Market Pulse: Equity Views€¦ · Respondents represented corporate, public and Taft-Hartley plans, endowments and foundations, insurance companies, healthcare-related organizations

Executive Summary

Investors appear to be maintaining their faith in equities and have begun to cautiously rebuild equity portfolios.

This report summarizes the results of a survey conducted by J.P. Morgan Asset Management from April 16 to May 5, 2009, in which 324 senior North American institutional investment decision-makers participated.

Respondents represented corporate, public and Taft-Hartley plans, endowments and foundations, insurance companies, healthcare-related organizations and religious and other not-for-profit institutions—the majority of which reported having $1 billion or more in assets under management. We are grateful to these investors for sharing with us their views on and intended responses to what has been one of the most challenging equity markets in decades.

Market Pulse: Equity ViewsSurvey results for J.P. Morgan Asset Management’s latest poll of institutional investors

Despite the ravaging effects of the “Great Recession” on equity markets, overall, investors appear to be maintaining their commitment to the asset class for the long term and have begun to cautiously rebuild their equity holdings. We see this sentiment revealed in:

Allocation targets: • While some investors are “pausing” on rebalancing, on average, 12 month forward targeted alloca-tions are only slightly below original year-end 2008 targets.

Investor preferences: • Overall, investors appear to prefer investment approaches, manager characteristics and strategy types that suggest a desire to go “back to basics.” In other words, they want to own what they know.

Return expectations: • Results are mixed with respect to the near-term outlook for equity returns, with greater consensus around moderately positive returns three to five years out.

While much has been written about massive de-risking, and we do see a more definitive shift away from equities on the part of some investors, our survey finds that for the vast majority, equity remains the largest target allocation.

foR InStItutIonAl uSe only

Partial list of Participants

J.P. Morgan Asset Management wishes to thank all 324 institutional investors who participated in our survey.

The following participating institutions generously agreed to have their names listed in this report.

Note: Inclusion on this list is not an endorsement of any investment advisory services offered by J.P. Morgan Asset Management.

AARP

Air Canada Pension Investments

Air Products & Chemicals, Inc.

Alcon Laboratories, Inc.

Alexander & Baldwin, Inc.

Alliant Techsystems

American Airlines

American Electric Power Company Incorporated

American Family Mutual Insurance Company

Archdiocese of New York

ARINC, Inc

Arlington County Supplemental Retirement System

Army & Air Force Exchange Service

Austin Police Retirement System

Barnes Group Inc.

Baylor College of Medicine

Baystate Health, Inc.

Bloomfield Township

Blue Bell Creameries, Inc. Pension Plan

Blue Cross & Blue Shield of Florida

Blue Cross & Blue Shield of Michigan

Briggs & Stratton Corporation

British Columbia Investment Management Corporation

Cargill

Casey Family Programs

Central Hudson Gas & Electric Corporation

Central Michigan University

Chicago Police Pension Fund

Chicago Policemen’s Annuity & Benefit Fund

Ciba Corporation

City of Baton Rouge Employees’ Retirement System

City of Clearwater

City of Miami Fire & Police Retirement

City of Milwaukee Employees’ Retirement System

Commonfund

Consolidated Edison Company of New York, Inc.

Cooper Tire & Rubber Company

Cummins, Inc.

Dalhousie University

Dun & Bradstreet

E.ON US LLC

Electrolux

Episcopal Diocese of Indianapolis

FedEx Corporation

Fluor Corporation

Fortune Brands

Foundation Western

GE Asset Management

General Board of Pension and Health Benefits of the United Methodist Church

Girl Scouts of the USA

Goodrich Corporation

Goodyear

Granite Hall Partners, Inc.

Guest House, Inc.

Hallmark Cards

ICMA Retirement Corporation

Idaho Endowment Fund Investment Board

Idaho Power Company

IWA-Forest Industry Pension Plan

Jack in the Box

Jules and Paul-Emile Leger Foundation

Kent District Library

Kruger Inc.

Legacy Health System

Lehigh University

Lincoln Heritage Life Insurance

Manhattan & Bronx Surface Transit Operating Authority Pension Plan

Marshall & Ilsley Corporation

MeadWestvaco Corporation

Michelin North America

Monsanto Company

Munson Healthcare

National Integrated Group Pension Plan

NewPage Corporation

Nicor Inc.

Ohio Police & Fire Pension Fund

Ontario Power Generation Corporation

Orange County Employees Retirement System

PacifiCorp

Pearson Inc.

Pennsylvania Power & Light Company

Pension Fund Society of the Bank of Montreal

Peterson Spring

Pompano Beach General Employees Retirement System

PPG Industries

Public School Teachers’ Pension & Retirement Fund of Chicago

Qwest Asset Management Company

Rexam Inc

Rockwell Automation

Rutgers, The State University of New Jersey

SAF-HOLLAND USA INC

San Bernardino County Employees’ Retirement Association

Sanofi-aventis

Shell Oil Company

Smiths Group

Southeastern Advisory Services

Springfield Foundation

State of Hawaii Deferred Compensation Plan

State of Wisconsin Investment Board

Teacher Retirement System of Texas

Teamsters Union No. 142 Pension Fund

Texas Health Resources System

The Brink’s Company

The Metropolitan Government of Nashville & Davidson County

The Reader’s Digest Association, Inc.

