Institutional investors embrace risk in pursuit of better returns and yield, finds Natixis survey

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  • Institutions seek new ways to meet long-term growth and liability goals by simultaneously mitigating and exploiting risk in low-yield, volatile market environment

  • Key strategies include growing use of private investments, illiquid assets, increased exposure to alternatives and greater reliance on risk budgeting and diversification

  • 75% of global institutional investors believe today’s markets are more favorable to active managers

Faced with volatility, greater risks and still-low yields, institutional investors are raising their exposure to higher-risk assets in pursuit of better returns, according to an international survey of institutional investors published today by Natixis Global Asset Management. At the same time, they are doubling down on risk management to better balance long-term growth objectives and liquidity needs, but say they need better ways of identifying risk across their portfolios.Natixis surveyed 500 managers of public and corporate pensions, foundations, endowments, insurance funds and sovereign wealth funds in North America, Latin America, the United Kingdom, Continental Europe, Asia and the Middle East. Collectively, they manage $15.5 trillion in assets.

Natixis surveyed 500 managers of public and corporate pensions, foundations, endowments, insurance funds and sovereign wealth funds in North America, Latin America, the United Kingdom, Continental Europe, Asia and the Middle East. Collectively, they manage $15.5 trillion in assets.

The findings provide insight into how institutional investors, largely considered to be the world’s largest, smartest investors, are using risk to their advantage. Meanwhile, (75%) of institutional investors think investors might be taking on too much risk in pursuit of yield.

Sixty-two percent of institutional managers feel they can handle near-term market risk despite greater volatility, which they say poses the biggest risk to their performance. Their top organizational concern, however, is low yield. Given the prospect for greater volatility and persistence of low interest rates, few institutions are relying on traditional portfolio strategies to meet their performance goals. In their efforts to manage the risks, they believe the more effective techniques include risk budgeting (87%), diversifying holdings across sectors (86%), currency hedging, (78%), and increasing their use of alternative investments (76%).

The survey reveals that the percentage of institutions using alternatives to manage risk has exploded from 53% in 2015 to 76% today. In addition, 56% report that their organization is investing in more in illiquid assets today than they were three years ago.

“While risk factors change over time, the challenge for institutional investor remains to deliver long-term results while navigating short-term market pressures,” said Kevin Haran, Managing Director for Natixis Global Asset Management Australia. “Given their mandates, avoiding risk is not an option for institutional investors. They have to beat the odds or change the game, and they are doing so by balancing risks and embracing alternatives to traditional 60/40 portfolio construction, but always with an eye on their long-term objectives”.

Pursuing growth: bigger role for real assets, alternatives

In examining their goals, 70% of investors believe their return expectations are achievable, but confidence may not be as strong as it seems on the surface. Half (50%) of the institutions expect to decrease return assumptions in the next 12 months. One reason for setting their expectations lower is the challenge of finding returns: 75% of those surveyed say alpha is becoming harder to come by as markets become more efficient. While most are confident they’ll be able to meet their long-term liabilities, 62% think most of their peers won’t. Sixty-nine percent agree that traditional diversification and portfolio construction techniques need to be replaced with new approaches.

The survey found:

  • Sixty-seven percent of institutional investors think private equity provides higher risk-adjusted returns than traditional asset classes, and more than half (55%) believe private equity provides better diversification than traditional stocks.
  • Seventy-three percent think private debt provides higher risk-adjusted returns than traditional bond investments. The three areas they consider most promising are infrastructure, healthcare and the technology, media & telecom sector. Many also say they are likely to consider increasing use of direct lending (44%) and collateralized debt (34%).
  • About one-third (34%) of institutions report that they are planning to increase allocations to real assets, including real estate, infrastructure and aircraft financing, in the next 12 months. As seen with their broader views on private markets, 63% of institutional decision makers’ primary goal for investing in real assets is earning higher returns.
  • More than half of institutions (56%) report they are increasing exposures to alternative investment strategies this year. The adoption of alternative investments isn’t limited to growth portfolios, as 77% of respondents say alternatives have a role in liability-driven investing as well.
    Balancing growth, risk, liquidity and liabilities

While institutions think that alternatives help to diversify portfolios and manage risk, more than half (55%) report that their need for liquidity has limited their ability to invest in alternatives. Many institutional decision makers (71%) believe more stringent solvency and liquidity requirements established by regulators around the world have resulted in a greater bias for shorter time horizons and more liquid assets. This has proven to be a significant challenge to meeting liabilities that stretch out over multiple decades. Respondents say their top risk management concern is balancing long-term growth objectives with long-term liquidity needs.

ESG (environmental, social and governance) investing is taking on broader dimensions for investment teams, providing a measure for identifying companies and investment trends that may provide long-term growth potential to the portfolio. Close to 60% of investors surveyed say that considering ESG issues is a way to generate alpha. An equal percentage says it is a way to reduce headline risks, such as lawsuits, environmental harm or social discord. Sixty-two percent believe ESG will be a standard practice for all managers in the next five years.

Active management is better suited to generating risk-adjusted returns

Nearly 75% of institutional investors believe today’s markets are more favorable to active managers – an increase of 6% over 2015. The projection for passive has dropped steeply year over year. In 2015, they assumed a 9% increase in allocations to passive within three years, now they anticipate an increase of just over 1% by 2019. Asked to compare the relative strengths of active and passive investments, 86% say active is better suited to generating alpha, to generating risk-adjusted returns (64%), for accessing emerging market opportunities 76%, and for ESG investing 75%. While institutional investors see the value of passive investments for specific objectives, they see potential problems for individual investors who have come to rely heavily on indexing. For 75% of them individuals are not fully aware of the risks of indexing which may conduct them to a false sense of security about indexing.

The challenge of liability management

Liability management is top of mind for institutional decision makers. Seven in ten institutions surveyed have adopted asset-liability matching strategies to help them align asset sales and income streams to future expenses with the goal of managing liquidation risk. Many of these strategies have relied on high-quality fixed-income securities, but institutions are now using a wider range of instruments in liability-driven investing (LDI).

They include hedging strategies (used by 47%), inflation-linked bonds (44%) and nominal bonds (37%). But they are also looking for a broader set of options. About three-quarters of institutional investors (77%) say alternatives have an important role to play in LDI portfolio management, as they offer valuable diversification and risk mitigation and complement the overall portfolio.

A significant number (62%) believe that despite using LDI strategies, most organizations will fail to meet their long-term objectives. Three in five (60%) say there is a lack of innovation in LDI solutions, although not as many (41%) are willing to pay a premium for innovative LDI solutions.

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