Seven in 10 portfolio managers say their firms will reduce return expectations for clients over the next 12 months, according to the latest report from Natixis, with eight in 10 believing they need to replace traditional portfolio diversification and construction techniques in order to achieve results.
The survey, which included 500 institutional decision-makers and 200 wholesale portfolio managers across 31 countries, also found that 65 per cent believe geopolitical risk will be the biggest cause of volatility over the next 12 months.
Amid such challenging market conditions, with the low yield environment and interest rate rises also being cited as causes for concern, six in 10 of those surveyed say they are willing to underperform their peers in order to ensure downside risk protection for their portfolios.
“If wholesale portfolio managers see the potential for increased market volatility, their views on active management provide a strong indication of how they may seek to capitalise on the opportunities volatile times offer,” the report explained.
“To navigate a riskier market, they say they will look to apply a one-two punch of active management and alternative investments.
“Eight in ten wholesale portfolio managers say the current investment environment favours active managers. Three-quarters say it’s essential to invest in alternatives to diversify portfolio risk.”
When it comes to specific views on risk, asset allocation and market performance, the survey results show that wholesale portfolio managers are resetting their risk strategy for the year, with 69 per cent of participants saying traditional assets are too highly-correlated to provide distinct sources of return.
Performance of indices since start of data
Source: FE Analytics
A further 54 per cent say it is “essential” to invest in alternatives if investors want any chance of outperforming the broader market today.
Does these mean investors need to overhaul their portfolios, or is there too much faith being placed in investing in alternative assets?
Martin Bamford, managing director of Informed Choice, says it is natural for asset managers to become more cautious when market valuations are so high.
“Traditional asset classes for risk reduction look less attractive in the current low yield environment, with inflated gilt and bond values due to quantitative easing,” he explained.
“The temptation is there to use alternatives for diversification purposes, although these come with different risks and a lack of liquidity should worry investors in the event of a significant correction.
“Within our own portfolios, we keep the use of alternatives under review but have not to date allocated anything directly to these asset classes. Investors in mainstream equity funds already have indirect exposure to miners, infrastructure and energy stocks, so it’s important not to get carried away with duplication through direct exposure too.”
Bamford adds that return expectations should be tempered following years of strong performance from equities and bonds, warning that a market correction is long overdue.
While 64 per cent of participants in the Natixis survey agree that a lack of liquidity limits their allocations to alternatives, more than 50 per cent say their firm is embracing illiquid assets more than it did three years ago.
A further 63 per cent believe the liquidity trade-off is worth the risk when looking at the potential returns of such assets.
The participants aren’t seeing attractive opportunities across the board when it comes to alternatives, though. Some 25 per cent favour private equity as the most attractive alternative investment while 23 per cent favour commodities. However, 32 per cent of wholesale portfolio managers believe real estate will disappoint and a further 27 per cent believe hedge funds will disappoint.
Ben Yearsley, director of Shore Financial Planning, warns that some of the alternatives being favoured by portfolio managers may only be suitable for a small percentage of clients who have very long-term time horizons as well as a high appetite for risk.
“I can see there’s a logic to having a proportion in those asset classes in higher risk portfolios but I’m not convinced they are suitable for everyone,” he said.
“Around 18 months ago, nobody was interested in commodities. Suddenly we had this 12-month run for commodities and people are becoming interested again. Why weren’t they interested 18 months ago when they should have been, rather than now?”
Performance of index over 3yrs
Source: FE Analytics
Like Bamford, he points out that many mainstream equity managers have been buying commodity stocks for a while because they have been good value. As such, he says doubling up exposure to such assets should be avoided at all costs.
“Asset classes such as private equity are a bit different because you’re not going to find them in your mainstream fund, but things like commodity exposure you could do as they’re seen to be a cheap value play at the moment,” Yearsley continued.
“There’s nothing wrong with diversifying but there’s something wrong with trying to be too clever and I think that’s the danger. Long term broad-based diversification probably aids you better than buying some of these more esoteric areas.”
When it comes to lowering return expectations for clients, he says this is perhaps a fair view given toppy valuations across equities combined with geopolitical risks such as ongoing Brexit negotiations and the unpredictability of US president Donald Trump.
“You have to say that, as a broad market, it is going to be harder generating high returns and you need to bring expectations down,” Yearsley said.
“But, that doesn’t mean that there are no pockets of value within markets. I’m a big fan of pharma and bio and they’re on cheap valuations.
Performance of index over 5yrs
Source: FE Analytics
“As a broad rule, I do agree equity returns will be harder to come by over the coming years because it’s a tougher environment than it was two years ago.”
When it comes to equities, the Natixis report found that emerging market assets are currently favoured, with 47 per cent of participants marking this as a bright spot among equity regions.
In contrast, 40 per cent predict that US stocks will be a disappointment.
Wholesale portfolio managers were also negative on traditionally ‘safe’ fixed income assets due to concerns over low rates, with 47 per cent of respondents calling for a credit play with high-yield bonds to pay off. Meanwhile, 57 per cent of portfolio managers call for government bonds to be a disappointment within the fixed income universe.
“Overall, we find that while wholesale portfolio managers anticipate greater volatility in the year ahead, they are not shying away from risk, which is reflected in their market outlook and asset allocation calls,” the report concluded.
“After a year of surprises in 2016, it seems as though wholesale portfolio managers across the globe are waiting for the other shoe to drop in 2017. But their anticipation is not filled with anxiety. Instead, they have embraced the uncertainty and come to terms with the risks.”