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The Case for Small Caps in a World of Deflation and Disruption

¿Por qué las ‘small caps’ representan mejores oportunidades de inversión en este contexto de mercado? — CC-BY-SA-2.0, FlickrPhoto: Susanne Nilsson. The Case for Small Caps in a World of Deflation and Disruption

Over the last 30 years, the case for investing in small caps has been debated extensively. The long-term statistics certainly suggest that smaller companies do indeed outperform larger ones. There is less agreement on the reasons. According to Schroders, the explanations range from the contention that small caps offer a risk premium in return for lower liquidity, that limited research means any new information has a bigger impact on the shares, and/or that small companies in aggregate tend to grow faster than larger ones.

Whatever the case, even though US small caps have underperformed large by over 10% in the last two years, their outperformance over a longer period is dramatic. So what of the future?

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In truth, the outlook for all investors is murky. Everything from disruptive technology to persistent low growth is making it easier to pick losers than winners. The challenges span the waterfront, from environmental concerns that put a question mark over the future of the carbon-based economy, to advances in artificial intelligence that could undermine the position of over 230 million knowledge workers around the world.

In these circumstances, and contrary to received wisdom, Schroders thinks that more winners may be found amongst the mass of lesser-known and under-researched smaller companies than amongst their larger brethren. With innovation and technological advances moving at an unprecedented pace, companies that are nimble and less burdened
by layers of management may be better equipped to keep up with these changes. In this environment, having a strong brand, a large installed base and a wide distribution network are not necessarily assets anymore. “Instead we are seeing a new generation of winners that are “capital light” and have a strong online presence. As industries evolve in this direction, barriers to entry are reduced and innovations progress faster, creating increasing opportunities for small companies.” They state.

However, periods of disruptive innovation inevitably create losers as well as winners. One classic period was the dot com bubble. During most of this time, the US small
cap index underperformed the large cap index. “However, a very different story emerges when the small cap universe is broken down into sectors. Smaller pharmaceutical, biotechnology and software companies outperformed the US S&P 500 Index of larger companies, whereas traditional industries, such as banking and retailing, lagged behind. This shows how vital it is to be able to actively pick winners when disruption occurs.”

For Schroders, what often handicaps traditional companies when it comes to developing or adopting a disruptive innovation is the fear of cannibalising their existing revenues. In contrast, smaller and newer companies not tied to an established product have more incentive to direct resources to the next disruptive innovation. Medical technology is a good example of this. Historically, incumbent providers of medical equipment, such as video scopes for internal examinations, focused on reusable technology that is high margin, but also expensive. Clearly, these incumbents had little incentive to produce a lower- cost alternative as such a course would have eaten into demand for their existing products. This allowed Ambu, a small cap technology company with fewer existing sales to defend, to launch a single-use alternative which was both cheaper and came with a lower risk of infection. Not surprisingly, this has allowed Ambu to disrupt the existing market and gain market share.

There are, of course, a number of examples of large technology suppliers operating in markets where the “winner takes all”. Here the so-called FANG companies with dominant technology (Facebook, Amazon, Netflix and Google) often use their substantial cash reserves to buy up smaller competitors. For investors in the shares of these publicly-traded small companies, this is clearly good news, even if it may limit their opportunities for making even larger gains.

“Of course, not all small technology companies are publicly quoted. With return prospects low, venture capital financing is popular and often more readily available than other sources of finance (Figure 3). In this environment, innovative companies may remain private long after the development stage, denying investors the chance to piggy-back on rapid growth.” For example, the electric car manufacturer Tesla floated when it was valued at over $2 billion, while the app-based taxi group Uber remains private and is already worth over $60 billion. “However, we would argue that the publicly listed universe of companies still provides ample opportunity to find disrupters. For example, at the end of February, the technology sector accounted for 3.8% of the FTSE SmallCap Index, more than twice the figure for either the FTSE All-Share or the FTSE 100 indices. In the tech-heavy NASDAQ index in the US, about 65% of the constituents by number are valued at $500 million or less.

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Beyond these general characteristics, they identify a number of specific areas where smaller companies enjoy advantages not necessarily shared by their larger rivals:

Unfilled niches
Pricing power
Better balance sheets
Investment impact
Lower profile

“Given the outlook for low economic growth and increasing technological disruption, we believe investors should pay particular attention to small caps. This environment will make life hard for large companies, whereas smaller companies have the opportunity to gain market share and grow faster than the market. At a time of unprecedented technological, social and regulatory change, small companies may be able to operate “below the radar” and dominate niches which are likely to grow in light of these changes. For investors, each investment will need to be evaluated on a company by company basis. They should not rely on the assumption that the small cap premium will operate universally. Being able to sort the wheat from the chaff will be vital to the success of a small cap portfolio.” They conclude.