The Rotary Foundation

Toshiba America, Inc.

Trinity Health

University of Alberta

University of Toronto Asset Management Corporation

Volvo Treasury NA LP

J.P. Morgan Asset Management | 1

2 Introduction

5 Survey Results

5 Equity Allocations

7 What Investors Want

9 Performance Expectations

12 Conclusion

13 Appendix

Table of Contents

2 | Market Pulse: Equity Views

Introduction

When we conducted our survey in April and May of this year, market participants had experienced one of the most tumultuous rides in decades.

Since the beginning of the “Great Recession” in late 2007, investors have witnessed asset price declines, market volatility spikes and liquidity strains that were without precedent in the post-World War II era; and it took the largest official rescue plan since the 1930s to arrest them.

The warning signs first appeared in debt markets: interbank, corporate credit and aggregate bond spreads began to widen in August of 2007 as mortgage-related losses started to emerge. But it was the equity markets, peaking in October and falling by some 20% to 25% over the following 11 months, that would ultimately take the brunt of the downturn’s impact.

In September of 2008 the recession became a full-blown crisis, marked by the failure of Lehman Brothers Holdings Inc. The extraordinary events of that period saw governments and central banks forced to take unprecedented steps to pump life into the financial markets and free up credit and liquidity. Interest rates were slashed globally, falling to essentially zero in the U.S. by December. Credit spreads and volatility peaked around year-end as liquidity conditions began to improve.

Equity markets however, continued to fall—a predictable follow-on to the financial crisis and its impact on financial institutions themselves. Having accounted for over 45% of S&P 500 earnings in the second quarter of 2007, the contribution of financials declined precipitously to an estimated -3% in the first quarter of this year.1 Finally, in March it appeared that the market had hit a low, registering a total peak-to-trough decline of some 55%. Investors had experienced not only one of the most devastating equity market rides in recent memory, but with the S&P500 down

some 3% over the ten years ending March 31, 2009, they had also been through one of the worst decades for the equity markets since the Great Depression. How dramatically and permanently would this experience impact their equity market views and portfolio strategies going forward?

Searching for GuidepostsAs markets began to show potential signs of recovery in April, investors sought to regain their footing, despite poor market visibility. Each institution has its own unique objectives, challenges and perspectives. Yet in the absence of a clear roadmap, awareness of how one’s peers are thinking and coping can at least confirm one’s own perceptions or provide an alternative point of view. However, while investors seemed to agree that markets were “not getting worse,” there appeared to be a lack of consensus about the best way forward.

In our own dialogues with clients, we continued to hear divergent concerns about—and contrasting responses to—the impact of this market crisis. For example, one CIO at a large utility told us: “Our board has emphatically directed us to stick to our rebalancing discipline. It was painful as markets declined, but we’ve begun to see signs of a pay-off since April.”

At the same time, some cash-rich institutions said that while their long-term strategic allocations remained appropriate to their investment objectives, they were making tactical adjustments to take advantage of opportunities in credit, secondary hedge funds or private equity markets.

Conversely, in the words of a pension plan CIO at a multi-billion dollar conglomerate: “We need to manage the volatility of cash flows and funded status and are willing to trade some level of return for greater return consistency. Over time, we are planning a significant reduction in equity exposure, taking it down by more than half.”

1 Standard and Poor’s


“our board has emphatically

directed us to stick to our

rebalancing discipline. It was

painful as markets declined,

but we’ve begun to see signs

of a pay-off since April.”— CIO at a large utility

“We need to manage the

volatility of cash flows and

funded status and are willing

to trade some level of return

for greater return consistency.

over time, we are planning a

significant reduction in equity

exposure, taking it down by

more than half.”— CIO at a multi-billion dollar conglomerate

Such indications of massive de-risking have made headlines and raised questions about the future of equity market allocations, as have reports of cash-strapped plans forced to liquidate equity holdings. While complete agreement across investors is neither likely nor desirable, we wanted to better understand just how pervasive these and other investor views and reactions might be.

Market Pulse Survey: equity Views — What Institutional Investors thinkTo put hard data behind these divergent responses to the recent market turmoil, we cast a wider net, inviting over 3,000 institutional investors to participate in a survey intended to take their collective pulse and to gather and assess their views, practices and preferences with respect to the equity markets. Our goal in undertaking this research was to deepen our own understanding as well as to offer institutional investors an opportunity to hear from their peers and to provide them with a valuable point of comparison as they chart their own courses through the wake of this market crisis.

