Despite global equities having risen by nearly 70 per cent since the market low of March 2003, concerns about monetary tightening in the US and the eurozone coupled with a slowdown in corporate earnings growth have dampened optimism. Fund managers also forecast a convergence of performance in global markets in 2006.
With little likely to separate global equity markets, Fidelity International says stock pickers face a stern test to achieve outperformance. The winners will be those with the freedom to stock pick outside indices or increase relative bets.
In particular, Fidelity believes the most promising stock-picking opportunities lie in Eastern Europe where a predicted rise in GDP of 5.3 per cent compares well with the 1.9 per cent anticipated in the European Union.
Forecasting only single digit growth in the UK and European equity markets, Aberdeen Asset Management favours global emerging markets and Asia on the strength of lower company valuations and higher growth potential.
Merrill Lynch Investment Managers (MLIM) also counsels investors to look east, but favours Japan where it says current strong performance is being driven by overseas investors buying Japanese equities. Buoyed by rising real estate values, MLIM expects the country’s economic recovery to continue.
China is cited as another good investment opportunity, although the commodity bull market is expected to mature as Chinese demand slows.
Also bullish on Japan is Baring Asset Management, which points out that although corporate profits have risen to their highest level in 15 years, they still remain structurally lower than the rest of the world, so creating further upside potential.
Newton Investment Management expects earnings growth of 10-12 per cent in Asia in 2006, with dividends and currency gains also accounting for a large share of total returns.
Baring sounds a warning about the US corporate bond market where downgrades are picking up. Percival Stanion, head of asset allocation, says that if downgrades continue to rise, the impact on corporate bond pricing given the narrow level of credit spreads could be significant.
But Invesco Perpetual notes that the continuing structural shift by institutional investors from equities to fixed income means that bond market returns will be highly dependent on coupon income with little capital gain potential.
Clear thinking on hedge funds
So what investment strategies will institutions be adopting in 2006? For a start, the trends witnessed in 2005 should gather momentum. Expect to see increasing demand for liability-led investing (LDI), tactical asset allocation, portable alpha and enhanced indexing.
More UK pension funds are likely to follow the example of the pension schemes of asset manager, Schroders and British retailer WH Smith, in slashing their equity exposure in favour of liability-led investments and alternative assets. A survey of trustees by MLIM and Engaged Investor magazine found that 65 per cent of respondents were aware of LDI and are planning to implement such a strategy. Low performance dispersion in equity markets and the need to control risk are likely to hasten this move.
The desire for portfolio diversification and a search for outperformance should continue to drive demand for hedge funds, private equity and property.
Of the three asset classes, hedge fund returns have not lived up to the high expectations of many institutional investors. Although certain strategies, such as CTA global, equity market-neutral and long/short equity, performed well in 2005, funds of hedge funds (FoHFs), the vehicle of choice for most first-time investors, produced disappointing returns.
A lack of transparency and high fees are major stumbling blocks for a large percentage of non-users of hedge funds.
However, this is changing somewhat. Fee pressure on FoHFs where inflows have been declining led to the launch of the first performance-only FoHFs in 2005. But Cerulli Associates found that top-performing single hedge fund managers can still command annual management charges of 4 per cent, in addition to a 40 per cent performance levy.
The speed of hedge fund growth in 2006 will depend on the industry’s ability to educate investors and allay their fears about lack of regulation and transparency, poor performance and the odd headline-grabbing hedge fund collapse.
Also, notwithstanding the findings about institutional interest in LDI, it is quite likely that many of these investors will need to be properly informed about use of derivative instruments that such strategies are based on.
The MLIM/Engaged Investor magazine survey found that 88 per cent of trustees planned to attend training courses in 2006. A good start.
Henry Smith, editor,
Henry.Smith@FT.com