“We Identify US Duration as The Strongest Source of Risk for The Next Couple of Months”

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“La duración estadounidense es la principal fuente de riesgo para los dos próximos meses en renta fija" — Hervé Hanoune, Head of Fixed Income at Vontobel AM and fund manager of the Vontobel Fund- Bond Global Aggregate. Courtesy photo. "We Identify US Duration as The Strongest Source of Risk for The Next Couple of Months"

Hervé Hanoune, Head of Fixed Income at Vontobel AM and fund manager of the Vontobel Fund- Bond Global Aggregate, explains in this interview with Funds Society where he is looking for the best opportunities in the asset class.

In a low minimum return environment in many debt assets, is there still value?

Yes, of course, from a bond investor’s perspective, the current environment is actually a rather positive one, in particular for spread products. The reason is very simple.We face a landscape with low interest rates and low inflation, combined with slow or even sluggish economic growth. Low inflation will keep rates down and slow growth will keep corporates above water and enable them to meet their coupon payments and roll over their debts. Currently, we retain a positive view on European financials, insurers, utilities and the euro-zone “periphery” – the latter due our expectation that ECB President Mario Draghi will stress his wishes to normalise spread levels within the euroarea. We particularly like legacy tier-1 paper Intesa, BNP, Natixis, NSBC as well as insurers like AXA, Allianz, Groupama and Zurich.

In the current environment, with low rates in spite of they are likely to increase in the US, what do you prefer, duration risk or credit risk?

I actually prefer a global flexible fixed income approach. I don’t believe that investors are well compensated by being exposed to duration. Duration risk is notoriously difficult to manage, particularly in the current environment, where it is exacerbated by the asymmetric nature of the risk caused by low interest rates. With central-bank rates near zero, this danger is self-evident. The increase in duration has the effect of exposing bond portfolios to ever-larger drawdowns. But the good news is the fixed income universe is very large and in addition to traditional strategies there are further strategies that investors should consider, for example, multiplying the opportunity set, and that means investing globally. Investors should diversify by investing across asset classes, investment strategies and time horizons which helps to improve the risk-return profile of their portfolios. Last but not least, investors can also harvest returns by seizing relative-value opportunities.

Does it depend on the geographic area?

I believe that geographical diversification plays a key role. Indeed, investors who broaden their geographical scope from a local or continental one to a global one will be rewarded with a far larger choice of investment opportunities and strategies. I believe diversifying in today’s environment is crucial as bond investors require an approach that is capable of delivering returns, regardless of the direction of interest rates and regardless of market cycles. So opportunities for fixed-income investors will arise as long as they diversify and remain flexible.

Can you comment your positions in credit and public debt in your portfolio?

Our top ten positions are balanced between credit and public debt which reflects our conviction on issuers and sectors. In terms of public debt, we hold long-term UK and Portuguese government bonds. The UK is offering very attractive yields and while the currency would be at risk from a potential Brexit, gilts should prove resilient in the face of a British exit from the EU. Portugal in turn is a big beneficiary from the ECB bond purchase programmeand the market has yet to price this fully. In terms of credit, as outlined above, we like solid carry products, too. For example, we favor solid Italian financial institutions like Intesa Sanpaolo, one of the largest Italian banking groups.

In this context with so many news of central banks, how can they weight on markets and how do you manage it in your portfolio?

Our investment proposition is well prepared to handle these challenges. We only invest in areas where we see value. Therefore, we are able to avoid investments that we consider too expensive following the ECB bond purchases, e.g. German government bonds. In other areas, such as the euro zoneperiphery, we see the ECB action as supportive for our investments in carry products. As announced in April, the ECB is happy for now with their measures including extended bond purchases. With regards to the Fed, we only expect 1-2 additional rate hikes for this year, but this expectation is not set in stone. We have seen that the Fed is in a really dovish mode and has somewhat changed their typical behavior, so we need to act with some flexibility here.

Which are the major risks in this environment?

We believe that the strongest risks are now tied to capital preservation trades, which could sharply deteriorate when market normalize. We identify US duration as the strongest source of risk for the next couple of months.The need to be flexible/tactical is even more important now than at the beginning of the year. Our central scenario of sluggish but positive global growth, with very low inflation pressure, continues to be the one signalled by the economic data released so far. Especially in Europe and Japan, an investment landscape with zero or negative interest rates can prevail for still some time. We continue to believe that there are many opportunities present right now as the low liquidity and market stress creates many inefficiencies.