Methodology

From April 16 through May 5, 2009, 324 senior investment decision-makers representing major North American institutions responded to our on-line survey. As profiled in exhibit 1A, respondents included institutional investors across all segments: corporate plans, public funds, endowments, foundations and Taft-Hartley plans, as well as insurance companies, healthcare-related organizations, religious and other not-for-profit institutions. In size, these institutions ranged from under $500 million to over $10 billion in assets under management (exhibit 1B).

exhIBIt 1: SuRVey ReSPondent PRofIle

1A: type of institution

The “Other” category includes healthcare-related organizations, insurance companies and religious and other non-profit institutions. Respondent base = 319

Public Fund19%

Taft-Hartley3%

Endowment/Foundation14%

Other10%

Corporate54%

1B: Assets under management (AuM)

Data as reported by respondent. Respondent base = 316

$500 million to $1 billion18%$1 billion to $10 billion

44%

Over $10 billion15% Less than $500 million

23%


Results, in brief

We found that despite the ravaging effects of the recent market turmoil, overall, investors appear to be maintaining their faith in equity markets for the long term and have begun to cautiously rebuild their equity portfolios. While some investors have set a course to “de-risk” portfolios, those moving dramatically away from equities represent a clear minority.

As the vast majority rebuild their equity allocations, they are increasingly taking a “back to basics” approach. In doing so, they are looking for risk-appropriate returns, relying on the investment skills of experienced managers who are committed to maintaining style purity.

We see these sentiments and intentions revealed by our respondents in areas such as:

equity allocation targets and shifts•preferences for different types of investment approaches, •manager characteristics and strategies

return expectations•

With gratitude to those investors who participated in our survey, including those who allowed us to publicly acknowledge their participation, this report summarizes our survey results and analysis.


Survey Results

equity AllocationsAmong our survey participants, actual allocations to equities in December, 2008 (“Actual ’08”) were 7% below their stated (“Original ’08”) targets at that time, while fixed income, alter-natives and cash were above target. For these investors, as for the market in general, equities clearly “took it on the chin.”

To rebalance or not to rebalance?

Theory suggests that routine rebalancing back to a strategic allocation target can help enhance portfolio efficiency. But, in the current environment, many investors are questioning whether this practiced discipline is still appropriate.

As seen in exhibit 2, survey results reflect a cautious sentiment among investors; only a third are strictly maintaining their rebalancing disciplines, while the majority (68%) are either delaying rebalancing (34%), adjusting their ranges (23%) or considering potential changes (11%). This tendency to “pause” on rebalancing or modify rebalancing practices (despite below-target equity allocations) can be attributed largely to volatil-ity—cited by 52% of investors as their greatest concern when considering equity rebalancing. Liquidity was the main concern of 32% of those surveyed and the cost to rebalance the major concern of only 12%.

Have equity allocation targets declined?

Results in aggregate: Despite deviations from rebalancing disciplines, over a short-term horizon (12 months out from the period in which our survey was conducted) we find that, in aggregate (i.e. looking at averages for Original ’08 targets, Actual ’08 allocations and “12-month” forward targets across all investors) equity targets appear to be moving back toward Original ‘08 levels, with an average 12-month forward target of 51%. This is roughly half way between where average port-folios actually were (47% equity) and where investors wanted them to be (54% equity) at the end of last year (exhibit 3).

exhIBIt 2: MARket tuRMoIl effeCtS on ReBAlAnCInG deCISIonS

Q. Has the market turmoil over the last 12 months changed the way you rebalance? Respondent base = 319

No, I am maintaining thesame rebalancing discipline32%

No, but I am considering changes11%

Yes, I am extending thetime period to rebalance34%

Yes, I am changing my disciplineby adjusting the ranges23%

exhIBIt 3: ModeSt ShIftS In tARGet ASSet AlloCAtIonS

original target end of 2008 12-month target

Q. Please indicate your asset allocation as of 12/31/08 as well as your original target weight at that time. Please also indicate what your target allocation is for 12 months from now. Respondent base: Original Target = 278; End of 2008 = 284; 12-month Target = 272.

Fixed Income31%

AlternativeAssets12%

Cash3%

PublicEquities54%

Fixed Income35%


Cash5%

PublicEquities47%

Fixed Income33%


Cash3%

PublicEquities51%


disaggregating results: To gain a more nuanced understanding of the behavior underlying these aggregate allocation trends, we also analyzed investors’ anticipated equity target allocation shifts individually over this short-term horizon. While there are interesting variations in the extent and the patterns of shifts among investors, in general, these shifts are modest in size, with the majority maintaining their Original ’08 targets or moving toward them following Actual ’08 declines.

As seen in exhibit 4:

While there are a few investors (roughly 4%) • increasing equity allocation targets, for 52% of investors, equity targets are unchanged 12 months out relative to Original ’08 levels.

Among the remaining 44% of investors (who are decreasing •equity allocation targets), 23% are decreasing target levels by less than 10% (e.g. from 60% to 51%).

However, the balance of those decreasing allocations (21% of •investors) do appear to be moving more deliberately away from equities; they are decreasing equity allocation targets by 10% or more.

exhibit 5 adds further insight into the various patterns of allocation shifts across investors, from Original ’08 targets to Actual ’08 values to 12-month forward targets.

