Institutional investors are responding to a daunting – and growing – set of challenges
by Dave Goodsell
No one could have predicted the crisis that enveloped the world’s health, economic and financial systems in the first quarter. When asked about their greatest concerns entering 2020, institutional investors said volatility, interest rates and a credit crunch; a pandemic and oil-price war weren’t on the radar.
That said, institutional investment teams were entering the year on high alert. Most expressed concern about the level of risk in the markets, given high equity valuations, low interest rates, large government and corporate debt loads, and the potential for complacent investors to panic in the event of a downturn. At the same time, they felt hamstrung by post-Financial Crisis regulations and market myopia, which forced them to emphasize short-term considerations over long-term strategy.
Then COVID-19 and related containment measures shut down global economies and sent markets into free-fall, and at the same time Russia and Saudi Arabia played a game of chicken with oil prices. If institutional investors’ challenges began the year at 8 on a scale of 10, they’ve since jumped to 11. The challenges include:
Managing external pressures. Beyond the immediate market risks, institutions must still grapple with the challenges of managing within tight regulatory constraints, staving off external pressure for short-term performance, and navigating an uncertain political landscape.
The pursuit of yield. Rates were already low. Now they’re even lower. Institutions will face an even more extreme version of the environment they’ve had to navigate since 2010, in which low yields force them to come up with creative ways to find returns with acceptable risks. That likelihood suggests that the trend toward private investments and other alternatives will continue and possibly strengthen.
How to integrate ESG. Institutional teams increasingly think their organizations have an important role in addressing big societal problems. But it’s not always clear to them specifically how they should marry their pursuit of ESG objectives with their primary mandates to achieve particular investment outcomes. They want to integrate ESG – and they want the tools and insights to do it in ways that maximize the societal and financial impact.
- Managing to long-term risks despite short-term distractions
- Rates much lower for much longer
- ESG is embraced. Now how best to do it?
- Forging a clear path forward
About the survey
With future liabilities extending out three, four, or more decades, institutions are inherently long-term investors. Recent market events demonstrate just how hard it can be to maintain that long-term focus when short-term pressures intensify. And even though a sudden global market downturn will put pressure investment strategy, institutional teams must also contend with a number of external factors that could distract long-term objectives.
Liquidity requirements set in place after the last market crisis continue to impede their ability to implement effective strategy and are amplified by new central bank policies that have again cut already low interest rates. Short-term performance pressures from the market at large, and for a significant number, their own boards of directors, can complicate an already difficult decision-making process. All while an uncertain geopolitical climate leaves the potential for more market disruption looming over portfolios.
A mismatch between regulations and liabilities
Regulations are particularly a sore spot. Institutions are in a bind. Ten years of ultra-low interest rates have pushed their liabilities higher, and the staggering central bank easing in the first quarter will only exacerbate that challenge. They need investments that offer a yield premium to meet their long-term mandates.
Yet many investments that pay attractive yields restrict short-term liquidity, and institutions must operate within the stringent liquidity requirements established in the wake of the 2008 financial crisis. Institutional investors feel hamstrung, as short-term considerations limit their ability to invest for their long-term objectives. More than half (57%) believe solvency and liquidity requirements create too much bias for short time horizons. Likewise, 43% say liquidity requirements challenge their ability to pursue long-term investment objectives, and 54% of insurance companies, which face some of the toughest liquidity requirements, agree with that statement.
More than half
believe the solvency and liquidity requirements create too much bias for short time horizons
Four in ten
say liquidity requirements challenge their ability to pursue long-term investment objectives
Chafing at short-termism
Likewise, many investors express frustration about being judged on short-term performance benchmarks when managing portfolios to meet obligations decades in the future. Nearly half (45%) say the market’s focus on short-term results inhibits their ability to execute long-term strategy. One-third (31%) also feel internal pressure from the short-term outlook of boards that are too focused on quarterly results. They want to protect against downside risk – in fact, most say they are willing to trail their peers to do so – but face the possibility of harsh judgment if their prudence caused near-term underperformance.
Politics raise concerns
Of all the geopolitical risks on the horizon, the US presidential election is a primary concern. Investors are worried about foreign election interference, which 7 in 10 (69%) say is an increasing problem globally. More than 6 in 10 (64%) expect the U.S. election to be a major source of market volatility.
Institutional teams on the whole are concerned about the volatility and uncertainty introduced by the presidential election, rather than about a particular political outcome. Like the American electorate, they’re split. Only a few percentage points separate the respondents who say the election will have a negative or positive impact (29% and 23%, respectively). About half say the markets will react favorably to a new president (52%) or that markets will react unfavorably if Democrats win both houses of Congress (54%) – suggesting that roughly equal numbers disagree with these views.
1 Scenario analysis
2 Have capital buffers/reserves in place
3 Be more nimble and agile
4 Prioritize risk based on some clear criteria
5 Create signposts that track risks
Low interest rates have been an albatross for institutional investors since the Great Financial Crisis. It seemed conceivable that global rates might tick up modestly in the coming year and offer some relief – and then the COVID crisis hit. The Federal Reserve quickly stepped in to stabilize financial markets, dropping interest rates to zero and initiating what has been dubbed “QE infinity,” and other central banks took similar actions. Now institutions will have to meet their mandates in an even more yield-starved world.
They already were turning to alternatives, including private investments. Seven in 10 (71%) say that the returns of private assets are worth taking on the liquidity risk, and almost the same number (68%) say they believe private assets will play a more prominent role in their investment strategies going forward.
