AB IQ Article

Tackling Investment Challenges

Consultant Roundtable

Dec 09, 2019

13 min read

In a world of lower expected returns, pressure on costs and regulatory change, institutional investors are facing a growing list of challenges as 2020 begins. We asked consultants from different regions to provide their perspectives on the biggest issues they see for the industry, from market trends to fees to cultural traits of asset managers that will foster investing success in the future.

What are the greatest challenges that asset owners face?
Steven Carew, Chief Investment Officer, JANA Investment Advisers (Australia): We believe the greatest challenges that Australian institutional investors face are:

Meeting investment objectives—We believe that meeting investment objectives from portfolios, such as real returns of 3%–4% above inflation, will be more challenging to achieve over the next decade than it has been over the past decade. Prospective returns will be constrained by the current low yields across the yield-based asset classes, including cash, bonds, credit, property and infrastructure. In addition, the outlook for relatively modest economic growth, combined with current valuations, presents headwinds for equity markets. However, much depends upon the future path of inflation. If inflation remains low, this will enable low interest rates to be sustained while supporting the current valuations of assets and potentially even driving them higher. In this type of 1%–2% inflation environment that supports current valuations, mid-single-digit returns are achievable, which would deliver on most portfolio return objectives.

Finding reliable hedges in portfolios—Over recent years, we have seen an increasing tendency for positive correlation between bond and equity returns, as well as poor bond returns (from rising yields, as we saw in late 2018) driving poor equity returns. The reliability of bonds as a hedge against equity risk, the dominant risk in most investor portfolios, is questionable, and the scenario of bonds performing poorly at the same time as equities is very real. As noted above, inflation risk is meaningful given investors have high exposures to long-duration assets and the potential impact on portfolio valuations of any sustained material rise in inflation and likely, interest rates.

Managing regulatory change and complexity—Requirements or demands for greater or more detailed disclosure of investment costs, portfolio holdings, voting and engagement activity, and management of ESG and climate change risks present significant challenges for funds in terms of resources and developing effective communication channels to large membership bases. Funds also face the challenging task of reconciling a greater focus of regulators on assessing their relative performance compared to other funds and the new member outcomes requirements, where funds are required to place greater emphasis on achieving defined outcomes for members. These two measures are not necessarily the same and may openly conflict with each other.

Brian Smith, CFA, SVP, Fund Sponsor Consulting, Callan (US):

Meeting return targets—Not only are asset owners experiencing one of the most difficult investing environments in history, but interest rates in the US and abroad are historically low, growth is modest, and capital market projections for virtually all asset classes have come down gradually.

Heightened volatility—Our proprietary forward-looking capital market projections, we found that investors need to take on twice as much risk as they did only 15 years ago to generate a 7.5% return. Looking back to 2004, an investor would have needed half of the portfolio in public equities to achieve a 7.5% return. To achieve comparable returns in 2019, that return-seeking portion is up to 96%. So, in just 15 years, the risk required to achieve a 7.5% return nearly doubled, from 8.9% to 18%.

Increased complexity and cost—The reason for increased risk is due to not having much protection in a deflationary environment. When fixed-income allocations are driven down to 4% means, the “safe asset,” or bedrock against which investors take risk, is virtually absent. This means that asset owners face a great deal of volatility, as an 18% standard deviation represents equity-like volatility for the total portfolio.

Importantly, return-seeking portfolios are now more complex and expensive than ever. In 2019, a return-seeking portfolio comprises just 4% fixed income and approximately 30% private equity and real estate. As asset owners strive to enhance return at the expense of increased risk, the high cost of diversification only causes further frustration to an already challenging condition.
Nick Samuels, Head of Manager Research, Redington (UK): Almost all asset classes are well valued, if not richly valued, and so when asset owners think about their likely forward-looking returns for these assets, they know that based on history, returns from here could well be muted. So, how do you make the types of returns they need to make in this environment? On paper, this looks challenging.

