Trends in Institutional Investing

Timo Löyttyniemi

Approaches to institutional investing have evolved over time. However, most of the core concepts were invented decades ago. Finance is an industry in which academic concepts are brought directly into practice. Institutional investors are all unique, and that uniqueness requires a human touch and experience. Institutional investing is, nevertheless, a discipline built around a number of key building blocks. This column offers an update on some of the key elements of contemporary institutional investing.

Total portfolio and sub-portfolio level

At the total portfolio level, the purpose of the institution and clarity of its liabilities are the key elements. If the liabilities of the entity are meaningful, they will certainly give direction to the asset management. The main goal of the institution is the element that must be respected above all. The challenge lies in benchmarking at the total portfolio level, as all institutions are unique. One therefore typically needs to establish a well-structured layer of multiple benchmarks in order to capture the “success” of the organisation. It may take time to find the right mixture of yardsticks and comparators. In addition, the comparisons may need to be altered over time.

Sub-portfolio asset management is steered by benchmarking. Many acknowledge the pitfalls of benchmarks, but benchmarks still provide an easy basis for managing the assets and for assessing performance. Where the benchmarking is clearly unsuitable, tailor-made index solutions are the best way to proceed. Tailor-made indices have typically been avoided because of the possibility of tweaking, and because they draw the portfolio manager into decisions about the benchmark, which is not recommended under a normal governance model. Sometimes, however, the means and goals of good overall performance should be the main driver, and the indices are merely the means of achieving it.

Index investing

Index investing has been a strong trend in institutional investing in recent years. This has been driven by the availability of index products, but also by the establishment of widely accepted indices. These indices may not always be the optimal ones to use, but public and professional acceptance has led to a convergence of indices. If an institution has the will and the professional capability, it should be encouraged to analyse indices more deeply. Is the S&P 500 the US equity market? Or MSCI USA, or MSCI North America? All of these indices take shortcuts. A recent example of such a shortcut was the SpaceX IPO and the acceptance policies of the various indices. Academically, one could justify a “full market” index, but such indices are typically constructed by combining a large-cap index with some tilt towards small-cap indexing. Performance management becomes somewhat blurred if the index choice is only approximate. One may therefore need to take a practical approach to over- and underperformance, and to information ratios measured against the wrong indices. At the end of the day, total performance is what matters, perhaps supplemented by a Sharpe ratio as an additional angle on performance.

Total portfolio management

Total portfolio management has been the latest buzzword in institutional investment management. Even so, the choices and goals mentioned above all remain valid when the approach shifts to total portfolio management. One needs to know the goals and liabilities of the institution, and one needs to find ways of assessing the institution’s performance. Perhaps the best way forward is always to use multiple metrics within a scorecard matrix that incorporates the investment horizon and various “benchmarks” or comparisons for each of those horizons. This ensures that nothing is missed when the success of the organisation is assessed. There is also a human dimension to judgement. When a new person assesses performance, there is always a personal element in how the metrics are weighted. The best advice is therefore to include all relevant information, rather than a minimalistic set of metrics that could point in the wrong direction.

Private assets

Private assets as an asset class are still being reassessed. The spike in interest rates in 2021 and 2022 changed the equation. Private assets had enjoyed a comfortable ride for years, until the higher level of interest rates placed new obstacles in the way of their performance. Some instruments and some managers had been using substantial leverage, and higher interest costs have put additional pressure on performance. At the same time, the exit market has been challenging. Economic growth figures and occasional crises of various kinds have not helped private market players either. Even so, the private market has performed better than expected. The past three years have been unsatisfactory but not catastrophic. Time will tell whether the industry comes through this in the years ahead and retains its appeal, or whether the golden years are history. Institutions are certainly more conservative about private assets, but they retain the will to invest as long as returns are satisfactory. Fee structures will come up for renegotiation one day, sooner or later.

Sustainable investing

Lastly, sustainable investing is undergoing its most profound rebirth. The strong upward ride of so-called sustainable investing is now history. The industry needs to reinvent the term, and that will be the story of the coming years. Sustainable investing, and all the terms associated with it, came to encompass every interesting field and topic, and as a result it became unclear what sustainable investing was actually about. The theme now is to take a few steps back and start again from the basics. The key questions in this rethinking are: what does the term mean, and what should it capture? The challenge is geopolitics, and the various themes that are disturbing otherwise good intentions. The defence industry, and attitudes towards it, is just one example of how sustainable investing got something wrong — something that is now being corrected. The most encouraging observation is that our societal systems are evolutionary and will correct themselves.

Conclusions

Institutional investing is being rethought, but the path forward is largely clear. Professionalism will open up interesting avenues of development for everyone. The finance industry and academia have shown that they can correct old wisdom when something better is found. Institutional investing always needs innovation, and evolution is always taking place. At present, some simplifications are getting airtime, such as maximising the proportion of equity investments in order to maximise returns. It is true that not everyone benefits from diversification, but most do. Finance as a profession, and finance professionals themselves, must tell the full story, assess the alternatives carefully, and come forward with a recommendation that is always tailor-made for the unique client.

Timo Löyttyniemi is Professor of Practice at Aalto University’s Department of Finance, a senior fellow at the Harvard Kennedy School, a board professional, and a former CEO of the Finnish State Pension Fund.