Regarding valuations, are the pricing a recession?

We clearly saw the credit market at recessionary type of valuations in January and February, but the recovery since then has led to more normal levels. We consider the general credit market fairly valued but pockets of value still exist.

Are there bubbles in some segments?

If you see the level at where German government bonds are trading, one can conclude that some government bond markets might be in bubble territory.

In Europe, you see value in peripheral debt, as Spain, Italy or Portugal. Why?

Yes, as mentioned before, peripherals are attractive, mainly Portugal and Italy, as their fundamentals are improving and they are supported by the ECB. There is an ongoing mutualisation of European debt, which is not priced in yet by the market.

Are you concerned about political risk in markets like Spain? How can it affect?

In the context of the current political trend where the electorate moves away from the established parties, this could have a negative effect. But as you could see it in Portugal, the market pays more attention to the ECB actions than to the national politics.

Currencies and sharp moves in markets like China or US are key issues now.

We remain short on various Asian currencies and will continue to actively manage our exposure to this theme when prices change. We also believe that the oil prices have stopped to correct and that producers will recover in the next few months with emerging-market oil-producing economies likely to outperform importers. As a consequence, we are long on the Russian rouble, and short on the Turkish lira.

We certainly have an element of competitive devaluation and the US took the main burden in 2015 by appreciating strongly. The US has made clear to the Chinese that they are not willing to accept a further appreciation at their expense and so the Chinese have turned to the Japanese Yen. Given that scenario, we can expect some indications that the BoJ will devalue their currency again.

Which sectors do you like?

We retain a positive view on European financials and insurers. In addition, we like utilities, industrials and peripherals. In summary, exposure to credit is defined from a top-down perspective. However, the sector and issuer exposure is constructed through a detailed bottom-up approach supported by our experienced credit analysts. As with all other asset classes within the permitted investment universe, the value of credit is continually assessed relative to other asset classes.

Geographically, how is positioned your portfolio?

Our top 5 country weightings are the UK, France, Portugal, Italy and Germany.

It is time to enter in emerging countries? What do you think about Latin America?

We remain cautious on emerging markets, particularly on local currencies. As mentioned above, oil prices have stabilized which will help producers to recover in the next months. However, we are still very selective in emerging market hard currency sovereigns. In Latin America, we therefore consider countries such Mexico and Colombia attractive.

This is the personal opinion of the author and does not necessarily reflect the opinion of Vontobel Asset Management.

“What Many Investors Do Not Realize Is That Most Hedge Funds Have A Positive Correlation with Equity Markets”

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“Muchos inversores no se dan cuenta de que la mayoría de hedge funds tienen una correlación positiva con el mercado" — CC-BY-SA-2.0, FlickrGuillaume Jamet, fund manager of the Lyxor Epsilon Global Trend Fund. Courtesy photo. "What Many Investors Do Not Realize Is That Most Hedge Funds Have A Positive Correlation with Equity Markets"

Guillaume Jamet, manager of the Lyxor Epsilon Global Trend Fund, explains in this interview with Funds Society why CTAs are an interesting option for investors in the current environment.

Taking into Account the current market situation, which are, in your opinion, the reasons why Alternative UCITS are becoming so popular?

In the current market environment traditional asset classes offer few entry points. Due to (ultra) low interest rates fixed income offers an unattractive risk / reward profile: carry is low and it seems unlikely that rates will decrease even further. Equities suffer from relatively high valuations across the board and from weak global growth trends, particularly in the US. In such an environment it is logical that investors turn to alternatives.

We see that in Europe alternative UCITS are doing very well. A broad set of alternative strategies has become eligible for UCITS wrappers since the UCITS III introduction in 2003. However, the credit crisis of 2008 has been a real turning point: since then regulators are actively stimulating the usage of UCITS legal vehicles, rather than offshore constructions. Investors appreciate the protective elements of the UCITS framework, such as concentration limits.

Which are the most demanded strategies? Are CTAs among them?

Morningstar data shows us that the top 4 collecting strategies in April 2016 are, in decreasing order of collect: Multistrategy, Market neutral-equity, Long-short equity UK and CTAs. The strategy has gained in popularity relative to 2015, where CTAs were “only” the 6^th largest collector. Due to the straightforwardness of their investment process and their ability to have a managed volatility, CTAs appeal to all investor types. Our own investor base includes amongst others banks, family offices, pension funds and distributors.

