Resilient Infrastructure: An Institutional Investor Challenge

INSTITUTIONAL INVESTORS POORLY SUITED TO ADDRESS GROWING RISK
Returns fail to meet cash flow requirements
Inability to address growing systemic risks
Structural inability to effect change as needed

Institutional investors, such as large pension and sovereign wealth funds, face three daunting problems:

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Every year, institutional investors struggle harder to produce the annual returns needed to meet obligations to their beneficiaries and capital commitments to those managing their funds.  Increasingly, they are having to demand higher contribution levels or reduce cash funding requirements.

A  growing set of global issues will force these investors to re-evaluate beliefs about portfolio value, diversification, entity structures and compensation practices.  An ever-growing set of asset categories, including energy, utilities, insurance, transportation, agriculture are increasingly exposed to climate change and other growing systemic risks. 

The governance and compensation schemes at most institutional investors make it challenging to deal with these issues:  Because they function as quasi-governmental institutions, public institution investors are far more constrained in their ability to compensate professional teams, they are required to be more risk constrained and they typically do not reward behavior that challenges the status quo.  As a result, they tend to perform nearer the median and be more exposed to large systemic changes, like recessions and depressions that affect all.

WHY AREN’T THESE INVESTORS RESPONDING?

Intelligent portfolio management requires constant re-evaluation of possible futures and the actions to take should one of those futures become the imminent reality.

Benchmark compensation systems, existing diversification/asset allocation strategies and the reliance on the traditional fund model all contribute to inaction:

– Benchmark driven compensation insulates managers from long tail risks – but Boards and owners held responsible for absolute performance

– Addressing systemic risk, by definition, requires action that is contra the benchmark

The world faces a set of very real risks to portfolio-as-usual behavior, yet most portfolio managers seem to be assigning extraordinarily low probabilities to change outcomes, and are taking few steps to hedge accordingly, even when such outcomes may have devastating consequences.

–  The risks we are focused on are known and real, the question is not if, but when

–  Current asset classes non-diverse to these risks

–  Current fund model not suited for long-term asset management

ACHIEVING BETTER OUTCOMES REQUIRES A DIFFERENT APPROACH