Investing February 10, 2017

Institutional Investors Doing Something Different to Get Returns

Real assets are anticipated to be the largest beneficiaries of institutional asset flows in 2017, a BlackRock survey found.
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Large institutional investors are set to put cash to work in 2017, a BlackRock survey found.

One in four (25%) institutions surveyed intend to decrease their cash allocations during the year, twice as many as those who plan to increase their cash holdings (13%). The survey shows a clear trend that this cash will be deployed in 2017, with institutional investors anticipating making significant shifts to less liquid assets. Investors are also looking to allocate to higher yielding areas, and are increasingly considering non-traditional asset classes.

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“The recent equities rally has been more than off-set by years of low rates, and many institutions are still suffering from underfunding.” says Edwin Conway, global head of the Institutional Client Business at BlackRock. “In the past year, investors have been challenged by global equities underperformance and negative fixed income returns. On top of this added pressure to deliver returns, reflation is set to take root this year and could well be the final prompt that institutions have needed to rethink their cash allocations and views on risk. The tide of institutional investor interest in less liquid assets is turning into a wave, with a significant uptick in allocations anticipated as they seek alternative ways to generate returns and income.”

Real assets are anticipated to be the largest beneficiaries of institutional asset flows in 2017, with 61% of those surveyed expecting to increase their allocations here. Only 3% of investors plan to decrease allocations. On a net basis, taking into account increases minus decreases, 58% of institutional investors globally will be increasing allocations to real assets. This compares to 49% (net) who expected to increase their allocations in 2016. More than half of institutional investors in the U.S. and Canada (53% net) expect to increase exposure to real assets.

Real estate is also set to see significant interest, with 47% of investors globally looking to increase allocations to the asset class, and only 9% looking to decrease allocations (38% net). In the U.S. & Canada 29% (net) plan to increase real estate holdings.

The outlook for private equity flows is also looking positive, with almost half of global investors (48%) planning to increase their holdings, and only 13% looking to reduce allocations (35% net). Nearly one-third of investors in the U.S. and Canada will look to increase their private equity holdings (32% net).

Conway adds: “Institutional investors are recognizing that they need to do something different to get the investment outcomes they want. With market volatility and lower returns expected from traditional asset classes for the near future, investors are having to look elsewhere for yield. They are increasingly seeking alternative income, and are embracing less liquid strategies to enhance returns. Many alternative asset classes, such as long lease property, infrastructure and renewables, are able to provide inflation protection, along with secure income streams, to take care of investors’ need for cash flows.”

NEXT: Credit exposure, hedge funds and active and passive equity allocations

Within fixed income, there is a clear global trend showing a move away from core assets and towards strategies with the potential to yield higher returns, according to the survey. Private credit is the clear frontrunner for fixed income, across all regions and investor types, as the area where institutions expect to increase holdings (61%), with only 4% looking to decrease slightly (58% net).

Credit strategies more broadly are set to benefit from a rebalancing of assets away from core and core plus (-10% net). U.S. bank loans are expected to see an increase in allocations from investors (26% net), followed by high yield (23% net), securitized assets (22% net) and emerging market debt (19% net).

Looking at fixed income allocations as a whole, institutional investors in the U.S. and Canada expect their allocations to remain broadly flat.

Globally, corporate pensions are decreasing their allocations to hedge funds (-22% net), especially in the UK and the U.S., and moving towards long duration bonds, likely pointing to de-risking trends. Insurers are also following suit, with a decrease of 12% in allocations to hedge funds globally, and increased favorability towards real assets and real estate.

Globally, one in four investors (28%) intend to increase their allocations to active equities relative to passive equities, with more than half (55%) planning to keep their current mix of active and passive strategies constant. Seventeen percent intend to increase their allocation to passive strategies.

In terms of equity allocations overall, the shifts differ substantially by region and client type. The U.S. and Canada is the only region in which institutional investors overall expect to reduce their equity holdings (-34% net), largely driven by corporate pension plans.

In November and December 2016, BlackRock conducted a global survey of 240 of its largest institutional clients, including public pensions (23%), corporate pensions (33%), official institutions (4%), insurers (25%), investment managers (7%), endowments and foundations (4%), and others (4%). In terms of geographic distribution, 39% of the respondents were located in North America, 38% in Europe, the Middle East and Africa, 13% in Asia-Pacific, and 10% in Latin America.
Investing February 10, 2017

Smart Beta Evolution Targets the DC Space

The potential for enhanced returns with reduced risks and costs would seem appealing to any plan sponsor, but what is really behind the label “smart beta,” and can it work in DC plans? 

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In a world of low yields and heightened volatility, investors are exploring different ways to navigate the market and reduce uncompensated risk; some are turning to “smart beta” strategies with a degree of success, and the corporate defined contribution (DC) space is taking notice.

