Institutional Investors Bite off More Than They Can Chew in Their Quest for Better Returns

Sovereign wealth funds, endowments, pension plans -- across the board, institutional investors are rushing into alternative asset classes to escape the purgatory of low returns they expect from public markets over the next few years. But a new report from State Street Corp.’s Center for Applied Research says these investors are failing to make decisions that will help them meet their individual objectives, manage risk and handle the greater portfolio complexity these moves will bring. “Irrespective of their stated goal, institutional investors are exhibiting a herd mentality by increasing their exposure to alternatives,” says Suzanne Duncan, the report’s Boston-based author. “While there is nothing wrong with alternatives, what’s worrisome is that investors feel unprepared to handle the risks and complexity.”

Based on input from more than 3,000 financial industry participants in 60 countries, including 200 face-to-face interviews with State Street’s applied research group, the report also highlights the tougher environment that asset managers still face after the financial crisis. From the 1980s to 2007, their growth seemed unstoppable as institutions diversified out of conservative portfolios and individuals socked away money for retirement. In the five years since the crisis struck, though, retail investors have gotten more conservative despite saying they need to be more aggressive to reach their goals. Meanwhile, institutional investors are adding hedge funds and other complex investments. To stay competitive, asset managers must respond to these wholesale changes.

“Investors are no longer acting in their own best interest,” says Duncan. She stresses that institutional investors of all stripes are pursuing similar strategies regardless of their very different aims.

In the U.S., 45 percent of respondents said low interest rates have increased their desire to add alternatives to their portfolios. In a separate State Street online survey of 100 institutional investors, 56 percent said they are boosting direct allocations to illiquid private markets, including private real estate, private equity and infrastructure. At the same time, when respondents were asked about their biggest challenges, the “complexity stemming from increased investments in alternatives” ranked No. 1.

Duncan says investors’ moves to plow money directly into certain strategies without using external money managers reflects disillusionment with the value they’re getting from intermediaries relative to the fees they are paying. “They’re looking to take matters into their own hands much more aggressively than in the past,” she explains. “They are being driven by artificially high expectations of future returns.”

On average, the expected market return for defined benefit and defined contribution pension plans is 8 percent, which most experts agree is wildly optimistic. To support their direct investing efforts, institutional investors are on a hiring spree.

To combat investors’ mistrust and poor decision making, Duncan says, asset managers should personalize performance reporting so it’s a better match with clients’ goals. Most performance is now reported relative to peers or commonly used benchmarks such as the Standard & Poor’s 500 Index. “We need to overcome trying to outperform a benchmark that might be meaningless to a client and quit attempting to compare ourselves against our peer group,” Duncan says.

Robert White, executive director and portfolio manager with J.P. Morgan Asset Management’s global multiasset group in New York, says the firm uses customized benchmarks to help investors analyze its performance over short time periods or to pinpoint the value a manager is adding. Such benchmarks make sense for, say, an endowment aiming for a real rate of return of 5 percent over inflation.

“Comparing a manager’s performance to peers or to a standard index wouldn’t help the endowment analyze whether it was on its way to meeting its goal,” White says. He adds that customized benchmarks are especially useful for more-open-ended mandates, such as when a pension fund outsources a portion of its portfolio to J.P. Morgan, giving the firm freedom to invest where it sees the best opportunities. “It’s a better way to judge success,”  White maintains. “An investor’s objective could be to manage volatility, protect on the downside or speed the time to close a funding gap.”