Which is the main advantage of including a CTA in a portfolio? Performance, diversification… and why?

Both performance and diversification. Performance of CTAs has historically been strong. The SG Trend Index, a performance indicator for the trend-following strategy sector, generated 6.5% annually since inception in 2000, clearly outperforming equities and bonds. CTAs offer true diversification opportunities to investors. Firstly, the strategy is intrinsically diversified: as it focuses on price data, all asset classes and markets can be reached in a single portfolio. Secondly, correlation between CTAs and traditional asset classes is low or even negative. Consequently, adding a CTA to an investment portfolio with traditional investments can significantly improve the portfolio’s risk/return characteristics. Thirdly, CTAs tend to do particularly well in periods of crisis as many asset classes show clear trends. Thanks to this “crisis alpha” ”, CTAs offer diversification when investors need it most. As an example: Epsilon Managed Futures generated 38% during the credit crisis, whereas the MSCI World Index plunged by 59%.

Their truly de-correlating characteristics make CTAs stand-out from many other alternative strategies. What many investors do not realize is that most hedge funds have a positive correlation with equity markets. E.g., the HFRI Fund weighted index, an indicator of general hedge fund performance, has a correlation of 0,74 with the MSCI World Index calculated over the period 1991 – 2015. Many strategy-specific hedge fund indices, such as the HFRI Equity Hedge (equity long / short), HFRI Event Driven and HFRI Relative value (fixed income long / short) also have a correlation of more than 0,5 with the MSCI World Index over the same period.

Which are the characteristic of your fund you would highlight over competitors?

First of all our track record. The Epsilon program was launched in 1994. Since then we continuously invested into research and development of the model, systems and infrastructure. Epsilon Managed Futures, one of our two flag ship funds, has an annual performance of 8,0% since inception in 1997. Secondly, our investment approach. We are a true trend follower, without any discretionary portfolio manager intervention. Many other CTAs apply an amalgam of techniques, making them opaque to investors. In our peer group of CTAs we are amongst those which have the lowest correlation with both the SG Trend Index. Thirdly, our diversification model. Many CTAs diversify equally over markets. Our proprietary research shows that this can lead to sub-optimal outcomes as many markets are correlated.

Which are the main risks the CTA strategies front nowadays?

Frankly, I don’t see any major risks. What is important for investors to realize is that CTAs generate their performance during relatively short periods. Most of the time CTAs generate zero, or even slightly negative performance, while “seeking” trends. During such periods, investors need to hold on to their investments, knowing that performance will be generated once two market conditions have been fulfilled: markets show clear trends and correlations between asset classes are low.

Schroders Enters into Strategic Relationship with Hartford Funds to Accelerate Growth Plans in US

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Schroders alcanza un acuerdo estratégico con Hartford Funds para acelerar sus planes de crecimiento en Estados Unidos — CC-BY-SA-2.0, Flickr. Schroders Enters into Strategic Relationship with Hartford Funds to Accelerate Growth Plans in US

Schroders has entered into a strategic relationship with Hartford Funds, a leading US based asset management company that offers a broad range of actively managed strategies to US financial advisors and their clients.

The relationship will involve Hartford Funds adopting 10 of Schroders’ existing US mutual funds, with potential for the partnership to expand over time. The adopted funds will be advised by Hartford Funds, sub-advised by Schroders, and renamed ‘Hartford Schroders Funds’. The funds, which include equity, fixed income and multi-asset strategies, collectively have $2.2 billion in assets under management.

Peter Harrison, Group Chief Executive at Schroders explained that “Hartford Funds is a high-quality company whose reach and scale makes them an ideal strategic partner for Schroders. The addition of funds sub-advised by Schroders to Hartford Funds’ investment platform will give investors in the US access to our diverse investment management expertise. This relationship will enable us to build scale in our US intermediary business and accelerate our growth plans in the US market.”

“This relationship allows us to expand the breadth of our investment capabilities and continue to deliver quality solutions to US investors, both now and in the future. Schroders’ history of product innovation and disciplined investment processes reflect our belief in differentiated, long-term thinking that helps investors meet their financial goals,” said Jim Davey, President at Hartford Funds.

Hartford Funds has $73.6 billion assets under management and offers more than 45 funds in a variety of styles and asset classes.

The fund adoptions are expected to be complete by the end of the third quarter of 2016, subject to shareholder approval.

Global Equity Income: Value Opportunities Emerging

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In this video update, Alex Crooke, Head of Global Equity Income at Henderson, reveals where his team are finding the best opportunities for equity income and capital growth. He also explains the long-term regional and sector findings from the Henderson Global Dividend Index, a research report into global dividend trends.

