PGIM, the global investment management businesses of Prudential Financial, published a white paper that looks deeply at the ongoing technological progress being made by investment managers and retirement plan service providers—tying this to the wider development and embrace of new technologies.
Naturally, the paper also looks to the long-term future and asks some heady questions about the ways individuals and societies as a whole think about and manage money. Simply put, PGIM sees a lot of disruption on the horizon, warning some changes in norms could occur far sooner and with deeper consequences than many investors expect.
Not Just About Tech Stocks
According to PGIM, to date, the institutional investor’s lens has been somewhat narrowly focused on the tech sector itself and venture capital-backed startups.
“We believe institutional investors should broaden their aperture and view technological change across at least three dimensions,” the white paper says.
First is the “macroeconomic implications” of more rapid technological change.
“Why are we not seeing rapid technological change translate into rising productivity? We argue that the boost in productivity is coming, but there is an inevitable lag between technological innovation and the spread of tech-enabled productivity improvements to a wide number of firms,” the paper says.
According to PGIM researchers, this lag has been exacerbated in this technology cycle by the fact that several near-term technological benefits are being captured by a few “winner take all” firms.
“Other companies lag significantly behind the adoption curve,” the paper says.
The second broad dimension to consider is “industry implications.”
“Since technological change is impacting companies far beyond the formal IT sector itself—think Amazon’s impact on retail or Netflix’s on media—the very idea of a ‘tech sector’ may no longer make sense,” the paper says. “In this new environment, how should we think about the investment implications of technological change on other sectors of the economy?”
In attempting to answer this question, PGIM researchers illustrate new investment opportunities in the real estate, energy, and consumer goods sectors.
The third broad area to consider, according to PGIM, is “portfolio implications.” As the paper explains, beyond specific sectors and asset classes, technological disruption can impact the “fundamental nature of how portfolio-wide opportunities and risks are assessed.”
“We believe the current wave of technological change will reshape how chief investment officers evaluate the risks and rewards of investing in companies at risk of tech-driven disruption; the investment strategies and vehicles they choose; how they assess their in-house teams and external managers; and how technological, regulatory and political risk are increasingly interconnected,” the paper says.
The concluding section of the paper suggests technological disruption may pose risks to investors’ portfolios, but it also opens a new set of investment opportunities.
Zooming Into Institutional Portfolio Implications
As spelled out in the PGIM white paper, the “economies of scale and network effects” embedded in new technologies can rapidly displace traditional incumbent firms or even digitally savvy firms late off the block. The result is that a single firm or small number of firms often emerges with a dominant market share. The paper cites the examples of Amazon in retail and as a third-party platform, Uber in transportation, AirBnB in home sharing, Google in search, and Netflix in streaming content.
“This winner takes all model means new entrants can rapidly displace long-lived institutions and blaze a trail of destruction, with small differences in quality or cost creating large variations in success,” the paper says. “This is not just happening in the tech sector. Industry concentration has increased across manufacturing, finance, services, utilities and transportation, retail trade and wholesale trade alike.”
The paper says it is a little perplexing to observe this trend of new technologies accelerating the death of companies with embedded traditional models, while at the same time investor demand for longer-term investments has risen.
“In the U.S., for example, the average maturity of U.S. corporate bonds has increased from 9.5 years in 1996 to more than 15 years in 2017,” the paper points out. “And investors are facing pressure to further lengthen the duration of their investments, for example as people are living longer and pension plans and life insurers adjust their portfolios to match the lengthening liabilities. Additionally, the low-yield environment post-crisis has put pressure on investors to reach for additional yield by lengthening loan duration.”
The paper says lengthening maturities are not a new phenomenon, but warns that today’s “unprecedented pace of technological change” can exacerbate the risks investors must weigh when making long-term buy-and-hold debt investments or illiquid investments in private assets, real estate or infrastructure.
“Those risks can include whether or not a firm survives long enough for a successful exit or to repay their debts,” the paper says. “Fixed-income investors may recall that Eastman Kodak issued $250 million of eight-year duration senior secured bonds less than twelve months before the firm filed for Chapter 11 bankruptcy.”
Faced with this “growing obsolescence risk,” PGIM says there are two concrete steps that asset owners should consider.
“First, CIOs may consider forming a cross-asset-class team to evaluate the impact of technological change across all their holdings. This could include a combination of periodic market studies to see which asset types, securities, or sectors face a higher risk of obsolescence from disruptive technology as well as case-by-case qualitative assessments of individual portfolio companies that may be underinvesting in technology and have a higher likelihood of being left behind,” the paper says.
Second, long-duration investments—especially those with credit portfolios wherein investors may bear the risk, but not the upside, of technological change—may require a closer look to build in adequate safeguards given the fast pace of technology-driven disruption.
“Asset owners should work closely with their investment managers to understand what the risks to their portfolio could be, and to identify tools (such as covenants or secured debt in the private markets that provide extra protection against secular shifts, or structured products in public markets) that could help limit the impact of such an event while still ensuring portfolio goals are adequately met,” the paper says.
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