Year of the Monkey review: SOEs, alts, passive vs active

Will China introduce meaningful SOE reform in 2016?

Answer: No

A year ago we expressed cynicism over the idea that Beijing would countenance short-term pain in the form of slower economic growth so it could truly reform China’s bloated, inefficient state-owned enterprises (SOEs).

We were right to do so. China's president, Xi Jinping, has sought to do what’s wise for China in the long term by steering the economy as a whole away from its addiction to exports and infrastructure and towards consumption. But this has had consequences in the form of slower economic growth (which stood at 6.9% in 2015 and 6.7% last year). The country has also increasingly resorted to credit-fuelled spending to support its still-high rate of expansion.

Meanwhile, the renminbi has lost some of its value, driving the People’s Bank of China’s foreign currency reserves to less than $3 trillion for the first time in three years and prompting the government to resort to strict capital controls to prevent a flood of capital from leaving the country.

Set against this backdrop, even Xi was not bold enough to try to instil root and branch reform onto the SOEs, which are full of – and supported by – competing power interests within the Communist Party. Such a move just when the state is in the throes of an anti-corruption campaign could have created a full-on civil war within the authoritarian party’s senior ranks.

However, SOE reform is still a necessary step if China is to improve its productivity and long-term growth prospects. The state companies sit at the centre of many core industries, consuming enormous amounts of resources and capital, yet they are bad at using these resources.

There are signs that change is afoot this year. The US edition of the China Daily, the state newspaper, ran a story on February 7 proclaiming that Beijing would complete ownership reforms at over 100 SOEs this year. The objective of these reforms is to create mixed ownership, which in common language equates to partial privatisation.

As Li Jin, chief researcher of the China Enterprise Research Institute, noted in the story, “the basic approach is going to be more aggressive than last year, but prudent in general.”   

Will active outperform passive net of fees?

Answer: No

The uncertain global economic conditions prevailing at the start of last year would have given active managers some hope that they could demonstrate the value they offered over their cheaper, passively managed rivals.

However, we were sceptical then and we remain sceptical now. Performance indicators consistently show that active managers as a whole fail to beat their benchmarks over multiple years. And while active managers might argue that riding benchmarks downwards in bearish market conditions is foolish, the fact remains they offer no certainty of beating the market, and they’re much more expensive too.

An increasingly large number of institutional and retail investors agree with that sentiment, as seen by almost $200 billion of assets inflows into US fund manager Vanguard, which invented passive funds back in the 1970s. That sum was more than its next 10 competitors. All-told, passive funds took in over $504.8 billion in assets during 2016, according to Morningstar data, as more investors decided actively managed funds charged too much for their services (typically at least 50 to 100 basis points or more, versus often a mere 7bp or so for passive funds), which diminished their dubious claims to being able to outperform benchmark indices.

In keeping with this asset flow, there are few signs that at least half of actively managed funds managed to beat the benchmark. Bank of America Merrill Lynch said only 19% of active funds tracking the large-cap Russell 1,000 index managed to beat it in 2016.

This year offers active managers fresh hope, with a highly pro-business and pro-US economy new president in the form of Donald Trump. Markets have already soared on his promises to deregulate and lower corporate tax rates. Of course, that’s led passive indexes to soar on the back of indexes.

Active managers have a much-improved equity market in the US; now they need to prove they can beat it.

Will multi-asset funds be eclipsed by a new trend?

Answer: No

Multi-asset funds rose to the fore in 2015 as investors sought means to invest money into areas that could benefit no matter what the market weather.

However, the wisdom of this approach came into question as 2016 began over concerns that assets were correlating too much on the back of too much liquidity, courtesy of years of quantitative easing by various countries around the world. And, indeed, the performance figures of multi-asset funds were nothing to write home about, as we discussed last year.

Yet, despite this, we noted that the marketing machines of global asset managers seemed to still be convincing many investors of the merits of these funds, despite the paucity of their returns. And that, we felt, would continue to underpin their success during 2016.

The prediction looked shaky at first, with reports emerging that multi-asset fund inflows in Europe had dropped to their lowest level in four years in December 2015 and that the UK in January had seen its first outflows in years, amid negative multi-asset funds returns. 

It didn’t last long. As heightened uncertainty took hold of global markets amid the Brexit vote and US presidential elections, multi-asset flows began to rise once more, with Lipper noting that there were more multi-asset funds for sale in Europe than bond funds in the second quarter.

Investor sentiment turned once again by the end of 2016 as the election of Trump prompted investors to flood equity funds and reduce their allocations to bond funds, in particular, but also to multi-asset funds.

Multi-asset may have ridden out 2016 relatively well but their appeal could be less certain if the US embarks on a big economic surge this year. If that is the case, it’s likely to be a case of equities, equities, equities. 

Which will be the best-performing alternative asset class on a risk-adjusted basis?

Answer: Private debt

With yields in swathes of the world’s largest bond markets trading at low or even negative yields, institutional investors have had to become more adaptable. Increasingly, that has meant investing more of their capital into alternatives.

The three traditional asset classes in the alternatives space are real estate, private equity, and hedge funds. While the latter has seen an exodus of assets, courtesy of years of poor performance, the former two have enjoyed substantial sums of money from the world’s pension funds, insurers, endowments, and others, as they seek higher yields from longer-term, illiquid investments.

But many investors are keen to keep their hands in the fixed income space, so they have increasingly also looked to private debt.

As we noted last year, private debt combines relatively high risk-adjusted returns with low volatility, a lack of mark-to-market concerns and decent predictability with regards returns and cash flows. That makes it an appealing asset classes for those with the stomach to swallow less liquidity.

Almost two-thirds of the investor respondents to an August 2015 survey by alternative assets data provider Preqin said they planned to commit capital to private debt strategies in 2016, underlining our confidence in the popularity of this asset class.

As the year developed, however, private equity and real estate really shone; the Cambridge Associates US Private Equity Index delivered an 8.54% return for the 12 months to September 30, while various NCREIF real estate indices rose by 9% to 20%. To a degree they were victims of their own success as some institutional investors sold out of some their positions in these areas in order to lock in profits. 

It’s harder to assess exactly how private debt performed in comparison, as by its very nature the asset class is opaque and comprises different forms of investment opportunity, such as unique books of distressed credit or loan portfolios from borrowers. 

But to judge by a Preqin survey of private debt investors in December, many were very pleased with their investments and keen to do more. All-told, 27% of investors felt the asset class exceeded their expectations and 57% intended to increase their private debt allocation this year.