Where are the best opportunities?

We are finding interesting opportunities within the financials sector. A number of central banks have started new policies, such as negative interest rates, which have been affecting sentiment and profits in the short term for a number of financial companies. Longer term, we believe this will create value so we are looking to selectively increase our bank exposure in Europe by investing in good-quality recovery companies such as ING, the Dutch multinational banking and financial services company. Insurance is another area that was negatively affected earlier this year but offers the potential for very good dividend growth. The pharmaceuticals sector has been impacted by market rotation this year after a strong 2015 but we believe it remains attractive and recent underperformance is providing an opportunity to invest in quality companies at more attractive valuation levels.

Which are the regional dividend trends?

Key findings from the Henderson Global Dividend Index (HGDI) reveal that Japan and North America have exhibited the best dividend growth during the last two years. We are also seeing some interesting opportunities arise in Europe, where companies are returning to the dividend payment list, particularly in the financials and consumer-related sectors.

Which are the sector dividend trends?

HGDI shows that the technology sector is continuing to provide good dividend growth. A number of companies are increasing their payout ratios (the proportion of profits paid out as dividends) as well as earnings and profits, which is feeding dividends. Pharmaceuticals and financials were the largest sectors in terms of dividend payments in Q1 16, although growth has been moderating. Consumer-based sectors are demonstrating good dividend growth and we expect this to continue through the rest of the year.

Dividend growth outlook

We are seeing a slower environment for dividend growth overall. This reflects slower economic growth from many countries around the world and the fact that payout ratios have reached higher levels than in previous cycles. With earnings, cashflow and ultimately dividends from commodity-based sectors still under pressure from recent price falls, markets with a high percentage of oil or mining companies, such as the UK and Australia, are experiencing dividend cuts. Despite this, many businesses outside of these sectors are delivering sustainable dividend growth.

Why global equity income?

In the current environment the benefits of a global approach to equity income are based on opportunity and value.

In opportunity terms, we can position the strategy away from difficult areas, such as concerns about growth from China and worries about a potential Brexit vote, while accessing growth in other parts of the world.

In terms of value, we are still finding some very good opportunities, with the dividend yield available on equities looking good value relative to bond yields and interest rates. We believe that by maintaining a good-quality bias and searching for opportunities in international markets and sectors we are able to provide an attractive long-term strategy for investors.

“In Markets, We Can Be More Confident That “Bad Will Be Bad” and “Good Will Be Good” When It Comes to News or Data”

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"En los mercados, podemos confiar más en que “lo malo será malo” y lo “bueno será bueno”, a diferencia del pasado" — CC-BY-SA-2.0, FlickrAndrea Mossetto, Investment Specialist of Parvest Diversified Dynamic Fund (BNP Paribas IP). Courtesy photo.. "In Markets, We Can Be More Confident That “Bad Will Be Bad” and “Good Will Be Good” When It Comes to News or Data”

Andrea Mossetto, Investment Specialist of Parvest Diversified Dynamic Fund (BNP Paribas IP), explains in this interview with Funds Society the secret of this strategy and the importance of flexibility in the current environment, as well as where the best opportunities.

According to the PDD dynamic multi asset strategy, which asset class do you currently think has more value?

In current financial markets, characterised by a declining influence of external stimulus, we can be more confident that “bad will be bad” and “good will be good” when it comes to news or data. This is a welcome development seeing how in the past “bad appeared good” given the uncertain environment brought about by central banks’ unconventional monetary policy.

In a “winner takes all” market, at first glance, performance will be the only parameter that investors take note of, with no distinction between the thousands of management styles populating this type of multi-asset investments still sustained by strong inflows across Europe.

Since the end of 2014, we at THEAM believe asset allocation flexibility has become paramount to limit drawdowns and turn market challenges into opportunities. Investment performance can come from the asset manager’s ability to efficiently capture market risk premiums. To accomplish this, six years ago THEAM built a strategy where the weightings allocated to the various asset classes are not set in stone and there are no guidelines favouring one asset class over another. At no time do these strategies hold just one asset class or focus, say, 60%, of the portfolio exposure on a single investment theme. Instead, funds are always invested in a range of assets and the mix is adjusted according to the realized volatility of each asset held in the portfolio.

Is it the right moment to invest in more risky assets within equities or should we be more cautious?

Our approach can meet the needs of investors who, in an environment that has become structurally more volatile, are looking for a strategy that seeks to provide a stable risk profile without sacrificing the potential return. Our ‘Isovol’ risk-based strategic asset allocation is designed to offer risk stability and exposure reactiveness in bull and bear markets. We are able to align a flexible asset allocation with market dynamics according to the realized volatility of each asset held in the portfolio.

