Some risks subsiding but investors overall still wary of new year

Money managers and asset allocators in Europe will not be immune to lingering risks in 2020 even if the Continent can avoid a recession, sources said.

European institutional investors may begin to feel some relief this year as political risks are shifting out of Europe into the U.S. amid an expected Senate impeachment trial of President Donald Trump, sources added. But even with political risks in the U.K. and Italy reduced, following U.K. Prime Minister Boris Johnson receiving parliamentary approval for his Brexit deal and Italy's budget deficit falling into line with the EU rules, liquidity and regulatory risks compounded by the European Central Bank's loose monetary policy are still looming large in investors' minds.

"The downside risk is lower than a year ago, but it still exists as monetary policy of central banks is close to exhaustion," Luba Nikulina, global head of research at Willis Towers Watson PLC in London, said in a telephone interview, adding that in this environment, investors should consider investing in companies with contractual cash flow, rather than cyclical growth stocks.

"In absence of a shock, the European Central Bank's policy is unlikely to change much in 2020," added Gareth Colesmith, head of global rates and macro research group at Insight Investment in London, noting that ECB President Christine Lagarde's hopes to get European governments to expand their fiscal expenditure are unlikely to materialize before German elections due in 2021.

Still, EU investors could be facing the repercussions of an expected economic slowdown in Germany this year, which could spark trouble for fixed-income portfolios. Barry Gill, head of investments at UBS Asset Management in London, said during a presentation of the firm's outlook event: "(Eurozone) bond yields don't have to go far from here to be completely wiped out," adding that an additional supply of German government debt is needed to be issued in 2020 to lead to an upward trend in yields in the eurozone.

For European regulators, liquidity risk is among their top priorities for 2020. The European Securities and Markets Authority is gearing up to launch in 2020 liquidity checks on European money managers to ensure UCITS funds don't ignore liquidity rules.

A heightened focus on fund liquidity was sparked in the U.K. in June 2019 when Woodford Investment Management Ltd. suspended the trading of its £3 billion ($3.9 billion) LF Woodford Equity Income Fund as a result of declining performance and to prevent redemptions. Having previously locked a portion of its capital in illiquid assets, the fund subsequently shut down on Oct. 17 due to uncertainty over meeting investors' redemption requests.

Among the fund's investors was Kent County Council Pension Fund, Maidstone, England. Woodford is yet to return £263 million to the £6.4 billion pension fund.

Following the Woodford fallout, investors increasingly are considering how the liquidity profile of their investments will hold up or how they can continue to access liquidity when investment opportunities arise, sources said. As half of all investment-grade corporate bonds are BBB-rated, some sources warn that in a wave of downgrades investors could be unwillingly pushed into markets with lower liquidity.

"Because central banks have forced investors into areas of low liquidity and high risk, investors will not be able to exit (investments) at a price they would like in a downturn," said Neil Dwane, portfolio manager and global strategist at Allianz Global Investors in London.

Liquidity risk is already an obligatory subject featured in discussions among investors and managers, sources said. "I can see that asset owners are being more careful about liquidity provisions," Willis Towers Watson's Ms. Nikulina said.

Fiona Frick, CEO of Unigestion in Geneva, Switzerland, added: "My concern as an asset manager (in 2020) is the liquidity of the underlying investments and if that is aligned with the liquidity of the client."

ESMA, the U.K.'s Financial Conduct Authority and the Bank of England are all pondering a revision of rules to help investors manage liquidity mismatch in open-end funds. "In 2020, we could see a recommendation (from ESMA) to the European Commission on the issue for funds that don't have daily redemption facility," said Camille Thommes, director general of the Association of the Luxembourg Fund Industry.

Liquidity is also higher on investors' agendas after U.K. regulators set a 2021 deadline for financial firms to transition away from the London interbank offering rate.

But moves to replacement rates for securities, loans and swaps — which currently utilize LIBOR as benchmark — could take time before new and liquid markets are formed as different countries move at different speeds of transition, said Robert Gall, head of market strategy at Insight Investment in London.