Another challenge is how much responsibility they take, with the power that they have being asset owners, in terms of the environmental challenges that we face. How much of their strength do they use in fighting climate change? How much do they potentially give up on the return side to think about the risks that we face as a society and as a global population? This is a long-term challenge that they need to face, and it will have a direct financial impact on their assets as well.

Mitsuru Mitabe, CMA, Managing Director, Pension Investment Consulting Dept. Daiwa Fund Consulting Co. (Japan):

The decline in expected returns due to lower interest rates

The increasing complexity of asset management due to a wider variety of strategies in the portfolio, which in turn is the result of the aforementioned decline in expected returns

Integrating the Stewardship Code and ESG into their asset management
Which of these challenges aren’t being adequately addressed by asset managers and advisors?

Nick Samuels: Clearly, asset managers and advisors are trying to think about these issues and the ways that they can be addressed, but it feels like it’s very early stage, particularly on the environmental side. On the valuation side, you’ve seen alternative strategies being launched for many years that are less dependent on market beta, and that will continue.

Mitsuru Mitabe: In recent years, Japanese investors such as pension plans have been making forays into new asset classes, as well as adopting new portfolio management techniques and stepping up diversification. Although progress has been made, their search for an optimal solution continues due to the protracted ultralow interest-rate environment.

Steven Carew: We think that asset managers and advisors are seeking to address these challenges. Arguably, the one that is most demanding to address is finding reliable hedges. For Australian investors, the Australian dollar tends to act as a shock absorber in periods of stress, as it tends to fall relative to the major currencies at these times, providing some counterbalance to falls in the value of offshore asset exposures. However, with the AUD below 70 cents, its ability to fulfil this role is probably reduced.

Many alternative investment strategies have struggled over recent times due to the poor performance of active management, although this does not necessarily mean that these strategies will not exhibit low correlation and even downside protection in future periods of stress. Finding hedges against inflation risk is problematic, given that the most reliable hedges, cash and inflation-linked bonds, appear very unattractive from a valuation perspective, with the latter also exposed to any rise in real interest rates that may accompany a rise in inflation.

Brian Smith: Many asset owners have refined the definition of the “growth allocation” to include high yield, real estate, convertibles, low-volatility equity, factor-based strategies and option-based strategies―the attempt being to tamp down risk without reducing the allocation.

This is counter to how most asset managers have approached product innovation. As asset managers have added new and improved product offerings, most have launched higher risk, higher-returning and, most importantly, higher fee funds. The rise of higher risk funds with loftier fees has left many asset managers vulnerable. As we continue to progress into the economic cycle, the demand for risk-mitigating strategies may outpace supply.
The scarcity of alpha has led many asset owners and their advisors to revisit traditional asset allocation. What are you doing differently in your asset allocation, what’s worked and what hasn’t?

Jay Kloepfer, EVP, Director of Capital Markets, Callan (US): We still believe in traditional asset allocation, and we believe asset allocation and the pursuit of alpha are two different questions. In our mind, there are still two basic investments: ownership and debt. Maybe three, if you included sticking money under a mattress, better known as cash. The appropriate exposure to ownership and debt and cash constitute asset allocation. The implementation of the asset allocation is where investors can seek alpha. We update our “traditional” approach to consider and potentially incorporate the numerous strategies and sub-asset classes that have mushroomed onto the institutional investor scene over the past 30 years, and particularly over the past 10 years.

We like to use the term “purpose-driven” asset allocation as we overlay a framework of esoteric investments on top of the standard investment molecules like equity ownership and debt, the two basic investment classes upon which all others rest.

What purposes? We see combinations that are really variations on a theme: growth, risk mitigation, real assets, unforeseen opportunity. For example, with a broader definition of growth, you can include far more than pure equity ownership (both public and private), such as private debt, high yield, bank loans and other forms of credit, convertibles, perhaps even structured products, as well as the more esoteric flavors of equity investing such as factor-based strategies, portable alpha, long-biased multi-asset class strategies and even risk parity.

