Natixis Investment Managers did a survey of 500 global institutional investors (including managers of corporate and public pension funds, insurance funds and sovereign wealth funds) in North America, Latin America, the United Kingdom, Continental Europe, Asia and the Middle East. In the survey, it revealed that institutional investors are concerned by the impact passive instruments have on market risk and asset pricing. Two thirds (62% and 60% in Asia) think the popularity of passive investments has increased systemic risk, with 61% (58% in Asia) highlighting that flows into passive strategies have artificially supressed volatility. More than half (52% and 42% in Asia) of institutional investors also think passive investing has distorted relative stock prices and risk-return trade-offs.

Demand for passives showing signs of plateauing, institutions continue to favour active

Against this backdrop, investors are also slowing down the rate by which they plan to increase their exposure to passive strategies, with institutions appearing to have found the sweet spot in allocations. When asked about allocations in 2015, institutional investors anticipated increasing passive holdings to as much as 43% within three years, but fast forward to 2018 and respondents have given no indication of making significant changes to their current allocation of 70% active and 30% passive over the next three years (same in Asia).

Institutional investors are also expressing a preference for active management ahead of anticipated market volatility in 2019, with four in five (80%, same in Asia) expecting to see increased market volatility over the next year. The same proportion (79% and 77% in Asia) suggests the current market environment will favour active portfolio management, a similar response (78%) in 2018. Investors remain optimistic about returns but have slightly lowered the average return assumption for the year to 6.7% (7% in Asia). This compares to 7.2% in 2017.

While the majority of investors believe the market environment is optimal for active investing, there remains a case for active managers to more clearly evidence their value, with half of those using passives because there are too many ‘closet trackers’ in the active management industry. However, if the industry can expose closet trackers then two thirds (66% and 58% in Asia) of investors think this will ultimately benefit those managers who follow a truly active approach, performance, and the majority expect active investments to outperform over the long term.

Oliver Bilal, Head of International Sales and Marketing at Natixis Investment Managers, commented: “Institutional investors seem to have found their optimum allocation between active and passive, and we are now starting to see a slowdown in the growth of allocation to passives. Our survey shows this coincides with investor concern over the impact passives could have on market infrastructure and investment returns. We believe that over time passives will pose huge concentration risk, which could lead to systemic risk and see them truly tested when the next market downturn happens”.

“At the same time, appetite for active strategies is a clear indication that in times of market turbulence, institutional investors want a skilled professional at the helm. However, expected increased market volatility and a more challenging environment for generating yield means there will be a widening distinction between managers who can generate alpha.”

Search for alpha driving demand for ESG

Environmental, Social and Governance (ESG) considerations are playing an increasingly dominant role in institutions’ investment strategies. Three in five (61% and 54% in Asia) institutional investors currently incorporate ESG factors, and more than half (55% and 58% in Asia) of survey participants said they expect to increase allocations to ESG strategies in 2019, with return generation and diversification key considerations. More than half (56% and 63% in Asia) agree there is alpha to be found in ESG; 43% (52% in Asia) of investors identify ESG factors as just as important as fundamental financial factors when analysing a company, and fifth (20% and 14% in Asia) see it as an important way to generate risk-adjusted returns over the long term.

Despite the increasing appetite for ESG strategies, measurement and the ability to demonstrate performance remains a challenge, according to 43% (39% in Asia) of survey participants. Two in five (40% and 48% in Asia) also have concerns that companies may be “greenwashing” data to enhance their public image.

Oliver Bilal, continued, “If ESG investing is now a matter of course for institutional investors, who expect the incorporation of ESG factors to become standard practice for all managers over the next five years, the next step for the industry is to ensure that we regulate and monitor ESG products, for the protection of investors and their investments. We need clear taxonomy and labelling standards across the industry and across jurisdictions. Only truly active managers with high convictions can respect and integrate ESG principles.”

Investors express preference for fixed income and alternatives

The combination of uncertain returns and a rising rate environment has forced institutions to look further afield to generate returns, and respondents have signalled a preference for alternatives and private market assets. Infrastructure continues to garner attention from this group, with more than a third (36%, 30% in Asia) planning to increase allocations here, followed by private debt (28%, 24% in Asia), private equity (27% and 22% in Asia), and real estate (24% and 22% in Asia). The trend towards private market assets is reflected by the seven in ten (71% and 63% in Asia) institutions who said private assets help to generate higher returns, while 60% say they provide diversification.

Investors are expecting to decrease their allocation to equities, while fixed income exposure is expected to increase. The majority of investors (84% and 79% in Asia) expect to see heightened volatility in the equity market and plan to lower equity allocations from 37.7% to 36.2% next year, while allocations to fixed income are expected to account for 38.2% in 2019, versus 37.3% currently.