LDI’s Collateral Damage

From aiCIO Magazine's 2011 Liability-Driven Investing Issue: Does LDI mean trouble for equity long-only managers?

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There are, of course, investors other than corporate pension plans pumping money into financial markets. Individual investors continue to bet on the equity growth story. However, with a significant amount of assets moving towards fixed-income, is there trouble brewing for long-only equity managers?

“Trouble has been brewing for active long-only managers for a long time,” says Robert Garvy, Chairman and Co-CEO of Intech, an asset manager that, perhaps ironically, focuses on low-volatility equity strategies. “In fact, it’s boiled over in many cases. Many equity markets topped in the late 1990s, so investors have been struggling for a while. Hence, the movement away from long-only equities into other asset classes in order to try to reach actuarially required returns.” Even though public funds have not altered their asset allocation as radically as corporate and endowment funds, Garvy says, they have begun to make the move in meaningful ways. This shift could wreak havoc with the business models of many asset managers, he suggests.

The data overall is not promising for equity managers as a whole. According to a study released in May by consulting firm Aon Hewitt, market turbulence has caused US-based plan sponsors to shift assets away from domestic equities into liability-matching products, with long-duration bonds being the unsurprising beneficiaries of the move. This trend has been mirrored in Europe as well: According to a June study by Invesco, European equity allocations have fallen from 29% to 27% over the past year. (It should be said that this is still 2% above 2008 levels, when markets were nearing their recession-era bottom.) It doesn’t take Bill Gross to discern that fixed-income is collecting capital as equity loses it—and that active equity strategies in particular are unlikely to gather significant assets as investors generally de-risk their portfolios post-2008.

Furthermore, those asset owners seeking to grow their way to solvency—think public plans worldwide—are increasingly moving assets towards alternatives and private markets in search of the double-digit returns needed to meet ballooning liabilities. Is this at the expense of equities?

“Many public funds are actively seeking strategic asset allocation approaches, which reduce their reliance on public equity returns and associated risk while at the same time maintaining their long-term expected rate of return,” says industry veteran John Meier, a managing director at consultancy Strategic Investment Solutions. “These approaches don’t necessarily increase fixed-income allocations, but the strategies being investigated call for a reduction in the allocation to public equity. That’s going to be a headwind for long-only equity managers.”

Others agree. “We’ve known for a while now that institutional investments in equity were out of favor, while interest in alternatives—particularly private equity—have increased,” David Holmes, of Louisville-based consultant with investment managers Eager, Davis & Holmes, told aiCIO in August. “Pension funds are seriously underfunded—they’re looking to increase returns. Equities have traditionally been a hedge against inflation, but they’re not the only answer now.” Holmes added: “Investments that address special situations or are favored in an inflationary environment are seeing more hiring activity. Examples are oil and gas, commodities, timber, real assets, credit, and bank loans.” Research produced by Holmes’ firm showed that alternative investments comprised 42% of placements in the first two quarters of this year compared to a 37% average over the past six years. Active equity placements, on the other hand, were down 42% in dollar terms for new mandates in the first two quarters of this year relative to 2010. July data from consulting firm Towers Watson echoes Holmes’ sentiment, showing that alternative allocations among global pension funds has risen from 7% in 2000 to 19% in 2010—largely at the expense of equities.

These trends seem to overwhelm the financial senses. So what should equity managers, hoping to secure large institutional mandates, do? “It is very hard to raise fees in the money management business when the alternative to active management is passive investment at fees near zero,” Intech’s Garvey says. “A big impact will be [seen] on the business models money managers embrace. High fixed-cost operations will have to rethink their strategy. Paying outrageous sums to analysts, portfolio managers, and client servicing and marketing people will come in for scrutiny. Finding ways to employ technology to reduce costs will be more highly emphasized.” Time for active equity managers to follow their own prescription, he says—and diversify.

-Kip McDaniel