Supported by governance reform and technological advances, long-term asset owners are finding innovative ways to reach their return objectives in the face of a prolonged period of low interest rates and increased regulation of financial intermediaries.
Institutional capital pools, which include pension funds, endowments, and sovereign wealth funds, now account for a quickly growing and large share of global wealth, on par with nearly a year of the world’s annual income. Reflecting their role as wealth builders in the communities they serve, they are tasked with generating robust investment returns while prudently managing risk. In the face of a rapidly-changing world, these long-term asset owners are innovating to find ever-more effective and efficient ways to fulfill these mandates.
Over the course of 2015, the World Economic Forum’s Global Agenda Council on the Future of Investing has surveyed 21 major asset owners and managers around the world to identify trends in their efforts to adapt to recent economic, financial, and regulatory developments. A few key insights cut across each of our case studies: in every example, robust governance frameworks, rapidly advancing technological change, and empowered leadership enable and drive innovation by these investors.
The three foundations of innovative investing
Institutional asset owners and their stakeholders have long known that strong governance structures are essential to their successful operation. Many public institutional asset owners began reforms at the end of the last century to put investment decisions at arm’s length from politicians. The organizations reviewed in our survey demonstrate the important role these governance arrangements play in creating the flexibility needed to adapt to the vagaries of an uncertain world. While each institution works in-line with its unique purpose and circumstances, each one features a governance system marked by:
1. Clarity of mission, vision, investment objectives, and time-horizon;
2. Self-awareness of their competitive advantages and disadvantages, and their implications for resource needs;
3. Respect for constraints, but an openness to new voices to help transcend them;
4. Open processes that provide transparency in decision-making; and
5. Robust internal reviews that continuously evaluate the impact of innovations and diffuses lessons learned throughout the organization.
The financial sector has also been an early adopter of improved technology, which is transforming the means by which data are disseminated and analyzed, as well as the ways in which capital is provided to businesses and households.
Modern, networked computers provide asset owners with a range of data and analytical tools, such as portfolio construction models and risk controls, which were previously obtainable only from out-sourced firms. Brought in-house through on-demand bespoke programs, mobile apps, and software plug-ins, these systems are usually less costly, more accessible, and better aligned with asset owners’ long-term goals than the services they replace.
Mirroring developments in sectors as diverse as biotech and fashion, new technology also allows asset-owners’ individual stakeholders, such as pensioners, and asset-managers’ clients to transparently and flexibly tailor their investments to their specific needs and objectives.
Finally, governance structures and new technology are only as good as the people who operate them. Across the institutions examined in our case studies, there’s a common appreciation that the right human capital is critical to produce the nimbleness and flexibility to innovate on a continual basis.
Strong governance, rapid technology adoption, and great people together underpin the innovation frameworks of all of the organizations we studied. As a trio, they have the potential to deliver better, individualized investment outcomes; lower costs; greater oversight by stakeholders; enhanced sustainability; more effective risk mitigation; and, in the case of public institutions, lighter fiscal burdens for governments.
Adapting innovation to the ‘new normal’
The advent of 2008’s Global Financial Crisis (GFC) and the shift to what some have called the ‘new normal’ of sluggish growth, persistently low interest rates, high debt burdens, and greater uncertainty, has made it harder for investors to meet their performance objectives.
Low interest rates, for example, have both cut asset owners’ incomes and, by lowering discount factors, inflated the present value of their long-term liabilities. Similarly, efforts to increase the regulation of financial firms is reducing some risks while simply shifting some to other parts of the global economy.
The next waves of innovation
In response to the post-crisis environment, the asset owners we studied are pursuing a few broad classes of innovation to ensure that their performance remains on par with their objectives. They are:
I. Creating new products and markets. In response to what Nouriel Roubini has called the ‘paradox of liquidity’ and intensified regulation, traditional financial intermediaries are providing fewer services and less market-making activity than they did in the past. Asset owners are stepping into this gap to provide new sources of financing and new types of financial products. In some cases, they have created indices and structures that they have shared on an open-source basis to create investable vehicles in markets and in asset classes, such as real estate, infrastructure, and private equity, which they previously found hard to access.
II. Focusing on deeper assessments of risk. Rather than deploying capital in set ratios across long-standing asset classes, asset owners are increasingly orienting their decisions around their underlying risk exposures. Institutional capital owners recognize that there are major limitations with traditional efforts to diversify across equities, bonds, and alternative assets: many types of risk are common amongst all three of these asset types. New factor-based portfolio construction frameworks enable proper diversification of these risks, but they typically require specialized computational and human inputs that only large institutional asset managers can implement.
III. Making external relationships more effective. As institutional asset owners gain greater awareness of their competitive edge and unique attributes, they are engaging more effectively with external service providers and asset managers to achieve their long-term investment objectives.
Mapping the way forward
Our forthcoming report* on the future of investing will explore each of these new classes or ‘waves’ of innovation with detailed case studies on how institutional asset managers are working to ensure they remain fit-for-purpose and capable of adapting to ever-changing circumstances.
The ultimate beneficiaries of these investment innovations will include the taxpayers and pensioners who depend on the investment returns generated by their pooled capital; the industries and economies that recycle this invested capital into goods, services, infrastructure, and employment; and the governments that need to cover their existing liabilities and invest fresh capital into inclusive growth initiatives.
*An initial set of case studies on eight institutional asset owners will be published in a whitepaper in the coming months. Additional case studies will be progressively made available on a dedicated website in 2016.
Authors: Alison Tarditi is Chief Investment Officer at the Australian Commonwealth Superannuation Corporation in Sydney and Chair of the WEF Global Agenda Council on the Future of Investing. Brett House is Chief Economist at Alignvest Investment Management in Toronto and a WEF Young Global Leader.
Image: An electric display chart shows the afternoon trading trend of the blue chip Hang Seng Index at a brokerage in Hong Kong, China July 8, 2015. REUTERS/Tyrone Siu