, but everyone is looking very intently at the volatility of their portfolios,” he says. “The view at the professional fund-buyer and CIO level is for more volatility, but that that doesn’t change the approach to long-term investing.”
The figure of 4%-6% strikes more of a chord with Pellis, who says that even in Asia today, private clients no longer expect bigger returns as they have understood how complicated they are to achieve. The 4%-6% figure applies to income-related products and “needs to be taken out of the capital”, Pellis says.
“In certain markets, that’s not possible due to tax implications and in certain markets, it’s not allowed. In other markets, it is allowed, and then it’s a question of whether the client wants to take that much out of their investment.”
Japan is one example of a market where people are prepared to do that. An ageing population means the imperative for income overrides any concerns about a decrease in capital. After a decade of low interest rates, income is in demand everywhere, and Pellis notes that the situation in Japan, where investors want income to supplement their pension, will soon pertain in Europe too. Just the same, geographic divergence in return expectations is becoming increasingly common, according to Shafer.
“Moreso than in previous years, return expectations depend on where you are in the world,” he says. “In the US and with a lot of our clients that are more geared towards investing in US securities, optimism for achieving high returns – 8% or better – is still there. In Asia, actual return expectations are higher but confidence in achieving double-digit returns is shaken.”
Shake-ups in emerging markets (EM), on the local currency as well as the equity side, have spooked Asian investors. As a result, Shafer sees them looking for new sources of alpha: “There’s been a huge move in Asia towards alternatives, both liquid and illiquid.” On the illiquid side, he observes a flight towards private equity in Asia in particular, as well as increases in investment in private market real estate, private debt and infrastructure. But, while these alternatives may help to boost returns, they aren’t for everyone. They all bring liquidity issues, and mechanisms to circumvent these, such as real estate investment trusts, bring problems too.
“You have to give in on the liquidity side, and then the problem is people don’t want to do that or by regulation you can’t do it,” says Pellis. The best way to circumvent these problems is to slot illiquid asset classes into multi-asset portfolios. For Pellis, this works best at large global asset managers where the client base is widely spread. “The more diversification you have in your client base, the easier it is to do that,” he says. “Not everyone will act at the same time and on the same information.”
This highlights an important point about distribution. Pellis draws a distinction between fund buyers, who include asset managers’ products in a wider solution, and fund sellers who sell asset managers’ products to clients. “With fund buyers, you can put in more difficult, technical products, because they have a better understanding and the end client doesn’t need to understand the product. But there are certain products that are very difficult to sell to the end client directly.”
The other great white hope for alpha generation and superior returns is active management. More volatility creates more opportunities for active managers, or so the argument goes. But here again views are mixed. “I see a big trend towards passive,” says Pellis, who sees demand, inter alia, for asset allocation solutions using underlying exchange-traded funds. “We do the asset allocation for the clients, and they sell that as a mandate to their clients,” he says.
Elusive excess returns
It is a central contention of the Natixis IM report that the new normal looks a lot like the old normal last seen in 2007. This is perhaps nowhere truer than in the active/passive discussion. For Beer, the argument that active managers can push returns to 8% doesn’t hold water: “If a diversified portfolio might be able to generate 4% with limited volatility, then that would require 400 basis points of alpha from active managers, and we simply haven’t seen that active managers have the ability in any asset class to consistently generate that excess return.”
Beer also disputes the notion that greater volatility favours long/short hedge funds or any alternative investments. The exception is managed futures. “If I were building a portfolio to try to protect capital over the next 24 months and potentially to generate longer returns, there is a strong argument to make a much larger allocation to managed futures than most people have today,” he says.
Shafer argues that the financial services industry now has an opportunity to discard “disappointing” active managers who don’t earn their fees. Passive is not a threat to active, he says, “because passive is already part of client portfolios”.
In any case, it is often a different element of investing – also mentioned in the Natixis IM report – that is driving fund buyers’ conversations with asset managers right now: environmental, social and governance (ESG) investing.
“ESG is becoming a theme,” says Pellis. “It’s no longer just institutional investors or high-net-worth individuals who want this. A broader client base is now interested.”
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