When asked where they are likely to increase allocations to private assets, institutional investors’ top four answers are private debt (37%), infrastructure (32%), real estate (29%) and private equity (28%). The changes in the world since our survey seem likely to push institutional investors further in this direction.
7 in 10 say
- that the returns of private assets are worth the liquidity risk
- they believe private assets would play a more prominent role in their investment strategies going forward
Where institutional investors are maintaining or increasing private asset allocations
Turning to outsourcing for help overcoming today’s challenges
Investing in alternatives is complex; doing it successfully demands particular skills and experience. That may be why three-quarters (75%) of institutional teams say they outsource at least some investment management in order to access specialized expertise. It also takes connections: Placement in top-tier managers’ funds is limited, and acquiring it can depend on relationships. More than 4 in 10 institutional investors say they rely on outsourced managers for efficient access to illiquid assets.
Other reasons to outsource also seem tied to the current environment, as institutions are looking for creative solutions to generate the returns they need within their risk parameters. Roughly one-third (36%) say they are outsourcing to help them look for strategies that are tailored to their risk-return profile, and almost the same number (32%) say outsourcing gives them new sources of diversification and yield.
Access to specialized expertise
Efficient access to illiquid assets and alternatives
Access to strategies tailored to our risk/return profile
Institutional investors increasingly believe that long-term investment success is not separate from environmental, social and governance (ESG) goals, but intertwined with it. Now they seek clarity on how to express ESG priorities within their portfolios.
The ESG rationale
ESG has momentum. The Principles for Responsible Investment (PRI) has established goals, now agreed upon by 2,500+ institutional signatories, that promise to drive progress on many fronts, including climate, diversity and wealth inequality. In 2019, the Business Roundtable issued new Principles of Corporate Governance that for the first time asserted corporations’ commitment to deliver value to all stakeholders, not primarily to shareholders.
Almost all respondents to our survey – fully 96% – said they believe institutions have a role in addressing the world’s most pressing challenges. And about half say that institutions:
- need to influence the policies and actions of the companies in which they invest (49%)
- should put capital to work to address global problems such as climate change and diversity and inclusion (48%)
- should champion enhanced corporate governance (48%)
Most institutions (57%) say their main reason for integrating ESG is to align their portfolios with their institutions’ values. But the motivation isn’t exclusively altruistic. Institutions also see a strong investment case for ESG: Two-thirds (65%) believe ESG analysis has a valid place alongside fundamental analysis, and more than one in two (54%) say there’s alpha to be found in ESG. No wonder that a large majority (70%) say ESG will become a standard practice across the industry within the next five years.
Looking for clarity on the best ways to measure ESG performance
Although institutions are overwhelmingly convinced of the value of ESG, both for society and for their own investment success, they have questions about the best ways to make it happen. In particular, they are hungry for clearer, more robust data, with 71% saying that it’s hard to know which ESG data are material to investing.
They also are trying to figure out how to align ESG objectives with their investment mandates. Six in 10 (60%) say they would be more willing to invest in projects that help provide solutions to societal challenges if those projects presented a risk/return profile in line with their portfolios’ long-term goals.
96% of institutional investors
say they have a role in addressing the world's most significant challenges
|Influencing policies and practices of the companies in which they invest (49%)||Putting capital to work to address global problems such as climate change and diversity and inclusion (48%)||Championing enhanced corporate governance (48%)||Leading the change in the investment practices of the industry (40%)||Engaging with governments and urging them to solve problems (32%)|
||Influencing policies and practices of the companies in which they invest (49%)|
||Putting capital to work to address global problems such as climate change and diversity and inclusion (48%)|
||Championing enhanced corporate governance (48%)|
||Leading the change in the investment practices of the industry (47%)|
||Engaging with governments and urging them to solve problems (32%)|
Blended finance as a solution
Only one-quarter of institutions say they do not actively pursue impact investing: investments made with the intent to generate and measure social and environmental benefits alongside a financial return. This approach has vast promise, as do infrastructure investments. But realizing their potential will require new models for collaboration between investors, asset managers, governments, NGOs and development banks such as the World Bank partner.
Consider financing construction of water systems in the developing world. These kinds of infrastructure investments have the potential for win-win arrangements on a massive scale. They could radically improve living standards in underdeveloped areas around the globe, while offering investors a potentially attractive investment profile characterized by long, recurring cash flows. Yet in many cases these sorts of initiatives present risks that are prohibitive for most institutional investors. Roughly a third (34%) are concerned about the risks of infrastructure investing in emerging and frontier markets, 31% worry that there are no clear measurement standards, and a quarter (24%) cite uncertainty about the ability to meet repayment schedules.
Blended finance offers a way forward. It provides a new model in which asset managers, investment banks and NGOs such as the World Bank partner to unlock the promise of impact and infrastructure investing in the developing world – for example, by establishing guarantees from government-backed institutions that make investment risks palatable to institutions. Such platforms have the potential to make investing in socially beneficial projects more realistic for institutional teams, freeing up capital to improve living conditions around the globe.
Institutional investors’ job has gone from hard to harder. They face an environment without precedent in global politics, finance and economics. And they are developing creative solutions to navigate it, drawing on a wider variety of assets and resources than ever to pursue their investment mandates. Meanwhile, they are continuing to dissolve the walls between the notions of societal good and investment success, as they pursue greater insights and more effective models to use their financial clout to make the world a better place.
This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed are as of April 20, 2020 and may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted, and actual results may vary.
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