To simplify exhibit 5 (A and B) we do not show the very small minority of investors (roughly 4%) that have increased their 12-month forward equity allocation targets beyond Original ’08 target levels, nor the very small percentage (roughly 3%) whose

Actual ’08 allocations were above both Original and 12-month forward targets.

Among the remaining 93% of investors (all of which were at or below Original ’08 target allocations at year end) we find:

71% (• exhibit 5A) are maintaining their Original ’08 targets (51%) or are moving back toward these original levels (20%);

Only the remaining 22% (• exhibit 5B) have set target alloca-tions at or below Actual ’08 allocations.

4%

52%

8%

15%11%

5% 5%

0

10

20

30

40

50

60

Increase Nochange

>0–<5%decline

≥5–<10%decline

≥10–<15%decline

≥15–<20%decline

≥20%decline

% o

f res

pond

ents

exhIBIt 4: MAJoRIty ARe not ChAnGInG equIty AlloCAtIon tARGetS

% respondents increasing/decreasing equity allocation targets, by size of change (12-month forward %–original ’08 %)

Respondent base = 265

exhIBIt 5: PAthS of AlloCAtIon ShIftS

5A: 71% are maintaining or shifting back toward original ’08 equity targets.

5B: only 22% have set 12-month targets at or below Actual ’08 allocations.

Note: For roughly an additional 3% of respondents, Actual ’08 allocations were at or above both Original ’08 and 12-month forward targets. Another 4% increased target allocations from their Original ’08 target levels. Respondent base = 264

Equi

ty a

lloca

tion

(%)

42

44

46

48

50

52

54

56

58

38% ofrespondents 54.9 48.0 54.9

13% ofrespondents

54.3 54.3 54.3

20% ofrespondents

56.8 44.4 50.8

Original Target Dec ’08 Actual 12-month Target

Equi

ty a

lloca

tion

(%)

13% ofrespondents

56.3 47.7 41.8

9% ofrespondents

58.2 46.2 46.2

Original Target Dec ’08 Actual 12-month Target 4042444648505254565860


Reallocation to other asset classes

We also examined where the outflows from equities were being re-targeted. Among the 44% of investors decreasing equity allocation targets, approximately half are shifting the greatest share of these equity assets toward fixed income; roughly one-third are primarily expanding alternative allocation targets and the balance are shifting toward cash or equally toward a combination of the above categories.

Given varied objectives, time frames, accounting standards and regulatory constraints across institutional investor segments, it is not surprising to find differences in how these segments are managing asset allocations in the current environment. In the case of corporate plans, for example, a decline in estimated funded status from 106% at year-end 2007 to 74% at year-end 2008,2 coupled with more stringent funding and accounting regulations under the 2006 Pension Protection Act (PPA) and FASB 158, have resulted in a decline in risk tolerance and a renewed focus on downside risk for these investors.

We see these concerns reflected in the fact that, among the 43% of corporate plans decreasing equity allocation targets, 62% are primarily shifting toward fixed income. On the other hand, among the 47% of public funds and 38% of endowments and foundations with decreasing equity targets 65% and 54%, respectively, are shifting primarily to alternatives, perhaps reflecting a greater focus on returns versus downside risk.3

Allocations within equities

Finally, target allocations within equity portfolios have changed very little in aggregate, the greatest shift being a decline of 1.3% (from 63.1% to 61.8%) in the share of equity portfolios allocated to U.S. domestic equities.

What Investors Want While equities have retained their position as the largest targeted slice of the institutional portfolio pie (both in aggregate and for nearly 80% of respondents), survey results point to some telling changes in investor priorities and preferences in which we see a desire to go “back to basics,” and an aversion to taking on risks for which rewards appear less certain in light of unprecedented recent market events.

Manager tenure and style purity highly valued

When asked to prioritize a number of factors influencing equity risk control, “manager tenure” and “style purity” were rated as most important by over half (58% and 54% respectively) of those surveyed (exhibit 6). Managers and investment processes are put to the test when two- and three-standard deviation events actually occur. Investors appear to favor managers who have navigated through up and down cycles and have had the opportunity to fine-tune their processes as a result.

2 Developed by J.P. Morgan CBS from information presented in J.P. Morgan’s Pension Tension—Pension Risk Ratios for U.S. Companies report (October 13, 2008) containing data on 1272 employers.

3 It is also interesting to note that when asked about their primary expectation for their fixed income allocation, corporate plans were more concerned with duration extension and somewhat less concerned with high absolute returns than public plans, endowments and foundations. See Appendix—Exhibit B for details.

exhIBIt 6: InVeStoRS VAlue MAnAGeR tenuRe And Style PuRIty the MoSt

Q. Please indicate the importance you place on the following influences on equity risk control. Respondent base = 307 to 312

54

42

1926

58

67

58

35

7

15 1416

7

3943

0

10

20

30

40

50

60

70

80

Stylepurity

Tracking error(high vs. low)

Internationalexposure

Sectorconstraints

Manager tenureoverall

Most Important Neutral Least Important

% o

f res

pond

ents


Fundamental strategies preferred

When questioned about their preferences today versus a year ago for various equity strategies, investors expressed: increas-ing conviction in fundamental strategies, little change in their appraisal of market neutral and all cap strategies and less inclination to invest in quantitative and 130/30 strategies—the vast majority of which use a quantitative approach. (exhibit 7)

In our view, these finding are not surprising. When a vast array of stocks are trading at historically attractive valuations (as was the case at the time of our survey), in-depth, probing, fundamental analysis can help identify companies which are not only “cheap” but also have strong management teams and long-term growth potential.

