Pension funds and other institutional investors believe they will be able to meet their long-term objectives, but it will be difficult to earn stable short-term returns and manage liabilities, says a new study by Natixis Global Asset Management.

Citing pressure to focus on short-term performance and their obligation to balance asset growth and protection, investors are cautiously pursuing innovative ways of generating income and alpha.

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The Natixis global survey of 642 institutional investors, including public and corporate pension funds, sovereign wealth funds and insurers collectively managing $31 trillion in assets, explores current market outlook and strategies in portfolio construction, risk management and operations.

While institutional investors are optimistic about equities in 2015, their outlook is tempered by market risks beyond their control and unknown liability risks ahead, particularly those linked to increased longevity. Despite their need for asset growth, institutional investors are twice as likely to reduce portfolio risk as to increase it in the next 12 months. And even with the use of liability-driven investing strategies, the biggest challenge is their ability to generate sufficient returns.

Key findings of the survey include:

  • While 87 percent expect to meet their long-term liabilities, more than half of the respondents believe most other organizations will fail to do so (consistent with results from last year’s survey).
  • 80 percent of institutions say it is challenging to generate stable returns in the short term, while 60 percent of investors expect it will be difficult to fund their long-term liabilities.
  • 60 percent of investors responded that the industry has not been innovative enough in developing liability-driven investment (LDI) solutions to meet current and future costs.
  • On average, institutions expect they can achieve yearly returns of 6.9 percent after inflation.
  • 81 percent of institutional investors believe it will be difficult to mitigate the impact of volatility, and more than three-quarters (77%) are concerned about their ability to manage tail risk.
  • The top four potential threats to investment performance in the next year are geopolitical events, European economic problems, slower growth in China and rising interest rates.

"Institutional investors, particularly pension funds, have a lot at stake as the portfolios they manage today are an important source of tomorrow’s income for the world’s aging population," said John Hailer, president and chief executive officer for Natixis Global Asset Management in the Americas and Asia.

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"Our Durable Portfolio Construction platform emphasizes risk as the primary factor to determine asset allocation, which may give investors the broader perspective needed to withstand market changes and surprises and generate the returns they are seeking."

Generating return in efficient markets

  • More than half (55%) of institutional investors agree that traditional assets are too highly correlated to provide distinctive sources of return. As the markets become more efficient, they are looking for new sources of performance. The survey found that most have turned away, in some measure, from traditional asset allocation and toward a greater use of alternative strategies:
  • 75 percent of investors feel that alpha is becoming harder to obtain as the markets become more efficient.
  • 81 percent agree that alternatives are suitable for institutional portfolios, and 60 percent say they are a good source of returns.
  • 71 percent believe that alternatives are necessary for institutional investors to manage liabilities and longevity risk.

Where’s the alpha? ESG investing

  • Many investors say they believe so-called ESG investing can be both a source of return and a way to reduce risk. An ESG approach to investing takes nonfinancial factors – environmental, social and corporate governance – into account to help determine the long-term sustainability and ethical impact of an investment. The survey showed:
  • 54 percent think that ESG investing has long-term growth and alpha benefits.
  • 55 percent agree that ESG investing mitigates risks such as loss of assets due to lawsuits, social discord and environmental disasters.

Market picks for 2015
As they look ahead to 2015, institutional investors are wary of higher interest rates and in favor of equities. "Even as they perceive stocks as next year’s best investment category, institutional investors are cautious," Hailer said.

Among the survey findings:

  • 67 percent of institutional investors expect difficulties over the next three years linked to rising interest rates, and 81 percent say it will be challenging to manage volatility in that time.
  • As rates rise, the top three ways institutional investors plan to position their portfolios are to move from long to shorter-duration bonds (61%); reduce exposure to fixed-income (46%); and increase use of alternative strategies (36%).
  • 46 percent of institutional investors predict stocks will be the strongest asset category in 2015, with U.S. equities standing above those from other regions.
  • Another 28 percent identify alternative assets as top performers, with private equity leading the way in that category.
  • Only 13 percent predict bonds will be best, followed by real estate (7%), energy (3%) and cash (2%).

In terms of asset allocation, real estate and value investments are favored by global institutional investors for next year: 40% plan to increase these strategies in their portfolio. Income generating investments is also in a good position, mentioned by 36% of respondents, states Christophe Point, Managing Director, Head of France, Geneva and Monaco at NGAM Distribution.