With our approach, investors can still have exposure to asset classes that they perceive as risky, while relying on the fund managers to scrutinize those risks by using a range of monitoring tools and their knowhow. At the same time, they are invested in asset classes that are typically less volatile, less cyclical, etc. and that can act as a counterweight.

As a result of such a multi-pronged strategy, investors can expect the portfolio to be shifted into higher-yielding assets in rising markets to maximize returns, while in a downturn, an adjustment to a more risk-averse portfolio should ensure that losses are minimised. Such an approach should appeal to investors intuitively.

Is it necessary to include other type of asset classes in the portfolio to look for such a decorrelation and reach a truly diversified portfolio?

On top of the Risk-based Strategic Asset Allocation, our Medium-term opportunistic ‘diversification assets’ aim to contextualize the portfolio within a dynamically changing world. The aim of such opportunistic trades could be to hedge the portfolio against a growth slowdown, e.g. in China (by being long Australian 10-year government bond), and an unstable market environment (by being long gold). Being long the US dollar index should allow the strategy to benefit from gains in the dollar against G4 currencies.

Tactically, the fund manager may put in place hedging strategies to manage the market inflection points he identifies, even before a rebalancing signal has been activated.

Will investors’ demand for balanced funds continue to grow?

Flexible multi-asset funds can be a good way for investors to diversify their portfolio investments. Current economic conditions, with still low interest rates, a hesitant global economic recovery and geopolitics-related risk aversion, have reinforced the perception of many investors that their usual investments can no longer ensure the looked-for returns. In many financial markets, the heightened degree of uncertainty and the potential for volatility spikes remain a challenge.

We believe such a transparent approach helps investors understand the reasons for changes in the asset allocation and the risks they could incur. The EUR 2.3 bln AUMs progression we experienced since beginning 2014 is the investors answer to this these funds, well-suited for this environment, willing to invest over medium-term horizon.

What is the fund’s investment philosophy?

A key objective and benefit of this approach is to minimize losses in a downturn and maximize returns when markets are rising. By combining the strengths of our asset managers and calculation models, the strategy has outperformed the market peer group since the end of 2009. It is simple and intuitive on top of being well suited for client searching for a transparent and straightforward approach to be exposed to financial markets.

Investor Demand For Real Assets Will Surge By 2020

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La demanda de activos reales crecerá un 50% antes de 2020 — CC-BY-SA-2.0, FlickrPhoto: OnCall team. Investor Demand For Real Assets Will Surge By 2020

Private equity, real estate and infrastructure managers anticipate strong growth in assets in the next five years, according to new research Building for the future: How alternative investment managers are rising the demographic challenge from BNY Mellon, prepared in collaboration with Preqin. the study surveyed 340 private equity, real estate and infrastructure fund managers globally.

Global macro-economic, social and environmental shifts are fuelling a need for investments in real assets, property and infrastructure worldwide. The report forecasts that appetite for these assets among retail and institutional investors will continue to grow. Sixty percent of infrastructure managers, 44% of real estate managers and 39% of private equity managers surveyed expect their assets under management to grow by at least 50% in the next five years.

“Deep-rooted demographic and macro forces are driving an unprecedented need for investment in real assets such as transport facilities, communications networks, housing and hospitals. These demands far outstrip the reach of government and public finances, and this creates huge opportunities for private capital to play a part in people’s everyday lives,” said Alan Flanagan, global head of Private Equity and Real Estate Fund Services at BNY Mellon.

While institutional investors, most notably pension funds and family offices, currently demonstrate the biggest appetite for real investments, almost half of the private equity and real estate fund managers surveyed believe that retail investors will account for a higher level of capital inflows by 2020 than they do today. Investment will come from mass affluent and high net worth individuals in developing markets, the continued expansion of sovereign wealth funds, and increasing numbers of defined contribution schemes.

“Investors are turning more and more to real assets to find yield, diversify their portfolios, and steer through volatile markets,” said Flanagan. “The growth in real asset investments has been impressive and there is no sign of it slowing down. As a result, the marketplace has become increasingly competitive on deal sourcing, presenting challenges for managers to successfully deploy the capital they have raised.”