At the same time, quantitative strategies have consistently underperformed their fundamental counterparts since July 2007. Starting in the second half of 2007, quantitative managers struggled as a result of significant redemptions and forced deleveraging of quantitative (mostly hedge fund) managers. Furthermore, these strategies tend to do well when market trends are clear, but poorly at points of market inflection, as witnessed by performance in 2008 and early 2009 (which saw multiple inflection points).

What may be surprising however, as seen in the following industry data on quantitative strategies, is that contrary to the widely held view that all quantitative strategies are very much alike, there is evidence to suggest that correlations among quantitative managers are not much greater than those among fundamental managers.

Active versus passive: some preference for indexing large versus small cap

Across different strategy styles (large and small cap, growth, core and value) the majority of investors (68% to 76%) are neither more or less likely to index now than they were a year ago.

While the percents are small, over twice as many investors were more inclined to index large cap (22% to 26%) vs. small cap (9% to 10%) allocations.4 (exhibit 8)

This general preference on the part of investors is likely driven by the perception that alpha opportunities are greater in less

exhIBIt 7: StRenGthenInG PRefeRenCe foR fundAMentAl StRAteGIeS

Q. For each of the following equity strategies, please rate your preference today versus one year ago. Respondent base = 306 to 312

More Preferred Neutral Less Preferred

10

1816

9

18

616469

5653

29

6

1815

3529

47 47

0

10

20

30

40

% o

f res

pond

ents

50

60

70

80

QuantitativeFundamental MarketNeutral

All Cap 130/30Concentratedportfolios

4 Respondents were also asked whether they were more or less likely to index Fixed Income and Alternative asset categories. Here too, most said they were equally likely to index now versus a year ago (60% to 78% of respondents in the case of various fixed in come products and 66% to 70% for different categories of alternatives).

All quantitative strategies are not the same

While quantitative strategies tend to do poorly at points of inflection in the markets—when leverage can compound performance issues—in fact, correlations for returns across quantitative managers are not much higher than for fundamental managers.

WeIGhted AVeRAGe CoRRelAtIonS AMonG MAnAGeRS

Fundamental-to-Fundamental 0.16

Quantitative-to-Quantitative 0.20

Fundamental-to-Quantitative 0.10

Source: J.P. Morgan Asset Management, E-Vestment; based on quarterly data from Q1:2004 to Q2:2008

exhIBIt 8: lIttle ChAnGe In InVeStoR PRefeRenCeS foR equIty IndexInG

Q. Please indicate whether you are more or less likely to index the following equity categories versus a year ago. Respondent base = 307 to 311

More Likely No Change Less Likely

% of respondents

23

26

22

71

68

71

76

76

76

6

7

10

10

9

6

15

14

14

0 10 20 30 40 50 60 70 80 90 100

Large CapGrowth

Large CapCore

Large CapValue

Small CapGrowth

Small CapCore

Small CapValue


liquid markets with less analyst coverage (small cap vs. large cap, developed vs. emerging markets, etc.). As seen above, our analysis of industry data on the percentage of active managers beating their benchmarks supports this perception over the long-term. Indeed, small cap managers have, over the 10 years ending March 2009, had greater success than large cap managers in beating their benchmarks. However, trailing one-year results show a greater percentage of large cap managers having beat the index—a fact which has apparently not affected the style-specific indexing preferences of our investors.

Managing risk/securities lending

The risks associated with securities lending have become much more apparent as a result of the credit and liquidity crisis that began in August 2007. Asset managers and prime brokers have been asked to provide more detailed information and transparency around their securities lending practices.

Given this increased concern, we asked investors about their policies regarding the use of equity asset managers engaged in securities lending. Results confirm the heightened sensitivity to the risks involved: over 25% of investors had either recently

reversed or planned to reverse their policy, such that the use of equity asset managers engaged in securities lending would no longer be permitted (roughly 30% said securities lending had never been permitted, while over 40% said they have allowed it for some time).

Large firms versus boutiques

These preferences with respect to equity managers have changed very little as a result of the current environment. Roughly 24% of investors said they now have a greater preference for large firms than they did one year ago, while 17% now have a stronger preference for boutiques.

Performance expectations At the time of our survey (April 16 through May 5, 2009), markets had been through the worst of the downturn thus far and were beginning to show signs of recovery and greater stability. The S&P 500, having fallen some 55% from peak (October 2007) to trough (March 2009), was up by almost 30% from its March lows at the end of April, while the CBOE Volatility Index (VIX) had improved by over 50% from its most volatile readings in November 2008.

