Institutional Investors Turn to Alts, ESG and Risk Management as Volatility Looms

While still making the most of what they can in today’s market, institutional investors have been bracing for the impact of renewed market volatility, taking steps to diversify and construct durable portfolios, according to new survey findings.

Natixis Investment Managers’ sixth consecutive annual global survey of 500 institutional investors finds that 78% of institutional investors expected stock market volatility to spike in 2018, but despite the challenges, say they “still have a few tricks up their sleeve” to meet average long-term return assumptions of 7.2% this year.

Among the factors that institutional investors believe could negatively impact investment performance are geopolitical events, asset bubbles, interest rate increases, low yields and the potential for banks to unwind quantitative easing. To address these factors, investors cite three broad strategies:

  • “opportunistic calls” for allocations to active management and alternative investments;
  • renewed emphasis on environmental, social and governance (ESG) and liability-driven investing (LDI) strategies; and
  • a measured response to the regulatory and business challenges.

“Historically low interest rates have produced higher investment returns, but given a lack of dispersion and differentiation of security performance, 60% of institutions believe traditional assets today are too highly correlated to provide distinctive sources of return,” according to the report.

Alt Strategies

In view of that, nearly 7 in 10 investors say it is essential to invest in alternative investments in order to diversify portfolio risk, and nearly 6 in 10 say investment in alternatives is necessary to outperform the broad market.

When asked to match the most appropriate alternative strategies with specific portfolio objectives, institutional investors pointed to the following strategies.

  • Diversification: Global macro strategies (47%), commodities (41%) and infrastructure (40%) investments were the most commonly cited as the best for diversification. Private debt (34%) and private equity (33%) were also viewed as useful in meeting this objective.
  • Fixed-income replacement: Infrastructure (55%), real estate/REITs (54%) and private debt (47%) were cited as top choices for providing a source of stable income as interest rates rise and the 30-year bond bull market ends.
  • Volatility management: Increased allocations to managed futures (46%) and hedged equity (45%) were viewed as best suited to manage volatility risk.
  • Alpha generation: Private equity (72%) was cited as investors top choice among alternatives for generating alpha; hedged equity (45%) was also seen as useful in meeting this objective.
  • Inflation hedge: Commodities (56%) and real estate (46%) were viewed as best for inflation hedging strategies.

Meanwhile, more than three-quarters (76%) of institutional investors believe that the current market favors active managers. And while alternative investments can pose portfolio risks, almost three quarters (74%) say the potential returns of illiquid investments are worth the risk.

The report further notes, however, that two-thirds of respondents say that solvency and liquidity requirements have created a strong bias for shorter time horizons and highly liquid assets. It adds that “hidden risks lurking within the dynamic macroeconomic and regulatory market make it even more challenging for institutions to balance short-term opportunities and long-term objectives.”

ESG Strategies

Institutions are also stepping up efforts for increased deployment of ESG strategies to help manage risk and enhance return potential. According to the findings, 61% of institutional investors say their organization integrates ESG factors in its fundamental process, up from 52% in 2016.

And the motivations appear to be changing. One year ago, the top reason for ESG integration was to comply with their firm’s mandate or investment policy, but now the top reason is to “proactively align investment strategy with organizational values” (47%), followed by “minimizing headline risk” at 41%, which is a 21% increase over 2016.

Moreover, while 56% of survey respondents agree that ESG mitigates risks (such as loss of assets due to lawsuits, social discord or environmental harm), nearly 60% believe there is alpha to be found in ESG. “Their convictions about the efficacy of this approach are strong,” Natixis emphasizes. The report further notes that 61% of institutional investors believe incorporating ESG into investment strategy will become a standard practice within the next five years.

“Our survey shows ESG analysis is playing a greater role in institutional strategy, with more institutions finding that this approach can help navigate a path to potential profits,” says Dave Goodsell, Executive Director of Natixis’ Center for Investor Insight.

While acceptance of ESG is growing, the report warns that it may still need clearer definition, as only a small number of respondents (14%) see the full potential of ESG today.

Outsourcing CIO Functions

A growing number of institutional investors are also turning to outsourcing as they pursue more innovative investing strategies. According to the findings, nearly one in five (17%) institutions is considering outsourcing investment decision-making during the next 12 months — a rise from 13% in 2016.

In addition, the report notes that 44% of institutional investors outsource at least some portion of their investment management function. Among those who do, they outsource management for approximately 41% of their portfolio. Their primary reason for doing so, according to 49% of institutions, is to access specialist capabilities.

Natixis’ survey included managers of corporate and public pension funds, foundations, endowments, insurance funds and sovereign wealth funds in North America, Latin America, the United Kingdom, Europe, Asia and the Middle East, with data gathered in Sept. and Oct. 2017 by the research firm CoreData.

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