Looking back over the past 10 years, institutional investors have faced mounting challenges amid rising geopolitical turmoil and intensifying competition from an array of new players. At the same time, aging populations in developed countries have started to strain retirement systems, creating pressure for higher returns. Changing social attitudes are spurring funds to earn those returns through more responsible investing.
In response, we've seen most sovereign wealth and pension funds grow bigger, go deeper into global markets and get more hands-on in managing their assets. There are, of course, different strategies adopted across the industry and we continue to see certain organizations outperform others on the operational effectiveness front. A key differentiating characteristic appears to be the ability and willingness of certain organizations to anticipate and adopt strategies to address these changes. Certain of these changes are described below.
Investment portfolios: more diverse and complex
The historic investment model saw funds pool their investments in liquid public and capital markets through external investors. Today's institutional investors are looking for higher yields for the longer term, and they're taking on progressively more complex investments across asset classes, including real estate, infrastructure, PE and credit. Many have also increasingly moved towards more direct ownership and active operations.
As portfolios grow more sophisticated and diverse, funds need to expand their internal expertise to ensure their assets are well managed from financial, risk and governance perspectives. This means building new capacity to insource key activities and to collaborate with strategic partners. This also means increased costs, which raise the need to obtain data and address considerations of management expense ratios such that a demonstration of the net (not gross) costs and return on investments can be determined.
Advancing technology: opportunities and risks
In terms of technology, we continue to see many organizations continue to implement new technologies in relation to front, middle and back office needs; however, it is very often without an organization wide technology strategy and can result in trapped or silo outputs. Certain leading organizations have started to tap the breaks a bit on implementing narrow technologies and instead are spending time on developing technology strategies while seeking out technologies that aggregate existing information and systems. Harvesting and coordinating existing data sources across group functions and/or asset classes via overlay solutions that work seamlessly with current systems is a recurring theme. For instance, expanded investment models - and the need to remain efficient and transparent - are often a key driver of technology demand for many investors. In a previous blog, I detailed how leading funds are using data and analytics to improve their ability to compete -- from forecasting trends and making investment decisions to digitalizing due diligence processes. For other organizations, addressing external stakeholder-technology is key. Many pensions, for instance, are working to address the needs of beneficiaries seeking access to greater information via desktops, tablets and smartphones to research financial products and make investment decisions. Other institutions face similar internal challenges to provide portfolio specific information to group finance, tax teams, deal teams and ESG professionals. The challenge is the same for an organization, whether focusing on its internal or external customers: providing real-time, accurate information to support critical decision making processes. Funds that get it right stand to win substantial benefits in building their brands while efficiently integrating with the vast technology solutions likely operating within their organizations.
We are also seeing a newer, growing risk that investors must increasingly address: security. All technologies come with risks. Institutional investors deal with high amounts of sensitive personal and financial information. Investment strategies and other forms of intellectual property, such as algorithms and source code, are also vulnerable to cyber theft. Fraud related to trading activities and electronic fund transfers is rising. Safeguarding information systems against cyber threats is not only a complex regulatory and legal compliance concern, it's also key to avoiding the reputational and financial damage that a serious cyber breach might inflict.
Investment decisions: adding ESG factors to the mix
Changing social attitudes continue to draw more focus to ESG concerns. Many institutional investors are under pressure to invest more responsibly -- whether from pensioners, activist directors, chief ESG officers, external groups or other stakeholders. Unfortunately there is no consensus on how to define and measure value for ESG purposes, especially where broader social impacts are concerned. Clearly, some investments can harm reputations, but most decisions based on ESG considerations are not black-and-white. From a social responsibility viewpoint, should you steer clear of an investment that does the wrong thing? Or is it better to help steer that investment toward doing the right things?
With no common definitions or ways to measure ESG impacts, institutional investors need to craft their own approaches. This means developing bespoke ESG parameters to guide decisions and measure performance based on the culture and values of the company, its beneficiaries and stakeholders, and broader community or nation.
Dramatically changing operating models
To manage the portfolio complexity, advancing technology, and ESG priorities briefly described above, many institutional investors are considering additional resources and capabilities, bringing more activities in-house, and putting more focus on transparency, governance and risk.
All functions, including tax and finance, are being called on to add more value and deliver strategic advantage, so they need to be more agile and contribute to better decisions. Technology should be part of the solution, but in fact we are finding the most critical step involves re-thinking functional silos and achieving new operating models (and technology solutions) that favor collaboration and teamwork across functions.
In step with their more globally diversified portfolios, many institutional investors I work with are growing their geographic footprint, and the trend toward more direct portfolio management is seeing more funds open satellite offices. Establishing local investment offices can prove very beneficial; however, the additional operational complexity must also be addressed. This often means such funds need strong policies over, for example, the degree of accountability and decision-making capability given to the satellite locations and how they tie into headquarters.
The trend to developing strategic partnerships has also spurred many leading institutional investors to up their game. Funds that establish dynamic operating models and capabilities can attract better partners. And the resulting improved (joint) capabilities can open access to compete for increasingly complex - and lucrative - opportunities. Of course, complex deals require more resources, strong governance and sophisticated capabilities. Increasingly, being a source of long term capital is no longer sufficient for institutions seeking the most lucrative consortium opportunities; rather, it is the ability to bring additive sophisticated investment capabilities to a group that is a differentiator.
In short, the scope of transformation we have seen in the past decade has been enormous. All institutions have undergone significant change, but those institutions at the forefront of change have become a distinguished group -- and they're winning much stronger competitive positions as a result.