Source: Lipper, Russell Investment Group, J.P. Morgan Asset Management.All data are based on Russell Indexes, and represent total return net of fees for stated period. Small company stocks may be subject to a higher degree of market risk than the securities of more established companies because they tend to be more volatile and less liquid. Each style is representative of corresponding Russell style index. Past performance is not indicative of future returns. Please see disclosure page at end for index definitions. Data are as of 03/31/09.

Large Value = Russell 1000 Value Index Large Core = Russell 1000 Index Large Growth = Russell 1000 Growth IndexSmall Value = Russell 2000 Value Index Small Core = Russell 2000 Index Small Growth = Russell 2000 Growth Index

PeRCentAGe of ACtIVe MAnAGeRS thAt hAVe hIStoRICAlly BeAt theIR BenChMARkS

trailing 10 years as of March 31, 2009

Beating the benchmark: Small cap versus large cap managers

Small cap managers historically have had a stronger record for benchmark outperformance than large cap managers… but not in 2008.

PeRCentAGe of ACtIVe MAnAGeRS thAt BeAt theIR BenChMARkS In 2008

trailing one year as of december 31, 2008

Value Core Growth

LargeSm

all

44% 74%38%

82% 75%46%

Value Core Growth

LargeSm

all

58% 36%51%

34% 18%27%


While we did not ask respondents for their rationale, market pundits continue to debate what countries and regions are likely to lead the world out of recession. Those espousing the “first-in/first-out” theory suggest that an earlier start to the downturn and more rapid policy response may see the U.S. recover before other developed economies. The U.S. unemployment rate began rising in early 2007, at least six months ahead of other developed markets, and the Federal Reserve was the first major central bank to begin cutting interest rates in late 2007. Furthermore, the relatively low export dependency of the U.S. makes a recovery less contingent on the strength of its trading partners. On the other hand, while China is more export-driven, its massive currency reserves, sizeable fiscal stimulus package, healthy banking sector and low levels of private sector debt could make it better able to recover from a fundamental standpoint. Indeed, China is one of the few countries to have seen outright expansion in its production survey data; the Chinese manufacturing purchasing managers (PMI) index moved back into positive territory in March.

Value favored versus growth: Investors favor value versus growth over a one-year horizon, but not by an overwhelming margin. Forty-six percent expect value to outperform, 36% favor growth, with the balance (18%) remaining neutral.

Our survey indicates that institutional investors are uncertain about near-term market prospects, with only a few areas of strong consensus across asset classes and segments.5 However, consistent with the rebuilding of their equity portfolios and continued faith in the asset class, there is greater consensus and optimism around longer-term equity market returns.

U.S. equity returns

On balance, the majority of investors (58%) anticipate positive equity returns over the next 12 months, while 42% see zero-to-negative returns. Over the longer-term, however, the vast majority expect positive annualized returns three and five years out (92% and 98% of investors, respectively). The most optimistic (over 15%) expect returns in excess of 10% over the next three- and five-year periods (exhibit 9).

Style and sector returns

In addition to their view of U.S. equity market returns overall, we also asked investors which styles or sectors they expected would outperform over the next 12 months. Results are summarized in exhibit 10.

domestic favored versus international: Among investors sur-veyed, the relative out-performance of U.S. equity markets over the next 12 months is one area where there is relatively strong consensus. Sixty-two percent of investors expect equity markets in the U.S. to outperform international markets, while only 26% held the opposing view and 12% saw neither as a clear winner.

exhIBIt 9: u.S. equItIeS (S&P 500)—ConSenSuS StRenGthenS WIth tIMe fRAMe

exhIBIt 10: exPeCted StRAteGy outPeRfoRMAnCe

Q. What are your annualized return expectations for the market (S&P 500)? Respondent base 1 year = 316; Respondent base 3 year = 295; Respondent base 5 year = 298

Q. Do you expect Domestic or International; (Growth or Value); (Small, Mid or Large Cap) to outperform over the next 12 months? Respondent base: Domestic/International = 321; Growth/Value =318; Small/Mid/Large = 324 * Respondents were asked to choose all categories that apply.

Less than -10% -10% to 0% 1% to 10% Over 10%

% o

f res

pond

ents

71 0.3

35

72

44

74

82

1418 16

0

20

40

60

80

1 year 3 year 5 year

Perf

orm

ance

(%)

Smal

l

Mid

Larg

e

Non

e

Small, Mid, Large Cap*

3228

50

8

0

10

20

30

40

50

60

70

Gro

wth

Val

ue

Nei

ther

Dom

esti

c

Inte

rnat

iona

l

Nei

ther

Domestic, International Growth, Value

12

36

46

18

26

62

5 See Appendix—Exhibit C for fixed income and alternative asset return expectations.


Value versus growth: historical perspective

Source: Russell Investment Group, J.P. Morgan Asset Management.Note: Plotted points above represent actual data points based on Russell Indices. Returns are cumulative annualized total return for 20 years.Data as of December 31, 2008. This graph is for illustrative purposes only.

Source: Russell Investment Group, FactSet, J.P. Morgan Asset Management. Note: P/E ratios are calculated and provided by Russell based on operating earnings for the last 12 months. Data reflects P/E’s as provided by Russell as of 03/31/09.

