From Big To Great The Worlds Leading Institutional Investors Forge Ahead by McKinsey & Company
Executive Summary
Over the past several years, leading institutional investors have opened offices around the world and built large teams with new talent specialties. What’s next for the world’s largest investors? How will they stay on their strong trajectory? What do the changes in the macro environment mean for them? How will they manage the increasingly complex internal structures they have set up?
To answer these questions, we have surveyed 27 large pensions and sovereign wealth funds that collectively manage $7.4 trillion in assets, and interviewed leaders of these institutions in depth. Our research shows that institutions have a strong desire for a more strategic approach to portfolio construction. They plan to elevate liabilities to a central role in asset allocation. And they want to broaden investment capabilities to include new asset classes, investment strategies, and approaches to value creation, all with a view to driving greater risk-adjusted returns for beneficiaries.
Delivering on these strategic priorities will require new capabilities. Institutions we surveyed identify seven areas in which they plan to invest: (1) developing a high-performing culture across the organization; (2) evolving the risk-management function to assess and manage risk embedded in illiquid assets; (3) improving the value proposition to attract top talent; (4) building a strategic approach to reputation and branding; (5) turning the research function into an “insight engine”; (6) “de-biasing” the investment decision-making process; and (7) creating an advocacy strategy to develop a voice commensurate with asset size. Developing these capabilities will be difficult, requiring substantial commitment and resources, but the payoff will define the leading institutional investors over the coming decade.
From Big To Great The Worlds Leading Institutional Investors Forge Ahead
Over the past several years, leading institutional investors have built significant organizations, opened offices around the world, and built large teams with new talent specialties. And with rapid growth in assets and strong returns since the global financial crisis, most are now heavyweights in every sense, recognized as essential players in the global financial system. Some of the largest pensions and sovereign wealth funds manage over $1 trillion. As US senator Everett Dirksen is alleged to have said, “A billion here, a billion there… pretty soon you’re talking about real money.”
What’s next for these behemoths? Institutional investors get full credit for their size from the financial system. But what will they do with their new bulk? Our new research suggests that some leading institutions will break away from the pack, and cease to be simply colossal pools of aggregated investment demand and agglomerations of talent. Leaders will live up to their name and become truly great institutions, with deep and permanent capabilities deployed against a broad range of investment practices.
We surveyed over 50 senior executives at more than half of the top 50 pensions and sovereign wealth funds worldwide, which collectively manage $7.4 trillion in assets (Exhibit 1).
We also interviewed leaders of these institutions in depth, and solicited the views of our colleagues around the world who work with leading investors. The research revealed two themes that turned up again and again. First, the world’s leading investment institutions are intent on evolving into true institutions that are more than the sum of their parts. Second, a re-examination of the portfolio construction process has become the top priority for many of the CEOs and CIOs we interviewed.
This report is intended primarily to present these research findings. But we will also attempt something more. We found a strong tendency of institutions to endorse leading practices, even before they allocate the necessary resources to implement these practices. In other words, institutions sometimes talk the talk before they walk the walk. Many of the leaders that we spoke with readily conceded this gap, and their ambition to close it. Accordingly, we have built on the current consensus, as revealed by the survey, to imagine what the leading edge of institutional investing might be like in five years’ time, with the aim of helping institutions set the right aspiration.
Portfolio Is The Priority
The importance of portfolio construction is not a new idea – far from it. Various academic studies over the past two decades have found that approximately 90 percent of variation in returns over time are attributable to a fund’s asset allocation decisions, and about 35 to 40 percent of the differences in performance between funds is due to differences in asset-allocation choices. What is new, however, is that traditional approaches to asset allocation are now seen as inadequate, and CIOs and CEOs are increasingly willing to rethink their process. Indeed, leading investors are not only questioning capital allocation across asset classes, but also the definitions of the asset classes themselves, and the decision-making process to get there. We found six ways that institutions will place new prominence on portfolio construction.
1. Putting strategy back into asset allocation
Until recently, strategic asset allocation (SAA) has been rather non-strategic. Most institutions used historical estimates of returns, correlation, and volatility, plugged in relevant constraints, and generated a frontier of portfolio options that theoretically matched their risk and return objectives. Because the estimates and constraints changed very little, last year’s SAA became a powerful anchor for this year’s allocation. Significant adjustments to the SAA have been rare, with the exception of a long-term trend among many institutions to shift an increasing portion of their portfolios to illiquid assets. Indeed, for most pension and SWF boards, the review of asset-allocation decisions has been more or less a rubber-stamping exercise.
Instead of working on the SAA, many institutions have spent the bulk of their time on the search for alpha through a number of means, including active management (both internal and external) and direct investing in illiquid asset classes. The work on beta has been mainly to reduce costs, often by internalizing management, with some exploration of enhanced-beta portfolios. Our interviews confirmed that institutions generally spend 20 percent of their time on beta, including the SAA, and 80 percent on the search for alpha.
In the biggest change to affect investing recently, leading institutions are realizing the implications of this mismatch. Low interest rates have added considerable capital to the global financial system, pushing up prices on all kinds of assets and effectively lowering risk premiums. Hitting “repeat” on the SAA from year to year has had the unforeseen consequence that institutions are not being paid for the risks they are taking. That’s costly: the payoff from getting the SAA right is worth a decade of good deal-making to create alpha at the margin.
With risk premia so low, some investors have considered going to the extreme of allocating more of their portfolio to cash. A small number of players have already started doing this, with the Australian Future Fund in particular raising cash levels to over 20 percent of the portfolio at the end of 2015. However, most institutions have limitations that prevent them from doing this and are exploring other approaches such as factor-based investing, a rapidly accelerating investment style. By one estimate, the AuM dedicated to this approach have quadrupled over the past several years.
Even more important than risk factors is a shift in the 80/20 management approach. Institutions plan to rebalance their efforts by doubling down on portfolio-construction capabilities, given that these drive the vast majority of long-term returns. The most striking finding from our research is that almost 80 percent of institutions plan to reinforce their central portfolio-construction team, with most expecting to add three to five people. In interviews, leaders also said they expect a more dynamic decision-making process structured around top-down economic scenarios, which they hope will provoke more debate and move them away from a rote approval of the SAA by the executive committee and board.
Exhibit 2 summarizes the key shifts that institutions expect to see in the portfolio-construction process.
In summary, by 2020 leading institutions will focus much more attention on the SAA, and will reshape it into a dynamic, forward-looking, keenly debated, and deeply researched document.
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