Institutions see risks returning, seek protection

Institutional investors and outsourced CIOs are adopting conservative, cautious stances in portfolios for the final quarter of what has been a difficult year, partly due to fears that supportive policies may be pulled back too quickly.

Before the end of the year, investors will also have to deal with political events — the U.S. presidential election and the end of the Brexit transition period — and the potential resurgence of the coronavirus and associated lockdowns in Western economies.

These fears are leading some investors to pare back on risk assets, while others are adding protection into portfolios in order to try to eke out gains from equity exposures while also hedging downsides.

"We have adopted a conservative stance as we move into the final quarter of the year," said Mirko Cardinale, head of investment strategy and advice for USS Investment Management Ltd. in London. USS IM is the in-house manager for the Universities Superannuation Scheme, London, which had £67.6 billion ($83.8 billion) in assets as of March 31. "This is because, while the markets rebounded relatively quickly after the initial impact in March, there are many clouds on the horizon."

Sources highlighted that much of the recovery in global markets and across asset classes is thanks to unprecedented monetary and fiscal policies, with trillions of dollars pumped into developed market economies and various employment and fiscal schemes adopted by governments and central banks. The fear that this support may be withdrawn is, in some cases, leading to cautious positions.

"The U.S. and European economies have been on life support for the last few months but there is serious risk of unemployment buildup and business failures if that support is pulled back too quickly. And that is without the risks arising from the political dimension," Mr. Cardinale said, citing the U.S. election and the potential no-deal outcome for Brexit.

Global markets plummeted in March following the outbreak of the coronavirus pandemic and subsequent lockdowns in western economies. However, markets quickly recovered: the MSCI ACWI is up 4.88% for the year through Oct. 15 on a total return basis.

"Importantly, neither the collapse nor subsequent recovery have anything to do with economic fundamentals — they're entirely virus-related — and that is likely to be the case over the next few months," said Rupert Watson, head of asset allocation at Mercer Ltd. in London. Over the coming months, "the degree and speed of that economic recovery will be very much down to the virus, government response and individual response."

The election and other risk events, as well as have led some OCIOs running assets on behalf of institutional investors to take equity risk off the table, moving instead into credit markets to play on the economic recovery but without adding exposure to equity valuations.

Monetary policy is what worries SEI Investments Co. the most, said Andy Daly, Philadelphia-based managing director and investment strategist in the institutional group. The presidential election, in contrast, is "no biggie."

While inflation is yet to test markets, "once money stops contracting and (we start) getting into a lending environment, we will start to see inflationary forces (taking) hold," he said.

That would be unsettling for markets, particularly as economies continue to recover from the impacts of COVID-19 and subsequent lockdowns, Mr. Daly said.

Within OCIO portfolios, SEI has started to add exposure to strategies that would do well in volatile environments – "multiyear investments using derivatives focused (predominantly) on currencies and fixed income. ... We believe there is substantial risk monetary and fiscal policy will lead to future volatility in financial markets," he said. The hedges will be structured to benefit from an increase in volatility "while still maintaining value if this volatility comes later down the road than we expect." Firmwide, SEI had $181 billion in global OCIO/discretionary assets under management as of June 30, of which $85.6 billion were institutional assets.

Protecting assets against further market falls has been implemented by some pension funds in the U.K. and Europe.

Brunel Pension Partnership, Bristol, England, launched a £1.2 billion ($1.6 billion) subfund on Oct. 7 that aims to provide downside protection during market turbulence. The pool's member funds asked Brunel to create a diversifying returns subfund to offer "meaningfully different exposures to others in their strategic asset allocations," acting as a stabilizer when returns in other portfolios are under pressure.

Emily Booth, senior investment officer at the £30 billion pool of U.K. local authority pension funds, is also cognizant of the market volatility.