The majority of alternative investment managers surveyed have seen institutional investor appetite for real assets climb over the last 12 months. A third of real estate and 41% of infrastructure managers are seeing the most demand coming from public pension funds, followed by private sector pension funds. Private equity managers see the greatest interest coming from family offices, followed by public pension funds (26% and 25% respectively). The survey also revealed that more than a third of infrastructure and real estate fund managers had altered their investment approach, either by diversifying their assets or exploring different geographies and niche strategies.

The need for transparency, driven by clients and regulators, is prompting a growing number of managers to consider outsourcing certain functions. Overall, two-thirds of fund managers across all asset classes feel regulation might lead to outsourcing in the future. Cost was the most commonly stated reason to outsource, in addition to having access to enriched data and analytics from an outsourcing provider and access to the expertise of external staff.

“Investment managers’ business models must have flexibility to thrive in such a fast-evolving environment and also be able to meet growing regulatory reporting as well as institutional investor demands for transparency,” added Flanagan. “To maintain strong allocations and achieve sustainable growth, it’s vital that managers of assets are invested in their infrastructure and supported by the right operating models.”

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Air Of Mystery

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La Fed ha perdido el misterio — CC-BY-SA-2.0, FlickrPhoto: Tim Evanson. Air Of Mystery

In courtship, it is often advisable to cultivate an air of mystery. Reveal everything (figuratively) to a potential suitor, and you are no longer in control of the conversation. The Federal Reserve long ago abandoned their own air of mystery, and decided to reveal everything to the market by publishing their rate projections. But the only problem is that the market does not believe the Fed’s “dot plots”. The Fed insist they are likely to hike rates several times, but the market found that as believable as a blind date claiming they are actually a secret agent.

In an effort to rekindle the romantic mystique, the Fed has been trying to generate a bit more uncertainty. First the minutes to the last meeting stressed that June was a ‘live’ meeting. So, despite the market’s scepticism, the Fed would likely vote on whether to hike rates next month. Then Bill Dudley, the influential President of the Federal Reserve Bank of New York, commented that the market was now more appropriately pricing in the probability of a June rate hike. Before the minutes the market had only priced in a 4% chance of a rate hike in June; that has jumped to almost 30% (Chart 1). And the probability of two rate hikes this year doubled from about 30% to 60%.

The pricing of rate hikes has been on a bit of a roller-coaster ride. When fears for the US economy were at their peak back in February, the market decided rates were on hold. Then right before the March meeting the probabilities rose once more, only to plummet again when Fed Chair Janet Yellen came across as more dovish. Despite the improvement in the probability of a June rate hike, the likelihood is still priced below where it was in March.

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And it is not just this year’s rate hikes. The market has even less faith in the Fed further out. The path of rates set out by the fifth most dovish dot in the dot plots (which is probably closest to Chair Yellen) still implies yield curves well above the actual market yield curve. The disconnect can be divided into beliefs about the speed of rate hikes, and also the terminal rate at which yields peak (see Economist Insights, On the Dot, for more details). This divergence widened significantly compared to last year, despite the most recent rise in bond yields (chart 2).

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Last year, the divergence between the Fed and the 3y US Treasury (UST) was all about the timing of hikes. But this year yields moved so low that the difference between the two is increasingly driven by divergences in the long-run rate (the rate at which interest rates get close to their natural rate). The divergence in the 10y UST demonstrates that the market is as doubtful as ever about the Fed’s timing of rate hikes, but even more doubtful about where rates will peak.

Trendy

The market is telling the Fed that growth is going to be lower and that inflation is not going to warrant rate increases. Some commentators argue that rates should stay low for longer because trend growth is lower. Unfortunately, this does not make any sense from the Fed’s view of how monetary policy works

If you believe that trend growth is now lower, then economic theory will tell you that you will need to hike sooner but the rate hiking cycle will stop at a lower rate than in the past. This is because a lower growth in trend, or potential, output means that the gap with actual output is smaller. The smaller this output gap is, the more likely that you will get inflation. But in any case the Fed’s objective is not actually high growth. The Fed’s dual mandate is maximum employment and stable price. So the metric for the the Fed is how tight the labour market is. The logic is similar to the output gap: what is the difference between the current unemployment rate and the neutral rate.

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The Fed is kind enough to tell us what their estimate of the neutral rate is, so we can get an idea of their forecast for the unemployment gap. Every year the Fed has been forecasting that the unemployment gap was gradually closing, and it is one indicator where they have routinely been too pessimistic rather than optimistic (chart 3). They forecast the gap to have closed in 2015 and moved into being outright tight from 2016.

When the unemployment gap closes, the Fed expects wages to start rising and inflation pressures to rise. Economic theory also tells us that when the gap is closed interest rates should not be loose – they should be neutral. The Fed’s median estimate of the neutral rate is 3.25%. The current rate is just 0.375%.

