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Article | 5 Key Trends for Institutional Investors

Investors feel the last three years have been exceptionally volatile. The reality, however, is there have been far-reaching changes in macroeconomics and financial markets over the last decade.

Speaking at Funds Congress 2023, Mike O’Brien, non-executive director of Carne Group, said: “Investors have lived through a significant sea change over the last 10 years.”

In 2013, tech was the growth sector, now it is laying off workers; central banks then were a source of stability, and now they are a source of volatility; and inflation has roared back into existence after being long dormant, he added.

  1. LDI lessons

In the UK, these issues were further aggravated last year when Liz Truss’ mini-budget caused long-dated gilts to rise rapidly, creating an LDI crisis for defined benefit pension schemes. This interest-rate hedging is used by defined benefit pension schemes to make the valuation of their liabilities less volatile.

O’Brien said: “While the dust has yet to fully settle on the LDI crisis, there is enough perspective to think about the lessons learnt.”

During the crisis, investment consultants and trustees learnt the importance of a governance framework that allowed quick decision making and rapid actions to reduce exposure, protect liquidity and investors.

The LDI crisis was, in a way, a problem 20 years in the making, and the result of regulatory and accounting standards changes designed to correct one issue that created another.

There is, however, a silver lining to the crisis. Pension trustees are now talking about how they think about governance and whether they have the right model – if it should be outsourced or insourced.

  1. Remaining innovative

While tech companies can afford to ‘fail fast and learn’, that’s impossible for the asset management industry. The funds industry cannot afford catastrophe when safeguarding investors’ assets and individuals’ wealth. That can slow down innovation.

There are bright spots. The industry is getting better at communicating with its clients to explain why it does what it does. The opening up of private markets is another positive, particularly as it is an important way of channelling capital to sustainable investment.

Fund providers have proven they are agile and adaptable. The industry managed to switch to remote working overnight during the COVID crisis – that would not have been thought possible before the pandemic.

Society’s values are changing with sustainable investment becoming increasingly important to today’s investors. There is growing pressure on the industry to innovate to keep pace with these demands and build trust with consumers.

O’Brien said: “A recent McKinsey report said European products with sustainable credentials on the packaging grew at 28%, while those without these credentials grew at less than 20%.” Consumers are voting with their feet and asset managers need to understand that, he added.

  1. Evolution of the active versus passive debate

While the active versus passive debate has rumbled on for many years, it’s becoming more nuanced as the products provided by systematic providers have become more sophisticated.

O’Brien said: “The battle seems to have been won by the index players that are now pushing into thematic products.”

But reports of the death of active managers may well be exaggerated. O’Brien noted: “The average active manager did outperform the index in 2022 – in the precise market conditions you would expect active managers to outperform when there was volatility and low cross stock and intra-sector correlation.”

Nothing can replace the people element of investing. That’s not just asset managers engaging with their clients, but also the conversations those portfolio managers have with companies’ executive boards.

There are times when the research-led approach of active management will pay dividends. Investors need to be judicious about choosing between passive and active. They should also bear in mind that some asset classes can only be implemented actively.

  1. The shift to decumulation

Much of the world is grappling with an aging population that is shifting pension savings from accumulation to decumulation. O’Brien said: “A number of years ago, the U.S.’ 401k-defined contribution system went to net outflow for the first time.”

This shift in requirements is a significant challenge for the retirement industry. Adding to this challenge is the change in demographic trends, meaning spending patterns have also changed.

When earlier generations retired, it’s likely their parents would be dead, they would have paid off their mortgage and their children will have left home. Now people might still be paying off their mortgage as they head into retirement, are likely to still have the children at home and could be caring for an elderly relative.

This requires much more complex financial planning that demands a broader product range. It’s likely there will be demand for guaranteed and income products alongside those providing capital appreciation.

But as the pension wealth shifts from defined benefit to defined contribution, this will present challenges for scheme members, as many lack the skills to take these complex financial decisions.

At the moment, however, there is around five times as much money in DB schemes than there is in DC schemes, which means there isn’t the impetus for the change required to ensure DC members can use their pension pots wisely.

  1. Diversification into private assets

The most popular asset allocation strategy, the 60:40 portfolio, has performed badly as equities and bonds fell at the same time.

O’Brien said: “The biggest investors protected themselves from these performance challenges  by diversifying into alternative assets. Half of the world’s GDP is now accessed via private markets as the number of constituents in the MSCI world has shrunk by about 20% over the last two decades.”

But it can be difficult for many investors to access these more complex and less liquid markets. One of the big challenges is the time horizon, with a shift to a more short-time horizon for pension schemes that precludes less liquid assets for these institutions.

It would, however, make sense to invest into private markets for DC schemes as the membership is much younger and can take advantage of the longer time horizons of these assets.

That requires a clear regulatory path so asset managers can provide the products that will enable scheme members to benefit from these assets.

In conclusion
While the last decade has been a period of change both in macroeconomics and financial markets, further transformation should be expected in the next 10 years.

Asset managers will need to adapt to changing consumer demands, increased interest in sustainability as well as the need to maintain trust in the face of greenwashing concerns.

Changes in demographics and a shift towards defined contribution schemes will also challenge the industry to broaden asset allocation and develop products that match the greater complexity facing those retiring in coming decades.

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