Finding opportunity in market volatility

Our third annual survey of institutional investors across the globe, organised in conjunction with Pyramis Global Advisors, a multi-class asset manager for institutions affiliated with Fidelity Investments in the US, reveals that many institutional investors in Asia struggle with their inability to take advantage of investment opportunities as they arise and would like to be more tactical in their approach.

Respondents (43 per cent) saw the biggest challenge in their decision-making process as not being able to execute timely asset allocation, particularly critical in this type of market. The sense is that the investment committee process at institutions is too slow, and 28 per cent are focusing on educating their investment committees to improve this.

Volatility took most votes as the biggest concern (34 per cent), followed by risk management (31 per cent) and the low return environment (23 per cent). In contrast, inflation was viewed as the top concern by only 1 per cent, and the impact of regulatory and accounting charges received just 6 per cent of the votes.

Furthermore, 25 per cent believe matching assets and liabilities is their primary focus in terms of challenges in the decision making process and 13 per cent cited the difficulty in tracking aggregate portfolio risks. Difficulty in controlling scheme costs was suggested to the respondents, but was completely eclipsed by the other factors.

“This finding highlights how overarching the other choices were as areas of concern,” says Young Chin, chief investment officer at Pyramis Global Advisors. “It is perhaps not so surprising in the light of where we are in the markets – return expectations are low, and there are concerns about economic growth and employment, and these concerns are dominating investors’ minds.”

Asked what changes they are implementing to overcome the challenges faced, 55 per cent said they are streamlining the decision-making process through pre-approved opportunistic allocation and 24 per cent said they are outsourcing more assets to external managers. Fourteen per cent cited giving fewer managers more latitude to make asset allocation decisions by way of strategic partnerships, with much the same aim. Around 19 per cent are tackling the issue full on and managing the investments internally.

“In the current market there are rapid shifts between asset classes and the appetite and patience for the traditional long-term approach has been tested,” says Mr Chin.

“Institutions now see the attraction of a greater ability to switch between asset classes and run an opportunistic strategy. The result is they are giving other parties oversight to be more tactical but within a specific range, so they can be more deft and expeditious than traditional approaches allow. Or a third party may be mandated to be able to make significant tactical moves across asset classes. These strategies will generally mean putting a larger proportion of the assets into a smaller number of managers in order to make a difference.”

DIFFERENT ENVIRONMENTS

When the results were analysed in two cohorts – Japan and Asia ex-Japan – both groups were concerned about high volatility and wanted to protect against it and put risk management in place, but the Asia ex-Japan group were more focused on how to capitalise on volatility. This may be a result of their environment; emerging markets are more volatile in general and have seen opportunities come and go.

In comparison, the Japanese cohort were more cautious, and the recent earthquake and tsunami may be other factors underlying their conservative approach. Japanese institutions are investing even further into fixed interest to protect themselves, while the Asian ex-Japan cohort are more opportunistic and are instead boosting their use of managers with flexibility to capitalise on volatility such as liquid alternatives, both as a way to manage risk and to increase returns.

“They are putting money in the hands of managers who can be flexible in terms of investing wherever the best opportunities are, such as emerging markets,” adds Mr Chin. “Outsourcing is increasing, notably to global macro hedge funds and large asset management organisations with product breadth and strong tactical asset allocation capabilities, and also more generally to flexible managers who take advantage of opportunities to produce a winning strategy regardless of the market’s direction.”

The developed (Japanese) cohort are reducing their home country bias and switching into emerging markets, while the Asia ex-Japan are staying at home because this is where the better opportunities lie, and they are consequently making only a small allocation to developed markets. But while the Asian ex-Japan group have a home country bias in the short term, they anticipate they will be more global in the next 10 years and have a heavier weight to alternatives, as they chase new opportunities.

Of the total respondents (of which 61 per cent were CIOs and investment officers), 43 per cent are considering reducing, and 23 per cent are likely/definite to reduce their equity exposure to help control volatility. Also, 24 per cent are considering an increase, and 54 per cent are likely/definitely increasing allocations to fixed interest. Currency hedging is likely to become more commonplace with 42 per cent (likely/definite) planning a strategy and an additional 34 per cent considering it.

Derivatives use should grow, with 24 per cent considering and 26 per cent likely to use fixed income derivatives along with 26 per cent considering and 27 per cent likely to use equity derivatives.

Many funds (40 per cent considering and 34 per cent likely/definite) are mulling over whether to add liquid alternatives such as long/short equity funds, market neutral, managed futures and global macro hedge funds, and growing acceptance of equity derivatives in part reflects increased familiarity with these hedge fund strategies.

Respondents were asked about potential changes to their asset mix to boost returns. Amongst these, switching from passive to active was relatively favoured, with 26 per cent likely/definite and 35 per cent considering. Sixty-one per cent are either considering or are likely/definite to consider aggressive sub-asset classes such as small caps, emerging market debt and equity, credit and high yield, often together with highly concentrated portfolios.

ILLIQUID ASSETS OUT OF FAVOUR

Institutional investors are shying away from increased use of illiquid assets classes such as private equity, real estate and infrastructure, with 31 per cent ruling this out, and a further 26 per cent saying it is unlikely. Only 17 per cent plan to hike their exposure to illiquid asset.

Regarding asset allocation predictions for the next two years, institutions are making significant increases to both their Asian and emerging markets equity and fixed income. The pre-eminence of the US is fading, however. Only 14 per cent of respondents intend to increase US equity exposure while 18 per cent intend to increase their US fixed income allocation.

In addition to increasing local and emerging assets, 25 per cent intend to increase their exposure to commodities and other sources of real return. “Participating in these hard assets opportunistically is another approach, such as CTAs which are increasingly interesting vehicle for going after those commodities that are appreciating rapidly as they enable you to get in and out quickly,” says Mr Chin.

“Demand for commodities continues to be driven by inflationary fears and opportunism,” he adds.