Structured products will continue to play a pivotal role in investment portfolios held by institutional investors seeking new ways to meet long-term growth and liability goals by simultaneously mitigating and exploiting risk in the current low-yield and volatile market environment.
According to Natixis Global Asset Management's (NGAM) annual international survey of institutional investors key strategies pursued by institutional investors include a growing use of private investments, illiquid assets, as well as increased exposure to alternatives such as structured products, and greater reliance on risk budgeting and diversification.
"The need for income streams is across the board, and this is where I think structured products can play a role," Euan Maclaren (pictured), head of UK institutional business at NGAM. "Downside protection remains a key element for institutional and private investors, and structured products can be used in combination with some of those other products to bring balance and hedge the risk in a portfolio."
The survey found that 80% of French institutional investors (75% globally) believe today's markets are more favourable to active managers and are raising their exposure to higher-risk assets in pursuit of better returns. At the same time, they are doubling down on risk management to better balance long-term growth objectives and liquidity needs, but say they need better ways of identifying risk across their portfolios.
According to Maclaren, the interest rate environment continues to influence the market and the products, and "although structured products don't offer as much as other products on the upside, they can be key in minimising the impact on the downside".
"The bottom-line when investing is what are you trying to achieve, and how much risk are you willing to take," said Maclaren. "We believe to build a balanced portfolio you have to use a combination of traditional and alternatives, including structured products."
The findings of the survey provide insight into how institutional investors, largely considered to be the world's largest, smartest investors, are using risk to their advantage. 75% of French institutional managers, versus 62% globally, feel they can handle near-term market risk despite greater volatility, which they say poses the biggest risk to their performance. Their top organizational concern, however, is low yield. Given the prospect for greater volatility and persistence of low interest rates, few global institutions are relying on traditional portfolio strategies to meet their performance goals.
"[Institutional investors] want to broaden the horizons and look at instruments that are not purely traditional equity and bonds," said Maclaren. "At the end of the day, investors should be looking to want to reduce the risk and the volatility in their portfolios. It is very important to establish what the institutional investor - just as the individual investor - wants to achieve."
The survey also found that the projection for passive investing has dropped steeply year over year. In 2015, they assumed a 9% increase in allocations to passive within three years, now they anticipate an increase of just over 1% by 2019. Asked to compare the relative strengths of active and passive investments, 86% say active is better suited to generating alpha, to generating risk-adjusted returns (64%), for accessing emerging market opportunities76%, and for ESG investing 75%.
While institutional investors see the value of passive investments for specific objectives, they see potential problems for individual investors who have come to rely heavily on indexing. For 75% of French institutional investors, individuals are not fully aware of the risks of indexing which may conduct them to a false sense of security about indexing.
According to Maclaren, this is about institutions building portfolios that can achieve their end goal not about building portfolios that will deliver the highest return. I think the active v passive debate is not addressing the real problem. There's space for both. They are complementary and not exclusive, and people need to realise that they can address particular needs through incorporating both passive investments and active investment. A balanced portfolio using active and passive strategies has a better chance of maximising the upside, increasing returns, managing risk and increasing diversification.
In their efforts to manage the risks, institutional investors believe the more effective techniques include diversifying holdings across sectors (88%), risk budgeting (83%), increasing their use of alternative investments (80%) and smart beta (75%). The survey reveals that the percentage of global institutions using alternatives to manage risk has exploded from 53% in 2015 to 76% today. In addition, 56% report that their organization is investing in more in illiquid assets today than they were three years ago.
According to Maclaren, funds of hedge funds are dead because they failed to deliver but there are other areas such as private equity, private debt and structured finance that are driving significant activity. "We have seen more activity around aircraft finance in the last 18 months than in the last decade," said Maclaren, adding that the reason for this is that investors are seeking income streams as a result of the yield depression, and some of these segments including structured products "can deliver this plus capital appreciation".
While global institutions think that alternatives help to diversify portfolios and manage risk, more than half (55%) report that their need for liquidity has limited their ability to invest in alternatives. Many institutional decision makers (71%) believe more stringent solvency and liquidity requirements established by regulators around the world have resulted in a greater bias for shorter time horizons and more liquid assets. This has proven to be a significant challenge to meeting liabilities that stretch out over multiple decades. Respondents also say their top risk management concern is balancing long-term growth objectives with long-term liquidity needs.
ESG (environmental, social and governance) investing is taking on broader dimensions for investment teams, providing a measure for identifying companies and investment trends that may provide long-term growth potential to the portfolio, according to the survey findings. 67% of French investors surveyed (59% globally) say that considering ESG issues is a way to generate alpha. An equal percentage says it is a way to lessen headline risks, such as lawsuits, environmental harm or social discord. 62% believe ESG will be a standard practice for all managers in the next five years.
According to Maclaren, ESG and smart beta remain in focus for institutional investors as they can generate returns. "Smart beta can also be applied to fixed income strategies, and add to what investors can get via traditional market cap indices, and they do not have the issues around closet indexing that has damaged the reputation of some asset managers," said Maclaren. "In relation to ESG, I have been involved in the market since the days of SRI and saw how it did not work as expected. ESG creates an environment where ESG is incorporated into the actual investment process enabling selection of the best opportunities is now the best filter to exclude unwanted exposure without having to sacrifice performance."
SRI was not what it was supposed to be but ESG is here to stay and "we see already the how much capital and attention is going to that segment", according to Maclaren. The investment bank licensed in the summer of 2016 the Euro iStoxx 70 Equal Weight Decrement 5% Index to develop a range of structured products. "At Natixis we have a very comprehensive range of ESG products through our affiliate Mirova, and will continue to expand our offering because we think these products have a role to play as we move towards a low carbon greener economy."
NGAM is building its defined contributions (DC) business and these kind of products "will fit very well with what's on demand", according to Maclaren.
"The millennial generation is also driving some of this demand because of the level of awareness, and as a provider we have to respond and provide products that tailor exposures to the ESG theme but most importantly that add value to investors," said Maclaren. "We also believe ESG strategies can be delivered in different formats, as we have seen recently with the World Bank index-linked green bond."
Click in the link to read NGAM's full report.
NGAM's annual international polled 500 managers of public and corporate pensions, foundations, endowments, insurance funds and sovereign wealth funds in North America, Latin America, the United Kingdom, Continental Europe, Asia and the Middle East. Collectively, they manage US$15.5tr in assets.
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