2017 was a year of global economic and market growth and exceptionally low volatility. Following a more volatile start to 2018, investors see signs to be positive about, including a normalisation of monetary policy in some territories, low inflation and strong earnings. There is, however, an increasing concern that disruptive events such as Brexit and the Trump tariffs, together with high valuations in markets, could pose a challenge to returns going forward.
In our annual European Asset Allocation Survey, we identified a number of strategies followed by institutional investors across Europe who are responding to this changing landscape and invest their assets in a time of rising volatility and inflated asset prices.
Climate Change Is Increasingly Seen as an Investment Risk
Although consideration of climate change has tended to be fairly low down on investor agendas, this year’s survey results show a material jump in the number of investors considering the investment risks posed by climate change – from 5% last year to 17% this year. Regulatory nudges have likely played a role here, with the UK Pension Regulator, the EU Commission and the Financial Stability Board’s Task Force on Climate related Financial Disclosure (TCFD) all making statements encouraging investors to consider the physical and policy risks posed by climate change.
UK Defined Benefit Plans Prepare for the ‘Endgame’
In recent years we have seen a large increase in the number of UK defined benefit (DB) plans becoming cashflow negative (with outgo larger than their income). Around 56% of UK DB plans are already cashflow negative (a similar figure to last year), but we have seen a marked increase in the number of cashflow-positive schemes that are less than five years away from being cashflow negative (an increase from 43% to 49% of cashflow positive plans). This finding is reinforced by the timeframes being targeted for de-risking strategies – the proportion of plans with a de-risking target of less than five years has almost doubled from 13% to 24% since last year’s survey. The maturing of UK DB plans has led to a further reduction in equity exposures (from 29% to 25%), a gradual increase in liability hedge ratios, greater use of alternatives and an increasingly urgent search for income-generative assets.
More Focus on Diversification
The search for diversification seems more relevant than ever and has encouraged investors to seek alternatives to traditional equity and bond assets. Two beneficiaries of this trend from among the alternative asset classes have been secured finance and private debt strategies (both benefiting from the focus on income highlighted above). The proportion of plans allocating to private debt increased from 7% to 11% over the year, while secured finance strategies emerged from close to zero exposure last year to 3% of plans in this year’s survey. We expect both areas to see further interest in the years ahead.
Hedging Equity Downside Risk
Equity option strategies gained in popularity over the year as schemes sought to manage their exposure to equity downside risk. Some 9% of respondents have implemented equity-option protection strategies, with a further 24% of plans having considered such approaches. By contrast, bespoke tail-risk hedge funds have remained a niche proposition. In this extended cycle, with stretched valuations across many asset classes, investors (especially those who are path-dependent or sensitive to volatility) are rightly thinking about approaches to managing their exposure to downside scenarios.
The Shift from Active to Passive
The slow but perceptible shift from active to passive approaches (in both equity and bonds) has continued in this year’s survey. Based on a consistent sample, the proportion of equity and bond assets managed passively has increased by 1% to 52% in equities and by 3% to 51% in bonds. This trend is likely to continue, with tailwinds including downward pressure on fees and costs, a desire to control the governance burden, and an increasing allocation of fee and governance budgets towards alternative assets (where credible passive options rarely exist).
It seems as if investors are concentrating on strategy more than ever. In a world that is likely to exhibit lower returns and “fatter tails”, they should focus on diversity and robustness as key pillars of a sustainable investment approach.
About the Survey
Mercer’s European Asset Allocation Survey 2018 – the 16th edition – gathered information from 912 institutional investors across 12 countries, reflecting total assets of around €1.1 trillion. As well as investment strategy information, the report tracks the drivers behind Environmental, Social and Corporate Governance (ESG) integration and two key areas within responsible investment: investor stewardship and active ownership rights and, secondly, the investment risks and opportunities posed by climate change.
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Disclaimer: This article does not contain advice in respect of actions you should take. No decision should be made based on this information without obtaining prior specific, professional advice relating to your own circumstances.
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