VAlue—A StRonG tRACk ReCoRd of RISk-AdJuSted RetuRnS

Based on returns for 20 years ending december 2008.

Value Blend Growth

LargeM

id

69.6% 50.4%93.1%

89.3% 50.9%147.4%

Small101.6% 73.0%123.6%

Standard deviation (risk) (%)

Tota

l ret

urn

(%)

Legend:A. Russell 1000 Value IndexB. Russell 1000 IndexC. Russell 1000 Growth IndexD. Russell Mid Cap Value IndexE. Russell Mid Cap IndexF. Russell Mid Cap Growth IndexG. Russell 2000 Value IndexH. Russell 2000 IndexI. Russell 2000 Growth Index

4

5

6

7

8

9

10

11

13 15 17 19 21 23

D

F

CH

G

I

B

A

E

= Value index

The absence of a stronger consensus on the outlook for growth versus value is understandable. As seen in the exhibit above, value has had a strong track record of risk-adjusted returns over time. However, at the time of our survey, this style category appeared overvalued on a current versus historical P/E basis and relative to growth—despite having underperformed growth for the 12 months ending March 31.6 This overvaluation was due in part to depressed earnings “inflating” current versus historical P/E’s for value stocks. For example, trailing 12 month earnings growth for the Russell 1000 Growth Index as of March 31 was roughly -12% while earnings declined -58% for the Russell 1000 Value Index over the same period.7

Some investors appear to be looking beyond value’s current high valuations (inflated by depressed earnings), anticipating improved performance for value versus growth over the next 12 months.

large cap favored versus mid and small cap: In evaluating the prospects for capitalization categories, 50% of investors expect large cap to outperform, 32% voted for small cap, 28% for mid cap and 8% did not see a clear winner.8

The expectation for large caps outperforming small caps as markets rebound defies historical norms—but is supported by the current versus historical valuation data above in which large caps look more attractively valued. Generally, small caps underperform during bear markets and rebound more strongly as markets recover. However, this bear market has been different. Small caps outperformed large caps from June through December 2008 but underperformed from January through March 2009—on both a price and 12 month trailing earnings basis. In fact, this reversed a six-quarter run in which earnings were stronger for small caps. Since the price underperformance for small versus large caps was less pronounced that the earnings growth differential, small cap relative valuations increased at quarter-end.9

Results suggest that a slim majority of investors see the possibility of “atypical” underperformance for small caps over the next 12 months. This may be due to small cap’s higher valuations—both relative to their own historical P/Es and to those of large caps—perhaps combined with some concern regarding the ability of smaller firms to access credit given current financial market conditions.

6 Russell Investment Group, J.P. Morgan Asset Management. For example, year-to-date returns as of March 31, 2009 for Russell 1000 Growth and Russell 1000 Value were -4.1% and -16.8%, respectively.

7 Russell Investment Group, J.P. Morgan Asset Management.

8 Percentages across categories sum to more than 100%; respondents were asked to select which categories they expected to outperform over the next 12 months, checking all that applied.

9 Russell Investment Group, J.P. Morgan Asset Management

CuRRent P/e AS PeRCentAGe of 20-yeAR AVeRAGe P/e

(e.g. large cap value stocks were 6.9% cheaper than their historical average)


We conducted this survey to take the pulse of institutional investors—their attitudes, expectations and strategic thinking with respect to equity markets and the role of the asset class in their portfolios.

With the most intense market stress tests hopefully behind us, the beginning of the second quarter seemed a propitious time for this check-up.

We found that the vast majority of investors (nearly 80%) are continuing to rely on equities as the largest component of their targeted portfolio allocations. Volatility and liquidity are still concerns and most have chosen to delay or modify rebalancing practices. Overall, investors are not massively reducing equity allocations, but rather slowly and cautiously rebuilding their portfolios—and in general, setting strategic equity allocation goals that, if achieved, will return them to levels quite similar to where they were at year-end 2008.

Consensus on the outlook for equity market returns is still building and at this stage investors appear more focused on overall allocations than on the specifics of strategies, geographies and styles. But what they are looking for is clear–risk-appropriate strategies that rely on a transparent, back-to-basics approach, with a preference for fundamental research-driven strategies in the hands of experienced portfolio managers, implemented with conviction and consistency in style.

Of course, much of the history of the current market crisis is still to be written and investors’ caution is well-placed. In these turbulent times, we remain committed to keeping our ear to the market, understanding investor needs and partnering with our clients to craft solutions most appropriate for their institutions.

Conclusion the vast majority of investors (nearly 80%) are continuing to rely on equities as the largest component of their targeted portfolio allocations.


Appendix

exhIBIt A: AlMoSt hAlf See lonG teRM Bond yIeldS InCReASInG oVeR the next 12 MonthS

A fifth see them decreasing and almost a third see no change.

