The shift to active ownership may help to foster longer-term value creation.
Banks and brokers are the most widely disparaged culprits behind the financial crisis, due to their short-termism and excessive risk taking. Yet, they were acting on behalf of large institutional investors who failed to effectively monitor their investments.
A broader transition to active institutional ownership is gaining momentum, largely due to the extensive shedding of debt taking place in the corporate and financial spheres.By replacing debt with equity, investment managers are likely to become less inclined to maximize short-term results and instead focus on companies' long-term value creation.
However, institutional ownership of large stakes in companies could provide better monitoring, and more aligned incentives, without necessarily increasing risk thanks to so-called relationship investing - or actively investing for the long term, in exchange for some say in how a firm is run. Stewardship should matter to institutions that take the long view. Some asset managers may not welcome it, as it involves spending more effort and resources.
Pension funds, endowments, insurers, and sovereign wealth funds should therefore share some of the blame, due to their passive corporate governance. In the future, they will hopefully act as better stewards of the companies they invest in by adopting a more active stance. Norway’s $1 trillion sovereign wealth fund, for example, has clearly stated its expectations for the companies it invests in, in terms of corporate governance, shareholder rights, social issues, and the environment. The fund’s active ownership is a tool to both protect shareholders’ rights, and to benefit the people of Norway.
Active ownership has implications for the relationship between asset owners and managers, with performance no longer hinging purely on short-term market benchmarking, but also on longer-term metrics like internal rates of return. The organizational impact of this will be profound, as layers of intermediaries are reduced, more reliance is placed on internal capabilities and in-house expertise, and fewer mandates are granted to external managers and funds of funds (a mutual fund, for example, that invests in other funds).
Dedicated teams can more effectively operationalize an institution’s long-term mission, and improve corporate governance at the companies being invested in. In principle, the cost of active ownership is the increased volatility that results from more concentrated portfolios; diversification is widely considered the surest way to achieve better returns.
However, until institutional investors start to behave like well-informed, responsible owners, managerial entrenchment will undermine the long-term prospects for finance capitalism.
Environmental, Social and Governance
Institutional investors are increasingly seeking out options like green bonds and impact investments.
A paradigm shift began after the financial crisis dramatically demonstrated the inter-dependence of individual financial choices, markets, economies, and global challenges like climate change. Meanwhile stagnant economic growth, mounting populism, and rising inequality all point to governments’ limited ability to provide effective solutions. Against this backdrop, new preferences are forming, particularly among young people.
One of the most promising developments is so-called “green bonds,” or traditional fixed income instruments used to finance exclusively environmentally sustainable projects. Another financial innovation gaining ground is impact investing, where commercial returns are coupled with socio-economic or environmental impact. Institutional investors such as endowments and sovereign development funds have been particularly active as part of this new investment model, which aims to achieve a triple bottom-line measured according to profit, environmental impact, and social benefit.
A growing share of consumption is focused on goods and services that provide a collective experience, for example, while an awareness of climate change is spreading, and sustainability has become a key buzzword as corporations increasingly observe so-called environmental, social and governance, or ESG, standards. Institutional investors have also started to embrace the ESG agenda.
In recent years, a number of related initiatives have emerged that have boosted the adoption of ESG. Only time will tell if ESG can become mainstream. The extent to which institutional investors begin to access and promote ESG objectives requires an assessment of where they align with existing asset classes and investment products - and an understanding of strategies that can further specific ESG goals. This shift in perspective will enable institutional investors to play a larger role in shaping the future of various industries, as they incorporate these criteria into their investment portfolios.
Long-term Incentives and Mandates
There is often an inherent mismatch between the goals of asset owners and managers
In designing long-term contracts, institutional investors should address whether or not fees and fee structures reward a long-term focus, to what extent benchmark-relative returns capture a specific strategy’s performance, and whether a contract encourages long-term commitment and protects against overreacting to short-term downturns. The asset manager should be able to commit to the long-term strategy, while maintaining the liquidity needed to meet permissible redemptions - and reporting tools should address long-term priorities. Starting a relationship with a shared, long-term mindset is more likely to lead to a mutually beneficial results for institutional investors and their managers.