Generally speaking, smart beta refers to investment strategies that are based on an index but use alternative weighting or other modifications to the index allocations to achieve some end—typically reducing risk or increasing potential returns compared with the original index.

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The broad label includes index-based portfolios reweighted based on factors such as dividends, correlations, volatility, value, etc. And while it sounds a bit like active management, smart beta is theoretically meant to live somewhere in between passive and active strategies. Naturally, the costs of smart beta strategies come down somewhere in between active and passive management, as well, making plan sponsors curious but cautious about smart beta.

Global financial research firm Cerulli Associates puts smart beta fund costs at an average of 25 to 50 basis points, depending on the complexity of the strategy and how it is actually delivered.

Today, investment managers like BlackRock are applying smart beta to target-date funds (TDFs). Last November, the firm rolled out its LifePath Smart Beta series. Like a typical lifecycle fund, its asset allocation focuses on higher returns for a younger investor and de-risking as he nears retirement. The “smart” approach comes with the automated adjustments of the relative exposures to stocks that may be of higher quality or of lower volatility than others in the benchmark index, given an individual investor’s long-term needs.

“For younger investors, we set the exposure based on a basket of factors: momentum, value, size and quality,” explains Nick Nefouse, head of BlackRock’s U.S. and Canada DC investment and product strategy team. “Those are factors we think will help us outperform the cap-weighted index. But by the time you retire, you’ll predominantly be sitting on low volatility factors.”

BlackRock ran a series of analyses comparing the performance of multiple market-cap indexes for a hypothetically constructed working lifetime to that of its smart beta portfolios. These smart beta funds used the same underlying investments but weighted them by factors other than market cap. In all cases, the smart beta portfolios outperformed their traditional indexes, according to BlackRock.

NEXT: Challenges for smart beta portfolios 

Of course, while factor-based investing seeks to outperform a given cap-weighted index, there is no guarantee it will, and any investor moving into smart beta must carefully study the specific products they are presented with.

A report on the concept by Cammack Retirement Group cites the performance of the PowerShares S&P 500 High Beta ETF, which outweighs securities that are supposed to have higher sensitivity to broad changes in the equity market. Thus, they are expected to generate higher-than-average returns in up-markets—but they may very well drive extra loss in negative markets. There is obviously also the risk that a portfolio that focuses too much on a specific factor could suffer accordingly when that factor underperforms or fails to be the most relevant over a given time period. To counter these risks, many investment managers take on a “multi-factor” and “multi-strategy” approach.

“The inherent problem with these products is they tend to provide exposure to one factor at a time,” explains Jay Jacobs, research director at Global X. “Just as we look toward diversifying stocks and stock-specific risk, multi-factor strategies look to diversify factor-specific risk. Over the long run, you can hopefully capture those historical premiums that have been associated with these factors, but at the same time diversify the risk of any one factor underperforming and being a drag on the performance of the strategy.”

Global X applies smart beta to exchange-traded funds (ETF), where much of smart beta is being deployed. However, Jacobs notes that investors’ long time horizons could be a catalyst for smart beta in DC plans. 

“This is a great advantage for factor investing in general,” he says. “Factors can fall in and out of favor. They can be a little volatile among each other. But what we’ve seen over long periods is that they tend to support outperformance. You can ride through some of those factor-specific risks and hopefully reap some of those rewards in the long term.”

NEXT:  Analyzing Smart Beta 

Experts stress that it is important to remember smart beta is a “catch-all” term that each provider will have its own definition for. That’s why it’s extremely important for plan sponsors and advisers to evaluate these products closely. And as noted, smart beta strategies can build around several “factors” that managers believe will support outperformance, and definitions of these factors will also vary among providers.

“It takes a good amount of homework,” explains Jacobs. “You have to dig into the methodology. How are they defining these factors? How are they approaching risk in that portfolio?”

Nefouse agrees that one of the biggest challenges with moving smart beta further into the DC market will be around education, but he believes it could ultimately “deliver an A+ strategy for DC.”

“We think that these strategies can add incremental returns adjusted for risks,” he suggests. “But we have to spend some time educating people. We see this a two-to-three year opportunity, not a 2017 opportunity.”

Nefouse further observes that even the concept of a target-date fund, now so ubiquitous, took years to gain traction. This is likely the path forward for smart beta as well: According to a 2016 survey by Cerulli Associates, asset managers report that only about 11% of smart beta products are available to corporate DC plans.

“More education needs to be promoted to bring investors up to speed with some of these new strategies,” Nefouse concludes. “We think it’s worth it because the returns can be very robust.”

The “Cammack Retirement Investment Research: Is Smart Beta Right for You?” report can be found at www.CammackRetirement.com. More information about Cerulli Associates research be found here. 

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