Times are changing for institutional investors. After three decades of a stable economic order that helped facilitate strong returns and steady growth, institutional investors now face a new era marked by uncertainty, disruption, and radical shifts in public expectations of business and society. A global pandemic, a war in Europe, an energy crisis, disruptions in global supply chains, inflation, and growing social division are just a few signs of disorder. In this context, the course of future events has become much harder to foresee and returns may be more difficult to come by.
To understand how institutional investors are responding to the new circumstances, we collected perspectives from senior executives at 40 of the world’s leading pension and sovereign-wealth funds, which collectively manage $10 trillion in assets. Our research uncovered insights into how institutional investors are navigating these external upheavals. As they aim to evolve their strategies in a far more unpredictable world, leading institutions are seeking to hone their “performance edge” by focusing on purpose, portfolio construction, and proficiency.
Interviewees: We’re at a turning point
Past turning points have released forces that fundamentally shaped the subsequent era. Consider how the breakup of the Soviet Union ushered in three decades of peace, rising prosperity, and global economic integration that institutional investors have grown accustomed to. In that environment, the median institutional investor produced 9.5 percent in annual returns from 2012 to 2021 (exhibit).
Institutional investors we interviewed unanimously agree that the current environment is radically different from the global investment conditions of the previous three decades. Indeed, interviewees recognize shifts in five domains that are likely to define the current era: shifts in the world order, technology platforms, demographic forces, resource and energy systems, and capitalization.1
A new world order
Changes in the world order are top of mind for institutional investor leaders globally. Ninety percent of interviewees cited these changes as a concern. The leader of a sovereign wealth fund said that the possibility of further geopolitical shocks has caused a rethinking of its investment horizon. Geopolitical tensions could also force institutions to divide their investment operations to limit information sharing. And many see an increase in economic regionalization.
Technology emerged as an area of focus for more than four-fifths of respondents. Institutional investors are beginning to incorporate technology into their investment processes. They have also become targets of cyberattacks. In 2022, there was a 243 percent increase in ransomware attacks, a 269 percent increase in crypto jacking, and a 94 percent increase in intrusion attempts.2 This ongoing threat is causing leading institutions to bolster their risk management.
Demographics looms large, with 76 percent of respondents raising it as an area of focus. Declining social mobility, increasing economic inequality, political polarization, and aging populations have prompted a renewed focus on social issues as an investment criterion and a consideration in guiding investors’ businesses.
Resource and energy systems
By far the most salient challenge for interviewees is global resources and energy systems. All investors we spoke to said it was a defining issue for their investment strategies. The amount of capital expenditure required is vast: about $275 trillion on physical assets for energy and land-use systems between 2021 and 2050.3 Institutional investor executives anticipate that they will be expected to finance a significant proportion of this outlay.
Many interviewees expressed unease about the challenges of reaching net zero and of managing pressure from vocal stakeholders who object to the adoption of net-zero strategies. They are constrained in their ability to accelerate the pace of change, particularly because the transition to net zero is riddled with challenges and nuances. For instance, one North American CEO pointed out that simply divesting from high-emitting assets is not an answer. What’s more, many expressed worry about the green transition creating further strain on global energy markets.
Last, three-quarters of interviewees named capitalization as a concern. Many described the rebalancing of the global balance sheet currently underway as a reset or a regime change. One North American chief investment officer considers this to be a near-term headwind for all asset classes but expects to persist with fundamental portfolio construction in the belief that the inflationary environment is here to stay.
Purpose, portfolio construction, and proficiency
In this context, institutional investors will need to be faster, nimbler, and better at anticipating and responding to change. Our interviews revealed that investors are intensely focused on three areas.
Institutional investors are built to deliver returns to their beneficiaries. But integrating environmental and social considerations is increasingly important. This change is highly visible as it relates to climate change, perhaps the world’s biggest long-term problem. As one interviewee observed, sustainable investing and long-term investing are the same thing.
When it comes to social considerations, institutional investors are at different stages of developing their strategies, with some launching social-impact investment programs while others focus on monitoring social factors within their portfolios. As institutional investors have intensified their work on social considerations, diversity within their own ranks has also come into focus; more than a quarter of institutions covered in our research have committed to improving diversity in the industry.
The challenge for investors is to develop a distinctive and nimble approach to portfolio construction. Interviewees’ short-term focus is to derisk their portfolios, paying attention to inflation-linked assets if they believe higher levels of inflation may be entrenched. Asset allocation is becoming more dynamic, with investors adjusting their exposures based on their expectations of medium-term trends.
As the macroeconomic environment becomes more challenging, many institutional investors are reexamining how they invest in private markets, paying more attention to their private-market exposures and the partners that manage them. More investors are jumping into early-stage investing, attracted by the value creation happening in the early stages of companies’ development.
Institutional investors have diverging views on emerging markets. While some investors are responding to current conditions by pulling back from emerging markets, others are continuing to buy but are increasingly focused on each country’s strengths and weaknesses.
As institutional investors have grown in scale and scope, many have sought to increase internal capabilities and move away from working with external partners. However, institutional investors recognize they cannot internally hold the full range of capabilities needed to thrive in an uncertain world.
A major question is where to focus on building capabilities and where to partner. Many institutional investors are building expertise in select areas and partnering with other organizations to complement their core capabilities. Some are exploring ways to combine resources to create longer-term, more stable pools of capital.
Technology can help support decision making around investments, and interviewees indicated that they are embedding data and analytics into their investment and portfolio management processes. Several leading investors are embedding digital and analytics–enabled tools directly into investment teams, with the goal of bypassing the need for separate analytics teams.
In the face of increased reliance on technology, many investors are looking to shore up capabilities in risk management, including in critical areas such as cybersecurity. Many institutions are responding to increasing risk by incorporating cyber risk in their due-diligence processes and reassessing their organizational cybersecurity.
Industry-wide, collaboration between institutional investors can help drive consensus on policy matters such as standardized environmental, social, and governance (ESG) metrics. Institutional investors are also increasingly compelled to work with public-sector stakeholders on global issues such as decarbonization, an area in which governments will likely be unable to underwrite the necessary investment on their own.
These changes, particularly ones related to internalizing capabilities, necessarily affect investors’ talent strategy. Professionals with skills in IT and responsible investing remain difficult to attract and retain. And many organizations are responding to macroeconomic challenges by looking for talent with skills such as partnership building and expertise across asset classes.
We believe this new era for institutional investors will create greater dispersion in investment outcomes. The institutional investors that evolve their purpose, their portfolios, and their proficiency to become more resilient, nimble, and responsive to the changing environment will have an edge in the next decade.
Download the full report on which this article is based, Performance edge: Investors hone their strategies for a new era (PDF–2.53 MB)