Not every Fed member would agree with this logic. Chair Yellen herself has in the past talk about ‘optimal control’, the idea that you might want to keep monetary policy looser than you normally would but hike faster later on to compensate (and possibly hike beyond neutral). But nonetheless the

Fed was rightly concerned that the market had completely disregarded the possibility of rate hikes. If markets were not even entertaining the possibility of hikes, there could be a lot of disruption if the Fed surprises them.

Then again, if the Fed really wants to change market behaviour, maybe they should have just surprised them. After all, an air of mystery loses a lot of its impact if you go around telling people that you have an air of mystery.

Joshua McCallum is Head of Fixed Income Economics UBS Asset Management.

Do You Need Inflation Protection?

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¿Es necesario tener protección contra la inflación en las carteras? — CC-BY-SA-2.0, FlickrPhoto: Atli Hardarson. Do You Need Inflation Protection?

“We believe inflation risks are underappreciated and underpriced. Now may be an opportune time for forward-thinking investors to add inflation risk management to their portfolios,” says Stewart Taylor, Diversified Fixed Income Portfolio Manager at Eaton Vance on the company’s blog.

According to Taylor, it’s easy to understand the lack of investor demand for this asset class. The CITI Inflation Surprise Index has been negative 52 of the last 53 months. With the exception of the financial crisis, year-over-year (YOY) headline CPI has been lower than at any point since the late 1960s.

“What many investors don’t appreciate is how persistent weakness in energy and food prices has hidden the underlying growth in services inflation. While energy and food represent only 21% of the CPI, they explain about 80% of its change,” he says while highlighting:

Spot WTI crude is down 55% from June 2014, while the S&P Goldman Sachs Food Index is down roughly 50% from its 2011 high.
Over this same period, the YOY run rate for services inflation has averaged 2.5% and has climbed above 3% over the past few months.

Because of this, Eaton Vance believes that the bear market in food is over and that the energy bear market is either over or in its very late stages. “Strength in energy and food should quickly translate to higher goods CPI, which, in turn, should help boost the already elevated services CPI. There is also evidence of increasing wage pressures. The 3.4% YOY growth in the Atlanta Fed Wage Growth Tracker in April is the strongest growth since February 2009. Historically, wage pressures have been associated with periods of higher inflation” Taylor writes.

The April CPI highlighted the changing inflation dynamic: The month-over-month change in headline CPI (0.4%) was the biggest monthly gain since February 2013. Also, at 2.1%, YOY Core CPI is now above the Fed’s 2% target; at 1.6%, YOY Core Personal Consumption Expenditures (PCE) (the Fed’s desired metric) is approaching its 2% target.

The trend in year-over-year Core CPI bottomed in early 2015 and has since been moving higher. Several alternate CPI measures that attempt to remove the most volatile index components to better ascertain the underlying trend also confirm this.

Taylor and his team think that investors are beginning to realize that the bear markets in energy and food are near an end. After roughly a year of outflows, net flows into TIPS funds and ETFs have turned positive over the past two months (ended April 2016), while break-even inflation rates on 5-year TIPS have begun to price in higher expected inflation. “We think these trends are still in their early innings.” And that “inflation assets are inexpensive relative to growing inflation risks.”

AXA to Sell Its Investment, Pensions and Direct Protection Businesses in the UK to Phoenix Group Holdings

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AXA venderá sus negocios de inversiones fuera de plataforma, pensiones y seguros directos en Reino Unido a Phoenix Group Holdings — CC-BY-SA-2.0, Flickr. AXA to Sell Its Investment, Pensions and Direct Protection Businesses in the UK to Phoenix Group Holdings

AXA announced today that it had entered into an agreement with Phoenix Group Holdings to sell its (non-platform) investment and pensions business and its direct protection business (Sunlife) in the UK. Completion of the transaction is subject to customary closing conditions, including the receipt of regulatory approvals, and is expected to occur in the second semester 2016.

The overall consideration for the sale of the UK Life & Savings businesses, including the transaction announced today, the sale of the offshore investment bonds business based in the Isle of Man announced on April 28th, and the sale of the wrap platform Elevate announced on May 4th would amount to ca. GBP 632 million (or ca. Euro 832 million). These transactions would generate an exceptional negative P&L impact of ca. Euro 0.4 billion accounted for in net income.

The operations affected by these transactions will be treated as discontinued operations in AXA’s 2016 consolidated financial statements. As a consequence, their earnings will be accounted for in Net Income until the closing date.