From a higher level, the division into growth, risk mitigation/income/liquidity, real and opportunity, still requires a thought process similar to the establishment of the old 60/40—how much growth do you need, how much risk are you willing to tolerate, and how much are you willing to give up to manage the risks that are important to you (drawdown, liquidity)? Are there tools that allow you to squeeze more out of a portfolio to both match your return needs and address your risk tolerance and your market expectations?

The much broader set of opportunities has led to far greater pursuit of diversification in many portfolios, and substantial complexity. What hasn’t worked? The confusion of the pursuit of alpha with asset allocation and the setting of risk tolerance. Allowing alpha to be the tail that wags the asset-allocation dog leads to disappointment in the long-term return, with unintended deviations from the intended tolerance for risk. Thoughtful implementation and vigilance are required to keep the investment program on the intended path to long-term gains at the appropriate level of risk.

SC: The major changes we have made to asset allocation have been driven by the fall in cash rates and bond yields rather than being alpha-driven. The fall in interest rates and bond yields has meant that significant proportions of investor portfolios that were invested in bonds and cash have moved from paying returns at or above inflation to well below inflation and becoming a material drag on prospective returns. This experience has been more prolonged in bonds, where reducing exposure has produced mixed results, depending upon where the funds were redeployed. If bonds were reduced in favor of other yield-based investments such as credit, property and infrastructure, this has been accretive for returns. Meanwhile, investments in cash, short-duration bonds and many alternative investments (due to the challenging environment for active investment-management strategies) have underperformed bonds.

MM: Japanese pension funds, for example, have been experimenting with various ideas, such as expanding into new asset classes and modifying asset-class classifications (e.g., no longer viewing domestic and foreign assets as separate asset classes, and setting up new classifications such as those based on return objectives, etc.). By doing so, they are seeking to enhance the diversity and flexibility of their investments, as well as to reorganize the concepts underlying their investments. As a result, we have seen more varied approaches to fixed-income investment and an increase in allocation to alternatives such as illiquid assets, for instance.

However, there is still no consensus on how to, or to what extent we should, make up for the lower expected returns resulting from lower interest rates. It remains a work in progress.

NS: There are two angles to what we’re doing differently. One is looking at alternative strategies, like risk premia strategies, or revisiting things that used to be the domain of hedge funds but that are now that more accessible to a wider range of institutional investors. The other angle is looking at more private asset classes, and particularly on the credit side in private credit.
Fees have been under the microscope for some time now. How do you think fee structures should evolve over the next decade?

MM: From the asset owner’s perspective, lower fees are generally desirable. But there is also concern that excessively low fees could lead to a decline in the quality of investment services. So, we do not anticipate a simplistic, one-way decline in fee levels. But downward pressure on fees will persist in some form, and fees will come down selectively in areas where the relevance and rationality of the fees are not accepted by investors.

SC: We think that the pressure for lower fees will continue to present in several ways. In the liquid asset classes, this includes greater use of passive or lower benchmark-risk-type strategies and the growing trend to internalization to reduce fees. We also expect to continue to see pressures on margins for active managers as the power shift from the sellers to the buyers of active investment management continues in response to consolidation and growth in scale of the buyers, and less demand from them as a result of the increase in use of passive strategies and internalization.

In the unlisted asset classes, we are seeing a dramatic increase in direct investments (where investors purchase stakes directly in assets led by their own due diligence) and in co-investments (where investors purchase stakes directly in assets, and funds in private equity) where fees are much lower, and in some cases, nil. It goes without saying that the appetite for high-fee investments (such as the “2 and 20”–type model) has drastically declined amongst Australian institutional investors.

NS: I think the they’ve come down a lot in absolute terms. I think there are certain areas where they can still come down. Particularly, fees on the private side are still high in general. So, I think there’s still some room for them to fall in absolute terms over the next decade.

But I also think that coming up with a fee structure that is more outcome dependent is important. We’ve had a base and performance fee concept for a long time in the hedge fund world, and it’s not universally popular for a variety of reasons. We’ve now seen things like fulcrum fees in recent years. So hopefully at some point, there will be a structure that balances the economics in the client’s favor a little bit more and is a bit more reliant on the outcome, as opposed to just being based on the assets.
What are the most important cultural traits that asset managers and asset owners need to address the challenges facing the industry?
SC: We believe that the following cultural traits will be most important.

