To understand the shape of the fund universe in Europe, you must think back to 2008, when an enormous amount of money ended up being held as cash.
“Even in an environment where rates may go up, the expectation is that they won’t go up dramatically in Europe. That’s certainly the consensus of our boutique fund management firms,” says Hilary Lopez, BNY Mellon Investment Management’s head of intermediary distribution, Europe.
“In that environment you’re not getting anything from cash.”
One of the reasons behind the recent good fortune for fund management groups has been the slow unwinding of that position into other asset classes.
“For example, in Spain and Italy, we continue to see strong demand for low-volatility absolute return strategies as an alternative to cash,” she says. “The Spanish market by itself has driven quite a lot of growth. Around €700bn plus of assets has moved from deposits into funds over the past five years.”
That trend is playing out across the whole of Europe. During the past few years, billions of assets have flooded into absolute return and alternative funds, and the hedge fund industry has been reborn as a wholesale-friendly option.
That is the long-term reality but, in recent months, there has been a sharp downturn in assets moving into these products. While it is not great news for someone like Lopez who has a substantial portfolio of alternative funds, she doesn’t believe this is the start of a reversal of these flows.
“That slowing down of demand is not so much an asset allocation decision but due to concerns around delivery from some funds,” she explains. “I think that has had the bigger impact on flows. You need to deliver against your objective.”
Some high-profile funds have run into problems in the past few months, and across the alternative space there is huge concentration that has affected a high proportion of investors. However, Lopez thinks it is quite fund specific and she is bullish in general because the drivers from fund buyers remain the same.
“One of the key questions fund buyers are trying to answer right now is how they allocate in their conservative portfolios. Solutions such as unconstrained flexible strategies that are delivering will continue to see asset flows.”
But it’s not just unconstrained and absolute return bond funds that have had problems, and Lopez attributes this to how well the traditional asset classes have been doing in the past year, particularly equities.
When uncomplicated, simple asset classes are having bull runs, the more complex strategies always look like more trouble than they are worth.
Lopez believes investors will start to pay more attention to periods when the markets have been hit hard and take that into account when selecting funds.
“Look at the relative performance of the absolute return sector in 2008. Our Real Return strategy performed substantially better than strategies in the long-only sector.”
It is key that fund buyers are asking what a fund is trying to do rather than simply looking at returns.
“Some of the strategies we run in the alternative Ucits space promise non-correlation or capital preservation, particularly in the low-volatility absolute return segment,” she says.
“For example, one of our strongest flows today is into an equity-market-neutral strategy, although I think that is a reflection of increasing investor nervousness about where we are in the market cycle.”
There has definitely been a more cautious approach from fund buyers this year. “The reality is that valuations are generally high across equity markets,” she says. “So equity fund selectors are wondering how far markets can go. On top of that, there’s more nervousness around trade wars and, in the UK, Brexit is weighing on both investor and general business confidence.”
There have been other significant shifts in buyer behaviour this year. First, there was a slight move away from geographical funds towards global thematic strategies.
“Global equity growth on a pan-European level has been where we’ve seen the most significant asset flows. There’s been a shift out of using regional building blocks.”
Five years ago, Lopez would not have thought global thematic funds would get a lot of traction; now they are seen as compelling stories by fund buyers. Not that themed funds would replace the bulk of traditional assets, however.
“With thematics, you’ve got investors with core portfolios that have a mix of bonds, equities and some alternatives,” she says.
“They see thematics as a kind of satellite to that allocation. And I think the reason why it captures the imagination is that often the thematic strategies support their values.
Lopez also notes significant demand for illiquid strategies. BNY Mellon has a couple of boutiques in that space, notably Alcentra, which is a sub-investment-grade specialist with a successful private debt strategy.
European private debt has been taking a lot of money, although mostly in the institutional and family office space.
“One of the problems in the wholesale intermediary market is that the liquidity profile of private debt and private equity is such that they can’t access it. We’ve seen significant demand in institutional and in the larger intermediary end of the marketplace.
“Where fund buyers are able to allocate a proportion of their clients into illiquid strategies then, of course, they’re looking to do so,” she says.
“It’s a rational decision by those firms because we know that yields and returns in the traditional asset classes have been historically lower. And to achieve that yield and high return potential often requires you giving up some liquidity.”
“However, we know the vast majority of the European intermediate market still buys Ucits funds,” she points out.
The key challenge for asset managers is to provide some of these strategies within a Ucits wrapper and liquidity profile, and Lopez is open about her desire to grow in this area. “We have the potential to launch strategies in that space,” she says. “We’ve seen a few asset managers move into the area and be very successful.
“I expect demand from intermediary clients for exposure to some of those asset classes, whether it’s infrastructure or part of the fixed income market that they typically wouldn’t access in a Ucits fund. This is an area asset managers will continue to focus on as they try to build a fund that can work within a Ucits liquidity profile.”
So, what will Lopez do next? “We’re adding to our alternative Ucits strategies,” she says. “We think we’re going into the right market cycle. We’ve already got a strong footprint and we want to reinforce that over the next 12 to 24 months.”
She believes there will continue to be significant support for alternative fixed income strategies in the next three to five years.
And, unsurprisingly, she plans to launch more themed funds. “I don’t think interest in that is cyclical; it’s a long-term trend.”
And what of ESG? “If I was starting a business today, I’d be launching ESG funds, of course. But I would also be building ESG into the core investment process,” she says.
“ESG has a very high profile globally and is clearly having an impact on the industry, which has moved from negative screening in the early days, to engagement and then integration into the investment process.”
According to Lopez, the biggest demand for ESG is coming from the markets of the Netherlands, Nordics and France. “I saw one stat that said something like 75% of French institutional mandates now have ESG principles embedded in them.”
At the moment, the opportunity lies mainly in the institutional channels, and mostly in northern Europe. However, Lopez thinks it will be the millennials and the generation Z-ers that drive ESG into the intermediary markets, because they are demonstrating, as a population, that they care about ESG concerns.
“There was a similar buzz around the alternative Ucits market in ’08, when they were fairly new. But there wasn’t substantial breadth in all the major asset classes.”
That made it difficult for a fund selector because it seriously limited how they could allocate. They ended up having to put all alternative funds into an alternative-specific bucket, obstructing the integration of these funds into the mainstream.
ESG currently is dominated by thematic funds and global equity ESG funds. There is not a deep pool of options covering all the mainstream, portfolio construction necessities and that limits its use by fund buyers.
To overcome this hurdle the industry must mature, covering more strategies and creating solutions designed to replace bigger chunks of mainstream portfolios. That will both allow ESG investing to grow substantially and also it will help it become less concentrated in a small number of players.
If that happens, then no matter how the investment fashions change, we should see a sustainable future for ESG.