May 21, 2008
The more money institutions funnel towards an asset class, the better that category seems to perform in the following months. A look at Casey Quirk quarterly product reviews since 2004 shows a potential correlation between increased institutional asset flows and higher performance — the opposite relationship between flows and performance among retail investors.
Experts caution that the relationship between flows and performance depends on many factors, and that there is no conclusive evidence that institutions are correctly predicting which asset classes are set to perform well.
If they are, such a correlation would indicate that global equity and alternative products will continue to outperform this year, while domestic equity will continue its nose dive.
Mercer’s latest Manager Search Trends says global equity and all types of alternatives are at the top of institutions’ shopping lists. Searches for alternative managers around the world increased about 20% last year. And while assets placed in global equity dropped nearly $10 billion to $19.5 billion last year, it was still the most popular search category among Mercer clients. The firm also names hedge funds and real estate as top institutional searches.
A recent Callan Associates paper reports inflows for global equity, 130/30 products and core-plus bonds in 2007 and outflows across the board elsewhere.
Steve Deutsch, director of separate accounts at Morningstar, says such findings indicate how well each of those asset classes is likely to perform in the coming quarters.
“It does seem to bear out that in most instances there is some amount of correlation between institutional activity and returns,” he says. “It may be that institutions are enforcing events more than leading them, but certainly in most cases there does seem to be some indication that most institutions correctly anticipated how trends would play out in 2006 and 2007.”
One of the most notable examples of this, he says, is the outflow from traditional asset classes, especially U.S. equity products.
Casey Quirk’s 2005 year-end product review reported $32 billion in institutional asset outflows from U.S. equity — the tenth consecutive quarter of outflows. The next year, returns for all styles of domestic equity sharply declined. The 2006 product review reported more institutional investors had jumped ship and domestic equity returns again dropped in 2007.
Studies published this year predict a continued institutional exit from U.S. equity, possibly signaling the decline in domestic stock returns will also continue.
“There is increasing anticipation that the domestic equity market is not going to return to its glory days of the late 1990s and have that market environment for a long period of time,” Deutsch says. “Most of the anticipation now is applying alternative strategies in the domestic market and looking for that diversification, with commodities and international equities as a counterpoint to what’s happening domestically. Also fixed income might have increased allocation in some portfolios, particularly for the safety factor of government bonds and possibly world bonds.”
But some say a connection between institutional inflows and returns is too tenuous to be conclusive. Northern Trust senior investment consultant Steven Pines says flows in some cases necessarily fluctuate with the market because institutions must adhere to a set portfolio allocation policy.
Pines says that if an institution’s growth stocks drop because of a down market one year, it will increase flows to that class the next year to rebalance.
An example of that could be emerging market equity. According to Casey Quirk’s product reviews, institutions put $8.3 billion towards emerging market equity in 2004. The following year, median emerging market equity returns were 37.1% at the end of the fourth quarter and investors cut flows to $1.5 billion. In 2006, performance declined. Emerging markets are now expected to see an inflow because investors will have to make slight adjustments to rebalance, Pines says.
“There is a relationship between a declining market and increased flows. But I think still, it’s somewhat coincidental. We know how markets operate. In some cases, we see an upmarket after a downmarket,” he says.
Philip Kim, senior associate at Casey Quirk, says trends among institutional investors could predict which asset classes will do well the next year. But he says it’s just as likely that institutions have recently made good decisions, such as moving away from domestic equity and towards global investments, alternatives and quant-based strategies.
“Institutional investors get hurt just as much as anyone else during uncertain markets,” Kim says. “Are they getting everything right? No. Are they doing certain things right? Yes.”
Morningstar’s Deutsch also warns the connection is not necessarily conclusive.
“I’d say that institutional inflows are certainly an influential factor in performance,” he says. “But I would not say institutions are the great oracles.”