Pension funds go beyond fundamental investment in quest to match liabilities
A move in institutional investing back toward active equity management is dovetailing with moves by pension funds to look toward more outcomes-based investments focusing on matching expected future liabilities and less on just capital accumulation, sources said.
But rather than a pendulum swing from passive investing back to fundamental active management, the shift back to active incorporates a wide variety of equity strategies — including some investing strategies normally traditionally categorized as alternative, such as private equity. Active fixed income, meanwhile, remains a favorite among institutional investors, sources said.
Among the varieties of equity strategies being used in growth-oriented portfolios and allocations are smart beta and factor-based strategies, risk premium, low volatility, even hedge funds and currency strategies.
For example, Stockholm-based AP7, which has more than 400 billion Swedish kronor ($50.4 billion) in assets, is increasing its active exposure by 10 percentage points. A spokesman there said both public and private equities are a focus for embracing active management.
"That makes sense," said Kevin Quirk, principal at money management consulting firm Casey Quirk by Deloitte, Darien, Conn. "If you think about a big umbrella of investors trying to solve their problems, the overarching theme is dictating how they allocate their assets — capital preservation, capital accumulation, income, liquidity. We've seen broad movement for investors to align more with those outcomes. A narrow definition of allocations was used years ago," such as U.S. large-cap equities and active or passive management.
"Institutional investors are now taking a more holistic approach," Mr. Quirk said. "Rather than bundling public equity separately, they're bucketing them together in a broader movement around outcomes."
And matching liabilities is no longer just associated with corporate defined benefit plans. J. Tyler Cloherty, Darien-based senior manager at Casey Quirk, said public pension funds are moving back to active to meet their liability needs.
"That outcome is staring them straight in the face," Mr. Cloherty said. "That's a driving factor." And Philip Anker, New York-based managing director, North America, at Investec Asset Management, agreed, saying that for active management today, "the benchmark is the liability, not the return."
Quant managers adapting, too
Even quantitative managers are adapting, creating what Matthew Peron, Chicago-based executive vice president and managing director of global equity at Northern Trust Asset Management, Chicago, called quantimental investing, combining fundamental active with a quantitative model on the front end with a concentrated focus.
Mr. Peron said the combination looks to be a way for "active survival."
"Once assets leave fundamental active, they're not coming back," said Mr. Peron. "There are a lot of different paths, like active to passive to smart beta, active to smart beta to factors, or active to passive and then stay passive. Most investors say they don't want to give up on active because they don't want to give up excess return."
"It's an exciting time" for active money managers, said Ted Noon, senior vice president, director, Americas client group, Acadian Asset Management LLC, Boston. "Quantitative, factor-based, smart beta, all are a systematic style of investment. That's a common thread with all of them. As a manager, that's exciting. Investors are targeting an investment outcome as opposed to just alpha."
Institutional flows into passive management are still positive, but active has seen recent inflows, according to Morningstar Inc. data.
Quarterly passive inflows were $12.2 billion as of Dec. 31, down from $20.6 billion as of Sept. 30, 2016, while quarterly inflows to active strategies were $14.2 billion as of Dec. 31, a change from $8.5 billion in outflows 15 months earlier.Also, institutional asset growth in active management strategies increased 30% in 2017 to $2.08 trillion after remaining relatively flat since 2014. Growth in passive investment assets increased 32.5% to $1.132 trillion in the past year and rose 72% from 2013 to 2016.
The Morningstar data shows that investors continue to take more of a barbell approach with active and passive investing, with more weight being put back in the active side. "It's not a zero-sum game — not a competition that one side wins and one loses, which I think is the narrative around passive," said Patrick Thomson, international head of institutional clients at J.P. Morgan Asset Management (JPM) in London.
A place for passive, but ...
"There's a place in a portfolio for passive investments, but they obviously won't give you alpha," said James MacLachlan, global head of equity manager research, Willis Towers Watson, New York. "But if you have a year like last year, beta is not a bad place to be. What we're seeing is a broader appreciation for getting the most return for the appropriate level of risk at the total portfolio level. Instead of how much equity risk we have in a portfolio, we tend to see more about restructuring the overall portfolio on a risk-return basis."
