With proper governance, Mercer suggests the ideal approach to creating value is to both establish an internal process to evaluate and capture market opportunities and to give external managers more flexibility. Anthony Brown, Mercer’s US director of strategic research, writes.
Volatility has returned to financial markets over the past nine months as global growth prospects have faded, and this has caused monetary authorities to grapple with stimulating growth in the absence of a coordinated fiscal response.
Bouts of volatility will likely be common in the coming years as market participants react and overreact to the uncertain macro environment.
Meanwhile, low or negative interest rates throughout the developed world and high-equity valuations make alpha generation necessary to achieving long-term objectives for many.
One way to add alpha is through a more opportunistic approach to investing – seeking to take advantage of market volatility and dislocations.
Plans can pursue a more opportunistic approach internally: as new investment ideas or opportunities arise, trustees or their delegates can evaluate and act upon them.
When contemplating internal approaches, the word “opportunistic” doesn’t imply, however, that such investments are made on a short-term basis.
Some opportunities might be relatively short-lived, but others will be longer-term in nature.
And while some opportunities will arise in traditional asset classes (for example, investment grade and high yield credit in early 2009), others could arise in previously unexploited areas of the market.
A willingness to accept illiquidity is ideal, as it broadens the opportunity set and allows institutional investors to monetise long time horizons.
One example of an opportunistic play today is European private debt to take advantage of bank deleveraging.
Looking forward, opportunities could emerge in distressed debt as the credit cycle matures, particularly in the US energy sector.
The major roadblock to an internal approach is the governance burden.
It could take anywhere from a few weeks to a few months for a typical trustee group to take an idea through to investment, with many at the longer end of that timescale, and this makes the implementation of an opportunistic investment approach extremely challenging.
One approach to resolving this issue is through the creation of an investment sub-committee that can commit a certain amount of time and resources to evaluating and implementing new ideas.
Investors can also seek external investment managers that invest more opportunistically.
In comparison to an internal approach, this should offer greater flexibility and responsiveness to market conditions and a streamlined implementation of new ideas.
However, the plan gives up a degree of control, and the impact of ideas at the total portfolio level will be constrained by the size of the allocation to the manager.
Giving managers more flexibility through broader investment mandates is one way to increase flexibility.
For example, transitioning from regional equity strategies to global mandates should increase the scope for astute investment managers to add value.
Likewise, moving from a high-yield bond strategy to a multi-asset credit strategy expands the opportunity set to include debt securities across companies’ capital structure, securitised bonds, loans and distressed securities, while in some cases providing the flexibility to hedge.
Taking this a step further, multi-asset strategies usually have the latitude to allocate across asset classes and instruments.
Multi-asset strategies come in a number of flavours.
For this purpose, those that tend to emphasise tactical or dynamic asset allocation and idiosyncratic trade ideas, with a lesser focus on a long-term asset allocation, are most suitable.
Hedge funds are another way to increase opportunism in a portfolio.
The universe includes a disparate collection of investment strategies, but their investment mandates and structures tend to give them far more flexibility than traditional, long-only investments.
Institutions with a material allocation to hedge funds will, therefore, tend to have more opportunistic investing embedded in their portfolio than those without.
Most long/short hedge fund strategies (equity and credit) have variable beta.
Other strategies look to capture cross-asset class opportunities; global macro funds and multi-strategy hedge funds stand out in this regard.
Global macro funds seek to capture cross-asset class opportunities through interest rates, credit, equities and currencies, while multi-strategy hedge funds have the scope to shift capital among hedge fund strategies as the opportunity set changes.
Measuring the success of external strategies can prove challenging, and appropriate benchmarks will vary from one approach to the next.
Investors should assess the impact of changes in asset allocation over time on a net-of-fees basis and ensure that they have a good understanding of the flexibility and complexity inherent in the strategy.
Transparency will clearly be helpful in developing an effective monitoring process.
Perhaps the most important condition for success in opportunistic investing is adopting the right mindset.
With proper governance, Mercer suggests the ideal approach to creating value is to both establish an internal process to evaluate and capture market opportunities and to give external managers more flexibility.
An internal approach is best suited to take advantage of longer-horizon ideas and illiquid opportunities, while investment managers are best positioned to capitalise on short-term dislocations and more granular opportunities.