Institutional investors often have relatively long-term investment goals, put in place in order to adequately fund liabilities, preserve endowments, and provide for future generations. For some of these asset owners, especially pension and retirement funds, these goals reflect the long-term needs of individual plan members - who rely on these institutions to safeguard and augment savings they will rely on down the road. Ensuring that assets are managed in line with these long-term horizons is critical. This presents a challenge, however, as asset owners may have specific objectives tied to return goals and risk tolerance, while asset managers have internal incentives for portfolio managers and business leaders that tend to reward short-term performance - which can lead to excessive risk taking. The relationship between asset owners and managers is therefore often a time-horizon mismatch.
Translating long-term objectives into investment mandates can involve re-thinking the key performance indicators used to evaluate asset managers. While a company's quarterly financial performance provides an easy measuring stick, for example, it is unlikely to provide much information about future prospects over the duration of a long-term investment mandate.
Ideally, there is an alignment of incentives and goals, often over a long period. Institutional investors’ best tool for this is an investment mandate that governs relationships, lays out specific terms, and can serve as a mechanism to align behaviors and objectives. Shaping these mechanisms with provisions oriented to long-term goals can help build stable, lasting investment partnerships and improve long-term performance.
Many investors have avoided thematic investing, because they think it is too complex to put capabilities in place to develop distinctive insights related to trends like a growing global middle class, increased lifespans, and lifestyle changes. Institutional investors are developing strategies based on structural, political and social trends.
A thematic approach can enable investors to generate unusually high returns by focusing on areas where significant amounts of capital may be required. It also provides a flexible way to validate insights. However, thematic investing demands a relatively significant amount of research.
In the years following the global financial crisis, structural economic changes such as ultra-low interest rates, global deleveraging (the shedding of debt assets), and technological innovation have changed the ways that institutional investors deploy capital.
The speed of that change is only accelerating, and institutional investors are questioning traditional frameworks based on relative performance - which may fail to incorporate the secular trends (long-term trends, such as the growing economic and geopolitical influence of China, for example) shaping the global economy. Institutional investors have therefore started to consider thematic investment, which goes beyond strategic asset allocation to hone in on these longer-term, structural, political, and social shifts.
Recently, though, more investors are creatively implementing thematic investing, usually as a complement to other models. As they gain a better understanding of particular sector exposures and then invest accordingly, institutions can increase their odds of delivering superior returns, and of helping to address pressing economic and social challenges.
Institutional investors are increasingly seeking to cut out middlemen and invest directly.
In the aftermath of the 2008 financial crisis, volatile, uncertain, and relatively unattractive returns on traditional investments encouraged investors to increase focus on illiquid assets - which are typically private equity-, real estate-, or specialized funds. US private equity funds, for example, have yielded relatively stellar annualized, compounded, net-of-fees returns over the past decade of close to 12%, outperforming all other asset classes. However, the potential for improved returns in illiquid asset classes has also led many institutional investors to explore the extent to which they can make these investments directly - and save management fees, while gaining greater control.
As the holders of “patient” capital, institutional investors play an important role in by helping to stabilize global markets while also funding long-term corporate growth, infrastructure development, and real estate. Any changes to the ways that asset owners allocate long-term capital can have a broad impact on society, and significant potential impacts on infrastructure and urban development.
Collaboration is a way to leverage limited personnel, to learn from investment partners, and to spread risk. Increased direct investment has implications for the global economy - it fosters long-term bets and therefore has a stabilizing, counter cyclical effect on markets. However, institutions as direct investors face daunting organizational challenges; whether or not they can succeed will depend largely on their ability to execute, source the right deals, and find the right talent.
There are constraints on the adoption of large-scale, institutional direct investing, however - particularly related to size. Only a very large institution can afford to run sophisticated, internally operated direct-investing teams at a lower cost than what would be incurred by fund managers. Direct investment will therefore not likely become the dominant institutional model, and instead will grow steadily in popularity, particularly for large institutions with flexible mandates and long-term horizons.
State-owned sovereign wealth funds, for example, have increased their allocation to illiquid assets like real estate and infrastructure such that it now accounts for more than half of their total investment. These sovereign wealth funds have also displayed an increasing desire to team up with other investors, particularly as institutional investors in a general move away from expensive, often ineffective external fund management toward internal portfolio management.
Institutional investors such as pension funds, insurers, and sovereign wealth funds find themselves in a changed world more than a decade after the global financial crisis.
As they more actively monitor standards and behavior at the firms they invest in, invest based on long-term themes like ageing populations, and increasingly focus on environmental and social issues, institutional investors are playing a key role in the distribution of capital, the growth, and sustainability of the private sector, and the promotion of strong corporate governance.