Invesco has published its sixth Invesco Global Sovereign Asset Management Study, an annual in-depth report on the complex investment behaviour of sovereign wealth funds and central banks, which this year shows that equities have now overtaken bonds to become the lead asset class for sovereigns across active, passive and factor strategies.
The firm writes that this year’s study was conducted face-to-face amongst 126 individual sovereign investors and central bank reserve managers across the globe representing USD17 trillion of assets, of which 62 are central banks (35 in 2017), reflecting their growing status as sovereign investors.
According to the study, average allocation to equities have increased to 33 per cent from 29 per cent in 2017. The increase in equity allocations has been driven by a number of factors, including the equity bull market. On average, equity returns were 8.7 per cent amongst respondents, which significantly supported strong outcomes at portfolio level (9.4 per cent in 2017, up from 4.1 per cent in 2016).
With allocations to equities increasing over the past five years, as a result, nearly half of sovereign investors are now incrementally or materially overweight in equities. Whilst many sovereign investors are content to remain overweight, some are not comfortable with the status quo. More than a third (35 per cent) plan to reduce equity weightings over the medium term, with the intent overall to make small reductions rather than cut significantly.
Of those looking to reduce weightings, many are driven by views that equity valuations are high on both absolute and relative bases, and that markets are at risk of correction, either due to geo-political or economic cycles. Specific issues acting as headwinds to equity markets include macro concerns such as the possibility of a trade war, China, valuations, and inflation.
As allocations to equities increase, this year’s study has revealed there are significant evolutions in approach. Passive management, and to an extent factor investing, have made significant inroads into portfolios. Over the last three years, just under half (45 per cent) of sovereign investors undertook some degree of rotation out of active strategies into passive and factor investing, to the point where less than half of equity portfolios are now actively managed.
This has been strongest amongst sovereign investors in the West, whereas sovereigns based in the Middle East still remain the most committed users of active management, with an average of 65 per cent of portfolios actively managed.
Within equity portfolios, factor investing is gaining prominence, and this looks likely to remain the case in the near future. Over the previous three years, over half (53 per cent) of sovereign investors have increased allocations to factor strategies, with 56 per cent planning to continue increasing over the next three years. Factor investing is gaining prominence in Asia-Pacific as 6 per cent of equity portfolios use this strategy, but overall usage to date still lags the West and Middle East where 14 per cent and 10 per cent of equity portfolios use factor strategies, respectively. While passive management is expected to continue to see adoption, over a third of sovereigns intend to decrease passive allocations either in favour of factor investing or targeted active management approaches.
Alex Millar, Head of EMEA Sovereigns & Head of UK institutional Business at Invesco, says: “Whilst sovereigns remain increasingly committed to equities as a core growth asset, there has been a real shift within these equity portfolios. Although passive strategies have been major beneficiaries, it is far more nuanced than a movement from active to passive; portfolio traffic is actually moving in multiple directions. Looking forward, factor strategies are the clearest winners, with sovereigns seeing factor as a third pillar between traditional active and passive management.”
The study revealed an enormous variation amongst sovereigns when it comes to fees. Typically, a common range is 25-45bps, but respondents cited total expense ratio equivalents which stretched from ~5ps to over 100bps.
As a broad group, over the last 12 months sovereigns have been seeking to reduce expense ratios. Where they have done this the objective has been principally to improve net returns.
“With a more difficult return environment anticipated, sovereigns are becoming more demanding of their asset managers. This is particularly prevalent in public market asset classes. However, in the more specialist end of public markets and in private asset markets, the belief in active management and persistency of superior performance over time is much more widespread,” says Alex Millar.
“We are also seeing amongst traditional sovereigns a strong acceptance of performance fees. The most common view of equitable fees is that a 25-30 per cent share of alpha generated should be paid to asset managers as total base and performance fees.”
Although equities remain at the core of sovereign investors’ portfolios, the average allocation to alternatives has doubled in the past five years, reaching an all-time high of 20 per cent in 2017, as sovereigns increasingly realise a broader set of benefits being introduced to their portfolios. Real estate and private equity remain the most popular asset classes, however infrastructure has recently gained prominence, especially amongst the largest sovereign investors.
Alex Millar says: “Private markets are favoured by many sovereign investors thanks to the long term and illiquid nature of many asset classes within this market. However, putting money to work in private markets has been a consistent challenge for sovereign investors, and as a result many remain underweight. Good opportunities are seen in infrastructure and in private credit, but respondents are seeing fewer attractive opportunities in private equity because of increased competition for assets and bidding up of prices. Over three fifths (61 per cent) of respondents raised concern that private equity is becoming overvalued.”
Despite these concerns, most sovereigns will continue to allocate to private markets, focusing on opportunities in new regions instead of the traditional home bias. Large initiatives, such as the Belt and Road initiative in China, have helped make APAC the most attractive region for infrastructure, with 64 per cent of sovereigns seeing this region as an opportunity. While infrastructure in North America is only seen as attractive for 41 per cent of sovereign investors, there is a potential for re-emergence if the Trump administration implements its mooted infrastructure plan.
Both North America and EMEA are strongly favoured for private credit, with 83 per cent of sovereign investors highlighting these regions as attractive. Non-core EMEA markets are particularly attractive for North American investors as they seek to diversify away from home market assets.
In emerging markets, relaxation of capital controls and improving economic and political stability conditions are creating more opportunities, particularly within private equity and infrastructure.
Alex Millar says: “Our study has once again highlighted how diverse sovereign investors’ investment strategies are and their increasing willingness to think globally in terms of finding the right assets for their portfolios. With sovereign investors seeing particularly strong outcomes over the past year, there is likely to be further evolution over the next 12 months as they become increasingly more sophisticated.”