Institutional Investors Face a Complicated 2015

While institutional investors are optimistic about equities in 2015, their outlook is tempered by market risks that are difficult to predict and control.

Pension funds and other institutional investors believe they will meet their long-term return objectives, a new Natixis Global Asset Management survey shows, but most are worried about increasing market correlations and the challenge of earning stable short-term returns in the current environment.

The findings are from the Natixis 2014 Institutional Investors Survey, which suggests institutions are struggling to generate sufficient and reliable short-term returns within traditional asset-allocation strategies. Fully 87% of the institutional investors polled by Natixis—which included public and corporate retirement plans—expect to meet their long-term liabilities, yet more than half of respondents believe most other organizations will fail to do so.

Underscoring this sentiment, six in 10 institutions say the financial advisory and investment management industries have not been innovative enough in developing liability-driven investing (LDI) solutions that help organizations map and meet future costs—especially those related to pension fund contributions and benefit liabilities.   

On average, investors polled by Natixis expect to achieve yearly returns of 6.9% after inflation during the years ahead. Despite their need for continued asset growth, institutional investors are twice as likely to reduce portfolio risk as to increase it in the next 12 months. Survey respondents pointed to geopolitical events, European economic problems, slower growth in China, and rising interest rates as potential drags on performance next year that could lead to a lower-risk approach.

One Natixis leader who discussed the survey results with PLANSPONSOR says this is the first in six editions of the survey where the theme of environment, social and governance (ESG) investing has jumped to the forefront.

“And it’s not just the survey results that are showing us the increased attention for ESG,” notes Robert Hussey, executive vice president, institutional services, Natixis Global Asset Management. “We have an ESG manager in Europe that we’ve been bringing to the U.S. quite a bit in recent months to meet with some of our institutional clients. They’ve really shown an increased interest in ESG solutions moving into 2015.”

According to Hussey, pension funds and other institutional investors are looking to ESG in more sophisticated ways than they have in the past.

“It’s encouraging that clients aren’t asking for hard overlays that say things like, ‘no tobacco’ companies or ‘no defense industry investments in our portfolio,’” Hussey explains. “That’s not what the next generation of ESG investing is going to be about. Valuable ESG investing is going to involve doing some real fundamental research to try and achieve alpha.” (See “Looking Ahead Responsibly.”)

To this end, Hussey anticipates institutional investors will increasingly look to green bond funds, as well as water and agriculture infrastructure projects. Others may decide to apply portfolio screens and avoid companies with uncompensated exposure to fuel cost risk, environmental safety risk, water scarcity risk, and other factors that are important to business success in a more populous and environmentally strained future.

ESG investing executed this way serves not only the philosophical and ethical objectives of the client, Hussey says: It can also be a real source of alpha in increasingly correlated and efficient global markets. The survey results find 54% of institutions think ESG investing has long-term growth and alpha benefits, and 55% agree that ESG investing mitigates risks such as loss of assets due to lawsuits, social discord or environmental disasters/scarcity challenges.

Other results from the survey show more than half (55%) of institutional investors agree that traditional assets are too highly correlated to provide distinctive sources of return. Hussey says this is in part a result of global markets growing more efficient through technology and emerging market maturation—a sentiment shared by 75% of survey respondents.

“Information barriers continue to break down and the interconnectedness of markets can only be expected to increase in the future,” Hussey continues. “As the survey found, this is leading most institutions to turn away in some measure from traditional asset allocation and towards a greater use of alternative strategies.”

In fact, 81% of institutions agree that alternatives are suitable for their portfolios, and 60% feel alternatives are a good potential source of return that can help an investor beat the wider markets. On the other hand, more than seven in 10 (71%) believe that alternatives are already a necessary portfolio component that helps manage risk and asset correlation.

As they look ahead to 2015, 67% of survey respondents expect difficulties over the next three years linked to rising interest rates, and 81% say it will be challenging to manage volatility in that time. As rates rise, the top three ways institutional investors plan to reposition their portfolios are to move from long to shorter-duration bonds (cited by 61%), reduce exposure to fixed income (46%), and increase use of alternative strategies (36%).

The Natixis Global Institutional Investor 2014 study is based on fieldwork carried out in 27 countries. Interviews were conducted in October and November with 642 senior decision makers working in institutional investment. Respondents were leaders of corporate, public and government pension funds; sovereign wealth funds; insurance companies; endowments and foundations; and other institutions.