By Kevin Olsen
Institutional investors, by and large, will be returning to the basics over the next 10 years, according to a new report from McKinsey & Co. Investors will be moving away from a focus on outperforming benchmarks and maximizing alpha regardless of market conditions, to one that emphasizes meeting their fundamental investment objective.
McKinsey's report, "The Best of Times and the Worst of Times for Institutional Investors," details major shifts that are expected in the investment landscape and a dichotomy developing among how institutional investors are adapting. Only time will tell which strategy will prove the right one, according to the report.
Rapid GDP growth in developing countries, more government involvement to reduce debt and changes in risk management also will play a large role in shaping the financial markets in this decade, according to the report.
"Institutions are getting back to the basics," said Jonathan Tetrault, Toronto-based principal at McKinsey and one of three authors of the report. "They realize it helps them to simplify a little of what they are doing and meet return objectives. Many are going back to fundamentals and moving away from indices."
Through discussions with more than 50 industry experts and investment professionals at institutions that collectively manage more than $3 trillion in assets, McKinsey researchers found that institutions agree they need to adapt to the new environment, but are using vastly different strategies to do so. Some are tweaking their existing approaches while others are completely rethinking their investment and operating models.
Mr. Tetrault said institutional investors are gradually moving from relative return to absolute return and focusing on longer-term targets. Portfolios will be built that are less aligned with benchmarking.
Among the major shifts investors need to make in order to adapt to the new market landscape, Mr. Tetrault said, is to adopt a more forward-looking investment approach involving more communication with managers on their objectives and strategies.
Institutional investors "came to the conclusion it (maximizing diversification) is not necessarily providing the best approach to meet investment objectives," Mr. Tetrault said. "Organizations are not trying to maximize returns, but maximize the chances to meet investment objectives with the smallest envelope of risk."
The market crisis of 2008 showed capital-market interconnectedness is both a boon and a threat. According to the report: "While market liquidity and efficiency has increased, this increasing interconnectedness could also lead to larger and more frequent asset bubbles, exposing institutional investors to increased variability in performance."
Although many of the outperforming investments in the next decade will be the result of growth in emerging markets, institutional investors will have to avoid the asset class' "free-lunch mirage" as equity returns show very little correlation with economic growth in the near and medium term, according to the Mr. Tetrault.
Right approach
Institutional investors will have to find the right approach -- whether it is using external managers that have offices and a global footprint in developing countries, or creating a network of local partners -- for emerging markets investing. How to be able to pick the best external manager for emerging markets was one of the top three priorities for 90% of the investors participating in the study, Mr. Tetrault said.
"What became pretty clear is exposure to (emerging) markets doesn't correlate to performance," Mr. Tetrault said. A simple passive index investing approach could well yield disappointing results, the report states. "We see the bar is rising ... for performance in these markets," Mr. Tetrault said.
In terms of government, Mr. Tetrault said the "big unknowns" for the next decade are how the U.S. and Europe handle their debt situations and how robust China's growth will be. "It is the first time in 20 years there have been three major question marks," Mr. Tetrault said.
The pressure on government balance sheets will cause a rapid deleveraging process that will last six to seven years, to reduce the ratio of debt to gross domestic product by 25% in developed countries.
"We believe that institutional investors can expect, over the next decade, a continuation of greater government involvement in the capital markets," the report states. "This will be driven by a variety of forces, which include a desire to address national economic challenges (e.g., competitiveness or income inequality) and an increased skepticism around the market's ability to police itself. We expect these government interventions to take a series of forms, including larger and more frequent open-market operations, more significant monetary policy actions, and enhanced financial regulation."
An increase in regulation and oversight may well increase costs for investment institutions and drive returns down, the report states.
Looking ahead to equity strategies in the next decade, Mr. Tetrault said institutions will typically limit the number of companies they invest in to 30 or 40, with larger investments, longer holdings and less volatility. Three such strategies stand out in McKinsey's report: long-term relationship investing, thematic investing, and "all-weather" strategies.
"Institutional investors have become much more focused on absolute risk and less sensitive to relative risk," Mr. Tetrault said. "Institutional investors have more and more absolute thinking in their strategies."
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