Flight to “Exotic” Fixed Income Funds is a Global Phenomenon (Except for Canada)

(May 8, 2013) — Burned by the poor returns of sovereign bonds, institutional investors are turning to non-traditional debt instruments in the search for diversified incomes, according to new research from Mercer.

The consultant’s latest Manager Search Activity report found investors are now reluctant to add to traditional fixed income holdings, such as sovereign and credit, at the current yield levels, and instead are turning to alternative mandates, including emerging market debt and absolute return funds.

Infrastructure investments are also on the rise, with an increase in searches for direct and listed infrastructure funds highlighted.

Global/international equity remained the most popular search. Interestingly, even though the number of searches in this category declined in 2012, the assets placed increased by almost 30%.

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US Equity was ranked second, followed by emerging markets equity, Canadian equities and global fixed income.

There were notable search variations by region: There was an increase in the number of searches in the UK in 2012, with a distinct move away from developed market equity mandates towards diversified growth and emerging markets (equity and debt) continuing.

The UK also saw an increased interest in alternative strategies utilising private equity. Global/international equity remained popular but there was a clear shift towards fixed income in all forms. A notable surge in interest was seen in non-traditional mandates such as absolute return Fixed income, Mercer said.

In the rest of Europe, searches increased in Spain, Ireland and Switzerland, but were unchanged in Germany, the Nordics and in Holland.

Over the pond in the US, overall searches declined marginally in 2012, but fixed income searches rose. The interest in fixed income occurred in both US and global mandates driven by investors’ desire to seek incremental yield. US fixed core investment grade searches more than doubled in popularity.

World (non-US)/EAFE equity was the most popular asset class followed by emerging market equity.

Terry Dennison, director of consulting for the US, said the shift to fixed income was driven by investors’ desire to restructure their allocations to take advantage of “interesting opportunities”.

“We appear to be in the midst of a secular change with fixed income experiencing an image change from a conservative plain vanilla asset class to one that is more exotic and exciting, offering investors a variety of strategies to increase yield and growth,” he said.

“However, investors must be conscious of the risks of historically low levels of interest rates, narrow credit spreads, and an apparent belief that a resurgence of inflation is years away.”

In Asia, there was a relatively low number of searches undertaken, driven by market uncertainty, among other factors.

Asian clients focused on strategic asset allocation review and manager review rather than manager search activity, Mercer found.

And in both New Zealand and Australia there was an increase in searches for domestic fixed income funds, as well as infrastructure funds and global fixed income. New Zealand also saw a marked increase in manager searches for natural resources.

The only country to buck the fixed income trend was Canada, where search activity analysis saw Canadian Equity remain the most popular category, followed by global/international equity and fund of hedge funds. Unlike the US and Europe, fixed income searches were actually down.

“The increase in Canadian equity searches was primarily driven by manager-specific events, causing investors to consider replacements. This masks the ongoing trend to global equity strategies as investors seek broader investment opportunities,” said David Zanutto, director of consulting for Canada.

“The quest to diversify also led to interest in alternative classes and we expect to see increasing activity in this area. We expect continued interest in more diverse core plus fixed income mandates.

“Apart from liability-matching activity, the overall decline in fixed income searches is likely to persist as investors target equities and real asset alternatives in the face of expected interest rate increases and the potential for higher inflation.”

(May 7, 2013) — Leverage in hedge fund portfolios has hit levels only seen in 2007 – the boom before the bust – the latest weekly report on the sector from Bank of America Merrill Lynch has revealed.

Across the sector, leverage, as measured by NYSE Margin Debt, hit $380 billion last week, the bank said, just $1 billion lower than the high point of 2007. The level is some 28% higher than at this time last year and 3.66% month-on-month. Additionally, cash balances in margin accounts went down to a negative $92.2 million in March – the lowest since 2000, the bank said.

Some of the largest movers were market neutral funds, which increased exposure from 7% to 10%, while equity long/short funds moved slightly up from 40% to 41%.

“Current levels of both net free credits and margin debt indicate extremely bullish sentiment in the equity market,” analysts at the bank said.

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In January, aiCIO reported hedge fund leverage had hit a 52-week high following a report by the prime brokerage unit of JP Morgan. This spike came in tandem with an uptick in performance.

Last month, derivatives brokers told the US Federal Reserve that their hedge fund clients were displaying a greater desire for risk and leverage.

Half of all respondents to a poll by the Fed reported that of their closest managers, risk pursuit had “increased somewhat” over the first quarter of the year. The remainder had stayed consistent, except for 4.5% which had “decreased somewhat,” the report said.

In a low interest rate/yield environment, investors have been seeking new ways to bring in returns.

Leverage has been generally increasing after a mass sell-off following the crash after the collapse of Lehman Brothers, and if recent upticks continue, could breach pre-crisis records.