"Whether (Mr.) Trump gets another term or there's a Democrat clean sweep, the election is not widely expected to derail the two main forces that have driven markets since March, which are a flood of liquidity from the central banks and some gigantic fiscal measures designed to prop up the economy. (But) were the results to be contested, it would not be unprecedented, but could cause investors to worry, leading volatility to spike upwards," she said in an emailed comment.

And Mikael Angberg, CIO of the 355 billion Swedish kronor ($39.7 billion) AP1, Stockholm, Sweden, said he is expecting equity markets to be volatile in the first few months following the election, regardless of whether Donald Trump or Joe Biden wins. As a result, executives are considering launching a derivatives strategy on 25% of its 264.5 billion kronor equity exposure to weather the volatility.

OCIOs, meanwhile, are also adding protection to portfolios.

Executives at River and Mercantile Investments Ltd. have "embedded downside protection against further market falls" while maintaining exposure to risk assets, said Ajeet Manjrekar, co-head of River and Mercantile solutions in London.

Mr. Manjrekar said a slowdown in the rate of new stimulus — which would stall global asset prices and economic support — as well as rising COVID-19 cases and the U.S. election, are the biggest risks to markets in the fourth quarter. River and Mercantile has £14.6 billion in OCIO assets.

Risk and investment management firm Cardano, which had £14 billion ($17.3 billion) in fiduciary assets under management as of June 30, came into 2020 "very lightly allocated to risk assets," which paid dividends for clients at the height of the coronavirus pandemic, said Nigel Sillis, London-based client portfolio manager.

The firm started adding risk through inflation-sensitive assets and credit. "That's where our preference would be right now. We are still minded to have increased risk in the portfolio, but credit and carry assets are probably preferred to equities because of valuations."

While some investors are concerned that supportive monetary and fiscal policies may be pulled back quicker than expected, leading to cautious risk positions in the fourth quarter, others are not particularly worried.

"For the first time in my career, I don't think one of the biggest risks is central banks," said Mercer's Mr. Watson. "I spend a lot of my time talking (about whether) central banks will tighten policy and bring the party to a close — that's not a risk over the next several quarters and probably years."

The biggest risk is inflation, he said, although not for the next two or so years, and lingering China-U.S. tensions are another concern.

And some OCIO managers are holding onto equity risk, despite an uncertain outlook, and cutting back on credit.

Earlier in the year, Mercer "had as much credit risk as we were allowed to have under mandates … as we saw the opportunities (as) being exceptional. That was not a view on the economy particularly, but on the support from governments and central banks."

Credit had a "huge rally" and while it is still attractive, "valuations particularly on investment grade aren't massively out of whack with normal," Mr. Watson said.

Legal & General Investment Management Ltd. executives think gains in equities are being held down because of the fourth quarter's risk events, including the election and the path that COVID-19 might take.

John Roe, London-based head of multiasset funds, said there are "quite symmetrical" upsides and downsides to equities. On the upside, slowing the spread of the virus could be done with relatively little economic impact going forward and the likelihood of a contested U.S. election is decreasing. On the downside, there is the risk of a plateau in the economy and what might happen until a vaccine for the coronavirus is found.

On credit, though, LGIM sees an "asymmetrical" case for the asset class. For example, investment-grade credit has "retraced almost all of the credit spread widening from earlier this year. We're back to a point where there is quite limited upside protection, but in a worst-case scenario, it could go back up higher." The firm owns less credit in portfolios, particularly investment grade.

And on global inflation, "where we tend to take more exposure, the upside … from here is quite limited" — another asymmetrical outlook.

With some OCIO clients, their "risk tolerance is dropping as well" as that of the manager, since sponsoring employers have also been battered by the impact of the virus, added Tim Dougall, London-based head of fiduciary management at LGIM. "Schemes are saying (the virus is) not going away anytime soon and are starting to have strategy conversations, renegotiating conversations (with their sponsors)." One question is whether trustees should be taking less risk at the moment since they are taking in less in terms of employer contributions due to the impacts of the pandemic on businesses, he said.