Added Eoin Murray, head of investment, Hermes Investment Management, London, "Shorter-term we are seeing a little bit of a resurgence of active management — a little more volatility, dispersion, means the opportunity set is a little bigger for active managers. Some flows that would have gone to passive are temporarily staying in active. But it is a very specific type of active: for the more efficient markets, a quantimental approach does seem very popular. For the less efficient it's high active share asset management, traditional active management — small cap, emerging markets and so on."
No longer all-in
Mr. Quirk said that, instead of taking an all-in approach back to active management, managers are adapting to a desire among asset owners to take advantage, for a portion of their equity allocations, of expectations that central banks such as the Federal Reserve will be raising rates in the near future. "In a more likely rising rate environment, it's a time the institutional investor is saying, 'If I can add a couple hundred basis points, I should do it,'" Mr. Quirk said.
Still, sources said, the move back to active won't be a simple move to fundamental stock-picking strategies. "I believe you'll see a newer point of active," said Loc Vukhac, Northeast institutional director, Investec Asset Management, New York. "Anyone who thinks we're going back to the old active-vs.-passive days, that's all changed. The financial crisis (of 2008-2009) changed all that."
Another change involves benchmarking — away from traditional indexes and more toward benchmarks that apply to a client's liability needs — in part in response to expected rate increases, Mr. Vukhac said.
"What happened with global quantitative easing, that created a difficult period for an active, benchmark-hugging strategy," Mr. Vukhac said. "The introduction of smart beta creates a bar that makes active managers justify their fees. And the concentration of passive at end-of-day trades will eventually create a huge opportunity for active when the market declines and everyone throws out the baby with the bathwater. New active won't be benchmark-hugging but will be higher tracking error, more stock-picking."
Also, managers have become savvier in redoing their fee expectations, as cost concerns were a major driver of the recent move by asset owners to passive investing, said Casey Quirk's Mr. Cloherty.
The fee question facing investors is one of going back to traditional high-cost fundamental active strategies, staying with low-cost passive or taking advantage of the science in money management such as quantitative investing, said Michael Falk, partner at Focus Consulting Group LLC, a Long Grove, Ill., money management consulting firm.
"If I sold trustees on the importance of low fees, should I go back to fundamental active and return to higher costs, or should I go to less expensive active using science?" Mr. Falk said. "People are more expensive than science. ... Science essentially tries to distill the actual factors to be as pure and concentrated, or to have more compatibility to an outcome that's expected."
That compatibility includes often thinking outside traditional style boxes and viewing alternative investments less from the prism of how liquid the investments are and more as an alpha generator.
"I think institutions are looking at efficiency — they are not loading up on what they did in the '90s, clearly there is a lot of interest around alternative beta and factor investing," said J.P. Morgan's Mr. Thomson. "Allied to that, there is still a very strong interest in alternatives. We would regard that as active but a different type. Infrastructure is particularly an area (where) we are seeing tremendous interest in actively managed assets."
Mr. Cloherty at Casey Quirk said asset owners now have "a better understanding" of alternative investing. "Private equity used to be lumped into an alternatives bucket, but there's a better association for that with capital appreciation and inflation protection. The same lens is being applied to the entire investment portfolio… When you pivot from strategic to outcome-based allocations, you lower constraints around what to do to achieve outcomes. Then you figure out how to combine strategies to reach that outcome."
While alternatives are finding their way into traditional active equity portfolios, managers that focus on concentrated equity portfolios are also finding a "new appreciation" among investors, said Willis Towers Watson's Mr. MacLachlan. "Active managers would argue they've made changes to how they invest," Mr. MacLachlan said. "If you look long only in particular, we advise for equity exposure to be concentrated, be diversified, be high active share. But sometimes we find it hard to find these products for our clients."
Said Sam Yildirim, partner, transaction services, asset management and insurance, at PricewaterhouseCoopers, New York: "If an institutional investor is in large-cap equity, it makes sense to have some in passive, but it's also good to have consistent managers with concentrated portfolios. Those managers are back in vogue. Smart beta is getting a lot of money, but there's also room for active with a factor-based model. There's more diversification within active."
The competition among active equity managers and particularly non-traditional active managers is fierce, said Acadian's Mr. Noon. "There's competition for mindshare in active managers," he said. "How much value add is there in private equity? Should I allocate more to emerging markets or small-cap strategies? Where can I find excess returns?"