A path forward for institutional investors amid market headwinds 

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Red path across white endless labyrinth © scanrail /123RF Stock PhotosThe impact of powerful trends, including aging populations and growing debt levels in the world’s largest economies, has been somewhat mitigated in recent years by the ongoing involvement of central banks in markets and declining interest rates. However, with rates at historic lows, this is not something that can be relied on over the next decade, and returns are likely to be lower going forward across most asset classes.

Ongoing central bank involvement in the capital markets may have been necessary at various points from the start of the great financial crisis until now. However, the overall result today is that we are in uncharted territory. Two decades ago, central banks influenced short-term interest rates, had very small balance sheets and made intentionally vague public statements about the future path of interest rates. That role has evolved dramatically. For example, today, the U.S. Federal Reserve balance sheet is bigger than the largest asset managers in the world, it intervenes directly in the market to influence bond pricing across the entire interest curve, it buys investment-grade and high-yield credit and its pronouncements about future rates are unequivocal.

This presents two challenges for investors: first, over the long term, markets don’t tend to work well when they are dominated by government intervention. Second, by driving rates across the curve into negative real territory, central banks have forced most investors to invest more heavily in risk assets and made it harder for bonds to have the same impact in portfolios they have historically had, namely as a diversifier and a source of return. As a result, investor portfolios are generally riskier today.

Finally, the coronavirus has not impacted all stocks and market segments equally. While many indexes sit roughly at their pre-pandemic levels, this again is tied closely to unparalleled central bank intervention. But, beneath the indexes, there is a high degree of dispersion in terms of individual stock and market segment returns, meaning there are both greater opportunities and risks for investors today.

So, what is an investor to do?

Focus on diversification

Though the term diversification is often over-used, it remains the most important strategy for investors to keep in mind. In a world of lower returns, most investors aren’t likely to have as balanced a portfolio as would be possible if bonds had higher returns and could occupy a larger percentage of their overall assets. Where portfolios are heavily titled to risk assets, it is even more important to avoid large asset class over-weights or under-weights. Investors also need to avoid relying heavily on any one return-enhancing strategy. Investors cannot afford to get it wrong today by placing too much emphasis on one risk asset class or return-enhancing strategy.

Carefully manage costs

Simply put, costs matter a great deal when it comes to investing, and this becomes especially true in a lower return environment. Many of today’s fee structures – like the two and 20 model – were developed when overall returns were expected to be much higher. However, fees have not come down anywhere near the same extent as return expectations. The reality is that every additional basis point of cost erodes net investment returns, so institutional investors must do what they can to reduce costs. This means developing an expanded set of internal capabilities, co-investing with private partners, negotiating preferential terms and avoiding costly external management models like managers of managers and funds of funds.

Ensure adequate liquidity

Liquidity is critical to both capturing the opportunities and avoiding the dangers posed by volatile and unpredictable markets. Most investors’ portfolios are built around the idea that risk assets generate higher returns over the long-term to compensate for higher volatility of returns in the near-term. As a result, they have a large allocation – often more than 60 per cent – to riskier assets. To effectively implement this strategy, investors need to be able to avoid selling at the wrong time, typically when markets are down.

Play to your strengths

Outperforming the markets is difficult, and the asset management industry overall does not have a great record in this regard, especially after taking fees into account. The key to outperforming is to focus on areas where investors or their partners have an actual advantage. For us, this generally means using our longer investment time horizon, our tolerance for illiquidity and our scale (which allows us to partner with some of the best investors in the world).

Watch the big picture

We are careful to navigate the big trends that can significantly impact investors’ portfolios. This does not mean speculating on the future or trying to spot obscure trends before anyone else. It means ensuring that our portfolios are adapted to powerful and often obvious and inevitable trends, like the rise of sustainable investing or the rapid acceleration in online shopping adoption driven by the coronavirus crisis.

While today’s investment climate is very challenging, the key to success is sticking to the core investment strategies that produce higher risk-adjusted returns over the long-term. Investors who can do this well will be strongly positioned to navigate this volatile and uncertain environment and emerge with momentum and confidence.

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Contex Group