By Kathryn Saklatvala, Head of Investment Content, bfinance
Institutional investors are seeking strategies that will help to provide resilience amid surging inflation, rising interest rates, heightened market volatility and geopolitical upheaval. Meanwhile, the climate risk agenda is still front of mind.
New data on asset manager searches launched by bfinance clients (pension funds, insurers, endowments and other institutions across more than 40 countries)—discussed in detail below—shows an ongoing decline in the proportion of mandates targeting conventional fixed income strategy types, offset by a surge in searches for (often illiquid) floating rate credit, short duration lending, income-generative and inflation-sensitive strategies, and hedge funds with strong diversifying characteristics. Overall, fixed income strategies comprised just 12% of all manager searches in 2021, compared with around 20% or more in 2016-18.
The figures also illustrate extremely strong appetite for private markets strategies: half of manager searches in 2021 were for illiquid investment strategies in Private Equity, Private Debt, Infrastructure and Real Estate, compared with approximately 30-35% in 2016-18. Overall, there was a 30% rise in new manager search activity in 2021 versus 2020—indicating heightened levels of new allocation activity as investors seek to reposition and optimise portfolios.
Diversification often brings unpalatable choices. Rarely have these been starker than they are now. Classic diversification through more conventional fixed income strategies has long been rather unappealing through the era of low rates; it is now even more unappetising in an era of forecast-busting inflation. Although equity markets ended 2021 with a flourish, attaining double-digit gains for the third year in a row, investors and multi-asset managers were increasingly cautious on overall equity exposure, given the imperative to mitigate the effects of heightened market volatility as central banks begin to raise interest rates. Volatility has of course surged further in 2022, amid Russia’s military assault on Ukraine.
Within public equities, manager search levels remained strong and consistent in 2021. A quarter of all manager searches targeted this asset class, just a little below historic levels. There has been a shift from Global towards Regional mandates—with North America and Emerging Markets favoured over Europe, even before the geopolitical turmoil that we see unfolding today. In total, 71% of new searches for public equity managers were directed towards global strategies in 2020; this figure slumped to 41% in 2021. Conversely, one third of new public equity manager searches targeted Regional Developed Markets Equity (up from 10%), with North America receiving particular attention, and 22% were for Emerging Markets (up from 14%).
Although this asset class has historically shown relatively good inflation sensitivity and performed well in rising-rate environments, this does differ considerably by strategy type. 2021 brought a resurgence in demand for Value and Income strategies; the turnaround in Value appetite was particularly marked after a long period when central bank policies have essentially favoured Growth stocks. We are now seeing notably heightened appetite for Small Cap strategies, which—one can argue—may produce a more direct inflation pass-through for investors than larger firms. Appetite for Low Vol strategies has remained muted since their disappointing run in 2020, but we are seeing signs of greater interest.
2021 also brought the first explicit targeted manager searches for “Impact Equities” (or, more broadly, Thematic ESG and Impact Equity strategies). Although there is something of an overlap between Impact strategies and the new SFDR Article 9 classification, investors should not overestimate the connection. More broadly, we see strong and growing emphasis on incorporating carbon and climate-related analysis within equity strategies.
The proportion of fixed income searches has been in steady decline over the years, falling from 22% in 2017 to 15% in 2020 and 12% in 2021. Within the asset class, investors have become more active in seeking out floating-rate exposure, including Leveraged Loans, broader Leveraged Finance and some securitised credit.
Asset owners’ interest in investment grade bonds continued to wane in the final quarter of the year as they focused their attention on higher-yielding securities—in the hope that those higher returns can remain above the rising-rate tide. Most telling is the sudden surge of search activity for Emerging Market Debt: there was virtually no new mandate activity from bfinance clients in 2020 in this space, but in 2021 it accounted for 29% of all fixed income searches. US High Yield search numbers were also strong, particularly for strategies focused on shorter duration, higher quality assets. Short-duration High Yield is not a sector with a wide range of ‘off-the-shelf’ product, but targeted searches for custom segregated accounts provide good optionality.
Floating rate credit exposure, income generation and inflation sensitivity are underpinning investor demand for illiquid strategies in today’s climate. Half of all manager searches in private markets during 2021 targeted Real Assets (Equity and Debt) in 2021, up from 46% in 2020. The rise has been particularly strong in Real Estate, whose share rose from 16% to 25% after a subdued period of activity at the peak of the COVID-19 pandemic. Other Private Debt searches rose from 27% to 34% of illiquid investment activity, with a particularly notable rise in demand for short-duration lending strategies such as Trade Finance and diversifying ‘alternative’ lending strategies such as equipment leasing and maritime finance.
Importantly, investors are not being complacent about inflation sensitivity within Real Asset unlisted equity. In Infrastructure manager searches, for example, we see increasing focus on open-ended strategies—which are more likely to target classic infrastructure assets with strong inflation linkages. It is important to carry out in-depth analysis on the likely impact of inflation on specific company types, rather than relying on generic asset class-level presumptions. Within Real Estate, we see particularly strong interest in niche categories such as Social Housing and Life Sciences research facilities. Timberland is also drawing attention, due in part to its potential carbon capture characteristics (although here, again, there are major differences between strategies).
During the last two years, searches for “diversifying strategies” in liquid markets have shifted away from Multi Asset and Alternative Risk Premia, towards Hedge Funds and Fund of Hedge Funds. These last two represented 65% of all “diversifying strategies” searches in 2021. Indeed, the hedge fund industry has experienced something of a renaissance in investor sentiment, supported by strong performance in 2020 and 2021; investors have increasingly sought refuge here amid rising equity market volatility. We see particularly strong appetite for multi-strategy hedge fund approaches, allowing the manager flexibility to perform in different market environments, and market-independent strategies (particularly Equity Market Neutral). Despite the current focus on inflation protection, commodity strategies have received very little focus; we have, however, seen considerable appetite for ‘CTA’ or Managed Futures funds, which tend to have significant exposure to commodity markets.
Alternative Risk Premia demand slumped in 2020 and collapsed in 2021 after a dismal period of performance: the average ARP manager lost just over 10% in 2020. Yet 2021 results have been better, in part due to the strong performance of Commodity markets. More importantly, perhaps, managers have made some notable changes to models and processes in an effort to improve resilience and flexibility; we may well see investor sentiment improve—especially among more fee-constrained allocators—as the imperative to deliver diversification from conventional asset classes becomes ever more pressing.
The war in Ukraine has reinforced some of the key dynamics that were in play in late-2021: structurally higher volatility, expectations that inflation would exceed forecasts, concern over how to manage the impact of rising interest rates, and geographic repositioning. Current signs are that many of the key allocator trends of 2021 are persisting in 2022—albeit with a heightened sense of urgency, depending on the investor’s specific situation and liability profile.