Q. Where do you see long term bond yields (Barclays US Aggregate Bond) going over the next 12 months? Respondent base = 322

exhIBIt d: the MAJoRIty SAId A 20% to 30% AlloCAtIon to AlteRnAtIVeS IS too hIGh

A third said 20% to 30% is just right and 8% said it is too low.

Q. When considering your total investment portfolio, would you say that a 20% to 30% asset allocation to alternatives is... Respondent base = 316

Just right58%

Too high2%

Other (please specify)8%

Too low32%

Decreasing21%

No change31%

Increasing48%

exhIBIt C: APPRoxIMAtely hAlf See An InCReASe In RetuRnS oVeR the next 12 MonthS foR CoMModItIeS, ABSolute RetuRn/hedGe fundS And InfRAStRuCtuRe

A majority of investors expect returns to decrease in real estate (67%) and private equity (50%) over the next 12 months.

Q. Where do you see returns going for the following alternative assets over the next 12 months? Respondent base = 315–317

Increasing Decreasing No change

% o

f res

pond

ents 42

25

33

Infrastructure

54

18

28

Commodities0

10

20

30

40

50

60

70

50

2228

Absolute Return/Hedge Funds

25

50

25

PrivateEquity

16

67

17

RealEstate

exhIBIt B: the MAJoRIty SAy CAPItAl PReSeRVAtIon IS theIR PRIMARy exPeCtAtIon fRoM theIR fIxed InCoMe AlloCAtIon

Corporate plans are more concerned with duration extension and somewhat less with high absolute returns than public plans, endowments and foundations.

Q. What is your primary expectation from your fixed income allocation? Respondent base = 307 to 311

Capital preservation Duration extension High absolute returns Other

% of respondents

45

60

75

67

72

9

14

8

21

14

22

7

7

10

11

11

7

0 10 20 30 40 50 60 70 80 90 100

Corporate

Public Fund

Endowment/Foundation

Taft-Hartley

Other(please specify):

40

www.jpmorgan.com/insight

IMPORTANT DISCLAIMER

This document is intended solely to report on various survey views held by J.P. Morgan Asset Management. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice. We believe the information provided here is reliable but should not be assumed to be accurate or complete. The views and strategies described may not be suitable for all investors. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations. References to future net returns are not promises or even estimates of actual returns a client portfolio may achieve. Any forecasts contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.

This material may contain certain projections and assumptions with regard to the opportunities described therein. This material must not be relied upon as advice or interpreted as a recommendation by J.P. Morgan Asset Management. Investors may experience results that differ materially from any information shown. The return on the opportunities will depend on the actual investments made and the economic, interest rate and regulatory environment during the relevant period. Please note that investments in international markets are subject to special currency, political, and economic risks. Exchange rates may cause the value of underlying overseas investments to go down or up. Investments in certain markets may be more volatile than other markets and the risk to your capital is therefore greater. Also, the economic and political situations may be more volatile than in established economies and these may adversely influence the value of the investments made.

J.P. Morgan Asset Management does not make any express or implied representation or warranty as to the accuracy or completeness of the information contained herein, and expressly disclaims any and all liability that may be based upon or relate to such information, or any errors therein or omissions there from. This material must not be relied upon by you in making a decision as to whether to invest in the opportunities described herein. Prospective investors should conduct their own investigation and analysis (including, without limitation, their consideration and review of the analyses referred to herein) and make an assessment of the opportunity independently and without reliance on this material or J.P. Morgan Asset Management. In addition, prospective investors are strongly urged to consult their own legal counsel and financial, accounting, regulatory and tax advisers regarding the implications for them of investing in these opportunities.

All indexes are unmanaged and an individual can not invest directly in an index. Index returns do not include fees or expenses. The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization. The Russell 1000 Index measures the performance of the 1,000 largest companies in the Russell 3000. The Russell 1000 Growth Index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 1000 Value Index measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell Midcap Index measures the performance of the 800 small-est companies in the Russell 1000 Index. The Russell Midcap Growth Index measures the performance of those Russell Midcap companies with higher price-to-book ratios and higher forecasted growth values. The stocks are also members of the Russell 1000 Growth Index. The Russell Midcap Value Index measures the perfor-mance of those Russell Midcap companies with lower price-to-book ratios and lower forecasted growth values. The stocks are also members of the Russell 1000 Value Index. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index. The Russell 2000 Growth Index measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.

J.P. Morgan Asset Management is the marketing name for the asset management businesses of JPMorgan Chase & Co. Those businesses include, but are not limited to, J.P. Morgan Investment Management Inc., JPMorgan Investment Advisors Inc., Security Capital Research & Management Incorporated and J.P. Morgan Alternative Asset Management, Inc.

245 Park Avenue, New York, NY 10167

© 2009 JPMorgan Chase & Co.

Authors

Barbara heubelSenior editorInstitutional Marketing

kimberley WestClient portfolio managerU.S. Equities

Annette WhittemoreHead of Market Research and Development

Contributors

Paul quinseeCIOLarge Cap Core

Documents

Market Pulse: Equity Views€¦ · Respondents represented corporate, public and Taft-Hartley plans, endowments and foundations, insurance companies, healthcare-related organizations