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Market environment driving asset owners to revolution

Revolution Fist

Revolution and pension funds typically don't go together. But today's investment landscape calls for a revolution in asset owner long–term fund management process and structure. An environment characterized by low returns, rising longevity risk and deteriorating demographics requires nothing less.

The scope of change on pension fund process and structure could rival the revolutionary impact of David F. Swensen, chief investment officer, Yale University, and the Yale model of asset allocation. Roughly 30 years ago, Mr. Swensen argued that asset owners should take advantage of their long-term nature to diversify into private, illiquid securities such as hedge funds and private equity. Today the average U.S. pension fund is invested 70% public equity and fixed income and 30% in alternatives. To survive and thrive in the years ahead will require long-term fund management to undergo a new revolution.

Today's environment is markedly more challenging than that of the past few decades. The global economic backdrop can be characterized by four factors: insufficient economic demand, excess supply, an absence of inflation and an overabundance of debt. Furthermore, recent economic analysis suggests many economies already are growing close to or at full potential while the natural rate of interest has plummeted, a combination that is likely to negatively impact future returns.

Three main challenges

The long-term fund management community faces three main issues:

• low investment returns. The average returns for U.S. pension funds for the 12 months ended last Sept. 30, are running in the 2% to 4% range compared with 8% over the past 10 years and close to 12% over the past 20 years;

• rising longevity risk; and

• weakening demographics as advanced and emerging economies age.

While the market decline at the start of 2016 is worrisome, the greater concern is the decline in the trend of asset owner returns coupled with the outlook for potential growth rates and the natural rate of interest.

Here's how these three challenges fit together: As the number of active workers falls relative to a rising number of longer-living retirees, the pressure grows on pension funds to shed risk as investment income becomes more important to pay benefits. So at a time when low returns would suggest taking on more risk to meet the average 7% investment return target for U.S. pension funds, risk mitigation efforts are driving the exact opposite strategies. This scenario suggests two things: return targets need to be recalibrated lower and asset allocation alone is unlikely to solve the challenge.

The long-term fund management future seems to be a good news, bad news story. The good news is that the cost of doing business is declining, from execution costs to human capital to the costs of technology. The bad news is that investment returns are falling while benefit demands are building. How to leverage the good to offset the bad is mission critical. This environment suggests the need for a dramatic transformation of the long-term fund management process and structure.

Seven step program to success

Here is a seven-step program to help pensions and other long-term managers survive and thrive:

  1. Invest in human capital to build internal asset management capability and develop cross-asset expertise.
  2. Cut costs. Core publicly traded holdings should be invested in passive, low-cost, minimum-volatility vehicles.
  3. Spend political capital to lower return targets. Current 7% targets are unrealistic.
  4. Develop partnerships and co-investment strategies both domestic and offshore.
  5. Use partnerships to develop operations in Europe, Asia, the Middle East and Africa to have easier access to regional opportunities.
  6. Prepare for greater competition — the amount of long-term capital is growing relative to the opportunities.
  7. Think about structure. Pressures to consolidate and achieve scale are only likely to grow.

Structural change needed

Continuing weak investment returns should encourage structural change in asset owner fund management.

Negative rates and fully valued equities challenge public market forward expected returns. Private markets seem little better. In 2015, hedge funds on average were big underperformers compared with a typical balanced allocation of 60% equities and 40% fixed income, while private equity faces challenges from the venture capital stage through to initial public offering stage. Adding to the pessimism is rising credit crunch concerns in the private debt markets. Real estate as an asset class has done quite well, giving rise to concerns about overvaluation. Infrastructure is interesting but there is far more money than projects, while timber and farmland are more niche, which won't add much to overall fund returns. The pressures on corporate plans to annuitize as they get close to full funding status, up fivefold in the year ended last Sept. 30 , are only likely to intensify.

Ten years from now the revolution's winners will look very different from the typical pension or endowment fund today. In aggregate, they will manage much more in assets in-house, use low-cost passive and minimum-volatility vehicles for core public positions, have much lower and more achievable return targets, develop partnerships and co-investment structures across the private investment space and run many of these strategies from regional offices in London, Singapore and Dubai. Smaller pension funds should consider these steps as well and use structural adjustment to optimize their process, for example joining with peers to set up regional offices or co-investment vehicles.

Look inside for success

The long-term fund management community, large and small, should look inside for success: one's structure, partners, locations. For this insight, high-level thinking needs to be done. Make it a 2016 priority.

The triple concerns of low returns, rising longevity risk and deteriorating demographics suggests the status quo in the pension fund community is not going to cut it, just as insufficient demand and excess supply suggest the same for the global economy. The juxtaposition of the two serves to reinforce the need for a revolution in long-term fund management structure and process. ???

Jay Pelosky is principal of J2Z Advisory LLC, a New York City-based investment advisory firm providing portfolio strategy and asset allocation advice to asset owners and money managers. J2Z focuses on the nexus between global economics, politics, policy and markets.