"Pension funds in the U.K. have largely dealt with the issue. While most U.K. plans are now hedging their liabilities with gilts, plans that hedged via swaps have either transitioned those instruments to sterling overnight index average or plan to adopt the International Swaps and Derivatives Association's protocol."

For U.S. pension plans, swaps will eventually be benchmarked to the secured overnight financing rate. However, it takes time to build a liquid market and volumes are still much higher in LIBOR, Mr. Gall said.

An increasing influence of the Markets in Financial Instruments Directive II is another risk for money managers in 2020.

MiFID II, which took effect on Jan. 3, 2018, was aimed at delivering data on equity trade flows, volumes and prices to a range of investors in an easily accessible and non-discriminatory way, boosting transparency of execution fees and transaction charges. But sources said the unintended effects of MiFID II haven't fully played out yet.

Glenn Poulter, head of brokerage, Europe, Middle East and Africa at Northern Trust Corp. in London, said money managers have had to rethink their operating models, as costs continue to rise and revenues come under pressure.

Post MiFID II, global commissions paid by money managers to brokers have continued to decline, having fallen to $17.3 billion in 2019 from $26 billion in 2008, according to McLagan, a London-based provider of compensation data and consulting to the financial services sector. Noting an analysis by Boston Consulting Group, Boston, Mr. Poulter said profit margins for the money management industry could fall to the mid-20% range in some regions from about 35% by 2021. "This in turn will put continued pressure on sell-side firms, as banks and brokers look to merge, consolidate or shut down unprofitable business units," he said.

Another issue under MiFID II for managers is cost calculation that buy-side firms need to conduct to disclose execution expenses to their investors. "While it is not uncommon for a new regulation such as MiFID II to be complex to implement, it's becoming increasingly clear there are areas which are not workable," said WTW's Ms. Nikulina. "The review of the regulation (in March 2020) by the European Commission will better specify the definition of costs and how they need to be calculated," she said.

The U.K.'s exit from the European Union might also spell a need to develop a third iteration of the directive to clarify standards around the delegation of portfolio management by money management firms to their parent entities or headquarters in countries outside of the European Union, including the U.K., noted Mike Booth, partner at advisory firm MJ Hudson LLP's regulatory solutions unit in London.

MiFID II does not distinguish what "business substance" is authorized in Europe, he said, adding that the regulation in its current form does not flesh out the standards for delegated services such as portfolio management when firms delegate a function to London, which after Brexit will be based outside of the European Union.

Sources also said there are more regulation-driven risks in store for managers in 2020.

Similarly to MiFID II's cost disclosure requirements, the U.K. Financial Conduct's Authority's newest regulation — Senior Managers and Certification Regime, effective Dec. 9, 2019 — requires individuals at money management firms to inform investors about fees to prevent overcharging.

In the first/second quarter of this year, the FCA is expected to release a report that will outline to investors how to compare services that managers are offering to determine which strategies could be considered value for money. Money management firms also must under this regulation assign responsibilities across their businesses, with individual senior executives assuming responsibility for potential losses to investors.

"Managers will start to worry about it when the FCA will start to reference individual people," Mr. Booth said.

Senior managers should reflect on the FCA's Nov. 19 £1.9 million fine to Janus Henderson Group and consider a course of action in those circumstances now the SMCR is in force, Mr Booth said.

"Janus Henderson (which ceased to utilize an active overlay in its fund) should have reduced management fees to reflect the value its investors were receiving," he said.

Across Europe, money managers are also preparing to help investors integrate carbon disclosures of the companies held in their portfolios under the European Union's disclosures regulation, which is expected to take effect in July 2020.

Noting the forthcoming changes under which managers must tell investors how their strategies relate to new pan-European standards, known as taxonomy, which was adopted on Dec. 18, Carlo M. Funk, head of environmental, social and governance investment strategy for EMEA at State Street Global Advisors in London, said his firm will be busy aligning investment products with taxonomy for the disclosures regulation in 2020.

Because the EU agreed to permit that investment strategies do not have to be aligned with the new standards, managers must at least spend time labeling investment solutions that are not compatible with the taxonomy. Mr. Funk said that any offering changes required to be made as a result of the regulation will be put to a vote by the board.