Looking ahead after 4 decades

Evolution and innovation will continue at a rapid pace, radically transforming institutional investment management by the time Pensions & Investments' 50th anniversary rolls around n 2023.

Predictions for changes a decade out range from wholesale abandonment of traditional asset allocation to a return to old-fashioned core-and-satellite portfolio construction with some very modern twists.

“In 10 years, investors will be much better at identifying risk and will be all-ocating risk rather than capital. The world will have woken up to the fact that the focus has to be on risk rather than asset allocation,” said Max Darnell, managing partner and chief investment officer of quantitative money manager First Quadrant LP, Pasadena, Calif.

“I think it will be a very, very different world,” a decade from now, he added.

Sources didn't shy from 10-year predictions.

“We're not talking about flying saucers ... the state of the investment industry a decade from now is visible today if you look very closely, talk to people and listen carefully,” said Terry Dennison, senior partner and U.S. director of consulting, based in Mercer's Los Angeles office.

Pensions & Investments used the occasion of its 40th anniversary to talk to a wide swath of industry sources, including both veterans and fresh-faced up-and-comers, about the future of institutional investment management.

“I'm very optimistic about the next 10 years,” said Simon Ruddick, CEO of alternative investment consultant Albourne Partners Ltd., London.

“There are smart, decent people on both sides of the industry that will come up with innovations and solutions. If you give institutional investors a chance to look at great investment deals, they will move toward them.”

By contrast, Robert Prince, co-chief investment officer, Bridgewater Associates LP, Westport, Conn., set a rather dark stage for the coming decade.

“Innovations usually arise in response to a problem” and chief among problems in the next 10 years will be low investment returns, Mr. Prince said.

Returns of defined benefit plan portfolios are likely to be 4% annualized over the next decade, according to Bridgewater's estimate, a far cry from the 7.5% to 8% annual return assumption many pension plans have adopted in recent years.

“Everyone feels pretty good now about their funded status (thanks to recent market returns), but over time, low returns will eat away at funded ratios,” Mr. Prince said.

He said there are only three ways to protect funded status: take more risk; apply risk more efficiently; and generate alpha.

Mr. Prince said if these solutions fail, the only other way to improve or maintain an acceptable funded ratio is to increase pension contributions.

In fact, “pension fund sponsors should really be raising contribution levels now, prior to the decline,” he stressed.

Efficient identification of and allocation to risk will be one of the most important drivers of change for institutional investors, and will be most evident in portfolio construction.

“Evolution over the last decade has shown that asset allocation is not an adequate framework for portfolio construction or for describing risk,” said Celia Dallas, managing director and director of investment research at consultant Cambridge Associates LLC, Boston.

“Plan sponsors know much more than they used to about what their risk is and how much they can take, but are inefficient in how they apply this knowledge,” said Ms. Dallas' colleague, David R. Druley, managing director and head of Cambridge's global pension practice.

Recognition of the inadequacy of traditional asset allocation models already is nudging some institutional investors to build risk-allocated portfolios, Ms. Dallas said, predicting broad adoption of the structure in the next decade.

“Over the next 10 years, the industry will have come up with a more standardized lexicon to describe common risk factors. Managers will have to build new risk-managed products with input from institutional investors,” Ms. Dallas said.

Among the new risk factors that institutional investors need to get their arms around is global macroeconomic risk, said several sources, including Mercer's Mr. Dennison.

“There has to be a lot more thinking about macro trends. Tactical asset allocation historically has been valuation based and people were only looking at specific valuations of specific securities. But the history of the past few years has shown that sometimes, the macro world interrupts the micro level,” Mr. Dennison said.

“Institutional asset owners had a mindset that because they are long-term investors, they could ignore intermediate volatility. This is illusory because if you aren't conscious of short-term risk, you will never reach your long-term goals,” Mr. Dennison stressed.

“When you step back and acknowledge that volatility has such a dramatic impact on the portfolio,” managing to volatility targets rather than asset weightings makes much more sense. “It is a completely different way to express your policy portfolio,” agreed Michael Thomas, chief investment officer, Americas Institutional, Russell Investments, Seattle.

Some Russell clients, which Mr. Thomas did not identify, have moved to managing portfolios based on volatility (i.e., in line with Ms. Dallas' risk-allocated portfolios), but it might take “three to five years before this trend really takes off” and then continues through the end of the decade and beyond, he said.

Sources were confident that the alpha-beta separation trend will result in wide implementation of core-satellite portfolios over the next 10 years.

“Smart beta is a different way of providing investors with low-cost indexes,” said Jason Hsu, chief investment officer, Research Affiliates LLC, Newport Beach, Calif.

In fact, Mr. Hsu predicted smart beta investment strategies “could be a trillion-dollar space,” if smart beta attracts 20% of the traditional indexing market.

“Investors are starting to segregate beta into separate portfolios that can serve as the core of a portfolio. The question then is what the satellite active portfolio will look like,” Mr. Dennison said.

“The future is separation of alpha and beta on steroids, an extension of a 20-year trend,” said Erik L. Knutzen, chief investment officer at investment consultant NEPC LLC, Cambridge, Mass.

In answer to Mr. Dennison's question, Mr. Knutzen forecast that alpha satellite portfolios “are going to get far more attention,” but stressed “the nature of alpha capture will change and that dynamism will be a very important part of the capture process.”

Alpha generators will need to be able to move quickly among fleeting equity, fixed-income, credit and other types of opportunities, which for many will necessitate broad-based investment capabilities and global reach, according to Mr. Knutzen said.

“Opportunities and dislocations will arise and decline very quickly, and managers have to be ready to immediately exploit them. If they can't, these managers will struggle to justify their active fees,” Mr. Knutzen said.

Regulation will provide some of the biggest investment opportunities for hedge fund and credit managers as U.S. and non-U.S. authorities continue to force banks to reduce risky assets they traditionally held, said Andrew Feldstein, co-founder and CEO of BlueMountain Capital Management LLC, New York. Demands by shareholders and other stakeholders also will keep pushing banks to offload their financing businesses, he said.

Credit managers like BlueMountain, which manages both long-only and hedge fund assets, will “fill the vacuum” created as banks reduce or shed specialty finance businesses such as mortgage origination, commercial real estate, automobile loans, student loans and equipment loans, as well as more plain-vanilla corporate lending, Mr. Feldstein said.

“This opportunity opened up by bank regulation is not temporary. It may not last forever, but we definitely see it as a long-term trend and we are hyper-focused on it,” he said.

“Regulation is here to stay,” Mr. Feldstein said, adding adaptation to the new environment will prove lucrative for credit managers with solid infrastructure and the capability to exploit swift-moving opportunities.

Even the descriptions of investment strategies used for defined benefit and defined contribution plans, endowments, foundations, sovereign wealth funds and other institutions, will undergo dramatic change over the next 10 years, accorrding to First Quadrant's Mr. Darnell.

“There won't be "alternatives' anymore, for a start. Alternatives will be completely mainstream in 10 years,” Mr. Darnell said.

“We won't be talking about developed and emerging markets, just global or local managers. Even the designation of quantitative and fundamental managers will be gone, as the blending of systematic processes with human judgment continues at an even faster pace,” Mr. Darnell said.