Have clarity in objectives and a plan for achieving them. Investors need to be clear on what they stand for and what they believe in. They need to have a plan for how they will tackle challenges such as how to achieve or maintain scale; how they will invest in a world of lower returns; and how they will provide what their beneficiaries are looking for.

Be nimble. In the rapidly changing and dynamic world and investment industry, investors need to be able to adapt all aspects of their operation, from their product design and investment-portfolio construction to their member communication and engagement strategy.

Know their competitive advantage. Investors need to know what it is and how they can play to it to maximize their chances of success.

MM: Integrity, in respect to the fiduciary responsibilities of each party in its respective role. Asset owners must be clear about their investment objectives and restraints when hiring asset managers, make appropriate performance assessments, and compensate those managers appropriately. Asset managers must fully understand the asset owners’ needs and provide appropriate investment services by fully utilizing their abilities and skills.

NS: It’s really about putting the client first and trying to understand the unique needs of each client, and each client group, and tailoring solutions to them. This is as opposed to what at least some asset managers did in the past by prioritizing simply asset-gathering. Products need to be closed at the right levels, and the products need to be created at the right fee levels for certain clients.

More of a client focus means doing the right thing for the client, and then allowing the benefits of that to come, as opposed to thinking about a product that might sell and launching it, marketing it heavily and trying to sell it. It’s less about trying to sell and more about listening and trying to find a solution.

Mark Stahl, SVP, Co-Manager of Global Manager Research, Callan (US): The six most important cultural traits are as follows.

Meaning and purpose

Creative confidence

Appreciation

Balance

Collective voice

Empathy
What are the attributes of asset managers, alpha and fees aside, that will resonate most with asset owners and their advisors?

SC: In this increasingly complex and changing world and investment landscape, we think investors will increasingly seek managers with whom they can form long-term, trusted strategic partnerships. This is likely to include transfer of intellectual property (assistance with asset allocation/investment strategy, product design and internalization of investment capabilities), tailored products and access to capacity-constrained strategies, and favorable fee structures (perhaps a single-fee structure across multiple investments).

NS: Asset owners are increasingly going to be assessing asset managers through an ESG lens. For instance, how do they consider diversity? How are they thinking about the environment? What are their beliefs? In terms of engagement, how are they working with companies that they are invested in to make sure that they improve their practices? There will be more emphasis on some of those more impactful decisions that they’re making outside of generating returns.

Mark Stahl: Trust. The marketplace is abundantly aware that investment-management firms need to pass a number of objective hurdles to be considered and retain client relationships. Many of these factors can be seen and measured. Stability, performance, portfolio characteristics and fees can all be measured and objectively compared across the competition. These are historical measures people can identify with to justify consideration.

However, the critical decision-making factors on what will happen moving forward into the future holds greater importance and is difficult to determine. That’s where the “soft” and subjective factors such as trust, integrity and the ability to clearly articulate an investment philosophy are so important. Senior leadership that creates a client-first culture will resonate with the marketplace and is a critical factor in not only hiring decisions but in retention decisions as well.

Over the years we have seen clients retain those investment managers they understand and trust much longer than those organizations that do not exhibit the partnership-like characteristics asset owners expect from their investment managers. Trust allows an investment organization time to work through difficult market environments and short-term periods of underperformance; asset owners benefit from having long-standing manager relationships developed over time that understand and help their clients achieve long-term goals. The active management business is a high-risk profession under intense pressure given the current environment. It will be critical for managers to maintain business practices that demonstrate trust and client-first decisions moving forward.

MM: The ability to provide appropriate communications in order to maintain the expectation and confidence of asset owners in regard to the future of their portfolios. For instance, asset managers must be able to convince asset owners of their investment rationale by providing timely and appropriate explanations and disclosures about the objectives and methods of each strategy, as well as actual investment actions and plans.