State Street sees transitions out of EM, US equities

Institutional investors are shifting equity allocations to developed markets other than the US and slashing duration exposure in fixed income, says Ross McLellan, global head of portfolio solutions at State Street in Boston.

His division includes the firm’s agency transition-management business, which in 2010 handled transitions for approximately $500 billion worth of mandates in equities, fixed income and currencies. Those mandates generated turnover in excess of $1 trillion.

That gives the firm a window on general market trends among institutional investors as they make allocation and rebalancing decisions.

For equities, the US is the primary source of funds as investors allocate elsewhere, McLellan says.

Until recently those outflows primarily went to emerging markets, but that stopped at the end of 2010. Now emerging markets are experiencing a net outflow of institutional assets, presumably based on fears that prices have gotten unsustainably high.

The reason for the continued sell-down of US equities is that many US pension funds are mature and need to sell assets to meet their benefit payouts. They have been doing so out of domestic equities, partly because valuations have recovered since the 2009 lows, and because that’s where they are already heavily exposed.

Asian investors, though cash rich and, on balance, adding US equity exposures, are not big enough as a group to compensate for the net selling among US and European investors.

The net recipients of flows are other developed markets, such as Canada, the UK, continental Europe, Japan, Australia, Hong Kong and Singapore.

McLellan also observes the global shift to passive strategies that dominated 2009 and 2010 has abated. Investor behaviour seems to have reverted to normal, with passive reigning supreme in obvious areas such as US large-cap stocks, while active managers for areas such as small-caps are seeing inflows again.

Despite these broad shifts, McLellan says asset strategies among investors are now quite varied. “There is no clear consensus on how to allocate assets following the global financial crisis,” he says. For example, before the crisis, many institutions favoured core/satellite structures to their portfolios. Today there is no such pattern.

This may explain why there is no net pattern between equity and debt allocations: the individual mandates increasing one or the other net out. But within fixed income, he says there is a notable shift to short-duration instruments.

For the past few years, fleeing risk, many liability-driven investors had moved from an average duration of four or five years in credit to long-term government exposures.

However, investors are losing faith in these exposures and are unwilling to lock in a 30-year US Treasury bond at a 4% yield, McLellan says by way of illustration. Expectations of eventual hikes in interest rates make the long end of the yield curve less attractive. Therefore investors are going very short duration, down to averages of only one or two years.

However this does not translate into a current desire for inflation-linked bonds. In the first half of 2010, State Street witnessed a surge of transitions into inflation-linked assets, but the sector has been quiet since.

State Street does not do transitions for alternative assets such as real estate or commodities. But it may be asked to hold onto securities or cash for a short while, as a client restructures its portfolio. Based on that, McLellan says appetite for alternatives is on the rise.

As a whole, Asian investors appear to State Street to exhibit the same behaviour and patterns as peers in North America or Europe. Today the US accounts for just over 50% of State Street’s transition mandates, but McLellan expects this to decline in favour of clients from emerging markets over the next few years.

Within Asia, about half the firm’s business comes from clients in Australia and Japan, and about half from the rest of Asia.