What do institutional investors really want when they design an investment portfolio? And how do they view some of the different investment portfolio models as ways to achieve their goals?
CoreData Research recently asked around 400 institutional investors in Europe, North America and the Asia Pacific (APAC) region what they see as the most important elements for designing an investment portfolio. Our research found the endowment model, as popularized by the Yale endowment, is their leading choice for portfolio design.
An investor’s organization type and its purpose clearly influence what they look for when designing an investment portfolio. For example, our research shows endowment & foundation investors see diversifying into uncorrelated assets and using skilled active managers as important. These features of portfolio design are central to the success of the Yale endowment model, with large allocations to assets such as private equity, venture capital and hedge funds. Many other endowments and foundations now emulate Yale’s approach and enjoyed spectacular returns in 2021 with this portfolio design model.
Pension funds usually seek a balance between returns and security, with factors such as their maturity and the strength of their employer, or sponsor, covenant influencing where they find equilibrium. For public and government pension funds, where liability management is less of an issue, diversifying into uncorrelated returns and investing in illiquid assets for the long-term are seen as important. Whereas for corporate pension funds, relying on an employer covenant or accumulated assets, generating sufficient yield without adding excessive risk heads the table of core elements in portfolio design.
When investors were asked which investment portfolio model offers the best chance of giving good risk-adjusted returns over the medium and long-term, the endowment model came out on top, ahead of the traditional 60:40 portfolio. This model combines 60% in equities with 40% in fixed income. In theory, equities provide growth, with fixed income giving stability, income and an asset that will diversify when equity markets fall. However, including credit risk, from lower quality fixed income, weakens diversification, as loans and high-yield debt behave more like equities. The enduring popularity of this traditional approach may seem surprising given the rise of alternative and private market assets, but it gives a flexible framework to build on, with additional asset classes or risk management strategies added to upgrade it.
Between these two extremes lie the three other approaches that investors could have chosen. One is allocation by risk factors, such as credit risk or equity risk. Arguably this means an investor’s risk budget is placed centre stage, with the risks of various underlying investments controlled. Another model is to do as some very large Canadian investors do, with big allocations to real assets such as infrastructure and real estate, along with private market assets. This can give greater control of the underlying assets and their cash flows, reducing reliance on potentially volatile listed markets. The final model here is allocation to a small number of ‘buckets’, such as liquid asset, long-term income or de-risking. This approach can be used by an industrywide pension fund to mix and match the needs of different employers’ pension funds. These models lag behind the endowment model and the 60:40 portfolio in popularity, although different types of institutional investor prefer different models. For instance, the large Canadian model is most popular among public pension funds and sovereign wealth funds, while insurance companies lean more towards allocation by risk factors.
Looking at the results, Professor Andrew Clare, Chair in Asset Management at the City University of London, commented: “My preference would be for a much wider mix of asset classes, somewhere between the large Canadian model and the endowment model, and that’s what most UK pension funds are really looking for. An eclectic mix of asset classes, with better diversification than a 60:40 portfolio, would be a better way forward”.
Overall, these results show that investors want a mix of qualities from an investment portfolio, with diversification and uncorrelated returns high on the list, along with sufficient yield and access to manager skill. As interest rates rise and quantitative tightening, among other factors, deflates asset bubbles, it will be interesting to see if investors start to look more to risk mitigation and hedging strategies in the future.
We also found that only 10% of investors see protection against geopolitical risks as important for portfolio design. This is understandable, as geopolitical risks rarely have a lasting impact on markets. But it will be interesting to see if sentiment here changes, following Russia’s invasion of Ukraine, as at the time of writing it appears this could have significant repercussions for investment markets and, indeed, for the existing world order.