CHANGES ON THE INSTITUTIONAL INVESTMENT HORIZON: Is short-term thinking on the rise? Sponsored by:

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1 CHANGES ON THE INSTITUTIONAL INVESTMENT HORIZON: Sponsored by:

2 Global executive summary Since the financial crisis, institutional investors have been challenged by a low-yield environment, regulatory change, political and financial sector instability, and shifting underlying factors such as demographics, technological disruption and climate change. These combined factors have led to a changing investment horizon for some investors and may have prompted changes in portfolio allocation strategies. The interpretation of risk and the response to it differs globally. This may be reflected in the fine balance investors are trying to strike between tactical asset allocation to stay focused on long-term strategic objectives and portfolio changes for short-term gains. In June-July 2017, The Economist Intelligence Unit (EIU) conducted a global survey of 571 institutional investors about how they are adapting to changing market conditions. The research, sponsored by Franklin Templeton Investments, explored how investors are adapting to the changing environment and to evolving risks, the effect on their investment time horizons and on asset allocation strategies, and the impact on long-term objectives. The survey is part of a global programme, Changes on the institutional investment horizon, which includes in-depth interviews with institutional investors from three regions: North America, EMEA and Asia-Pacific. The survey research and the interviews are featured in a series of reports, videos and infographics. These are the key findings: Institutional investors largely believe they are responding to short-term pressures while meeting their longer-term obligations. Asked if they have changed the process to determine return targets based on short-term pressure, 43% of respondents say they have by becoming more focused on longer-term objectives. Only 24% say they have become more short-term focused, while 28% say they have not changed their process as a result of short-term factors. Meanwhile, portfolio monitoring appears to be driven primarily by fiduciary responsibility (30%), principles and social objectives (26%) and long-term performance (21%). Short-term performance is the main concern of only 14% of respondents. In their search for yield, almost half of all investors surveyed (49%) increased portfolio turnover, with 21% of those doing so frequently. However, despite low yields, worsening demographics and the need to generate alpha, only 38% of investors are shortening their holding period while 38% have kept it unchanged. This lack of change is most noticeable in the EMEA and Asia-Pacific regions. In North America, more than two-thirds of investors have made adjustments, and they are just as likely to have made the period longer rather than shorter.

3 Have you adjusted your holding period to be shorter or longer? Yes, to be much shorter North America EMEA Asia-Pacific Yes, to be somewhat shorter No Yes, to be somewhat longer Yes, to be much longer Market volatility keeps horizons short, while regulatory change causes short-term headaches. The single greatest obstacle to lengthening the investment horizon is market volatility. But substantial numbers point to a variety of other external challenges, including broad factors like the global economic outlook, as well as more regional factors such as regulatory change. Internal barriers such as organisational silos and lack of staff incentives are of secondary importance. According to respondents, regulatory change and the processes around it has had a significant impact in the short term. Many say that regulatory change has been impacted by internal issues like mitigating compliance (53%) and reallocating internal resources (44%), while others point to external issues like the mispricing of risk (47%). However, the short-term impact of regulatory change is viewed differently across the regions: In North America, investors are most challenged by allocating resources effectively, while in Asia-Pacific, investors seem to feel that What do you consider to be the biggest impediment to lengthening the investment horizon? Market volatility Short-term requirements 27 Regulatory change 25 Reputational risk 25 Global economic outlook 24 Governance rules 19 Lack of staff incentives Media influence on decision-makers 13 Silos within the organisation 12 2

4 What do you consider the biggest risk to achieve long-term targets given longer-term trends like climate change and technological disruption? Short-term volatility 28 North America EMEA Asia-Pacific Liquidity risk Non-financial risk (e.g. political risk) Correlation risk Capital loss regulations are disjointed and inconsistent to the point of making a material impact on returns. The effect of regulatory change is also felt in other ways: most notably, on post-trade compliance (56%), provisions for investor protection across the life cycle (55%) and by provisions for pre- and post-trade transparency (46%). However, North American investors are considerably less likely than their counterparts in other regions to say that transparency provisions have been among the most affected by regulatory change (36% vs approximately 50% in EMEA and Asia-Pacific). Correlation risk and non-financial risk are the top two threats to achieving long-term targets. In light of long-term trends like climate change and technological disruption, investors identify correlation risk (49%) and non-financial risks such as geopolitical risk (45%) as the top challenges to achieving long-term targets closely followed by liquidity risk (43%) and short-term volatility (40%). At the regional level, short-term volatility appears to pose a greater threat to long-term goals in North America. In EMEA and Asia-Pacific, investors are threatened more by correlation risks. This may reflect the integrated nature of the EMEA and Asia-Pacific regions respective economies. But investors use the same tools to manage these and other risks almost regardless of region. These are alternative investments (44%), risk budgeting (41%), diversification among traditional asset classes (38%) and currency hedging (36%). Investors are looking to new markets, new products, and Environmental, Social and Governance (ESG) investments for fresh opportunities. Respondents consider the opening of new markets (48%) and the development of new products (46%) as the most promising new opportunities for creating alpha in the next 3-5 years. Although, only 20% of institutional investors believe that new technologies will present new opportunities in and of themselves. Two-thirds (66%) of investors plan to increase their exposure to ESG or principle-based investments within the next three years. But few say they plan to do so in the longer term: only % plan to increase exposure to such investments in the 3-5 year time horizon. And about one in ten have no intention of increasing their level of ESG or principle-based investments at all. Asia-Pacific investors are less excited about the potential presented by the opening of new markets (38% vs 53% rest of world). Meanwhile, North American investors see prospects as well as challenges in the current atmosphere of political and regulatory uncertainty: Almost half (46%) agree that differentials in regulation across jurisdictions will increase arbitrage opportunities. 3

5 Do you expect to alter your exposure to ESG or principle-based investments? Yes, increase it in the next 0-12 months Yes, increase it in the next 1-3 years Yes, increase it in the next 3-5 years Yes, increase it in the next 5-10 years 6 No intention to increase EMEA investors are favouring riskier assets to generate alpha. Yields remain at historic lows in the EMEA region, with obstacles encountered in the hunt for alpha. The top two challenges to meeting investment objectives in the EMEA region are political uncertainty (40%) and financial stability risks (33%). Other key challenges include the growth cycle (29%), risk mispricing (29%) and market volatility (22%). Corporate governance (8%) is the only obstacle that is not considered to be significant by at least one in five EMEA investors. The current environment has caused most EMEA investors to reallocate their portfolios moderately (46%) or significantly (17%). Only one in five says that they have not done so. And investment strategies look likely to change along with allocations: Fewer than one in three EMEA investors are not planning to adjust their approach to portfolio management. About 40% say they will adopt a more active approach, while 28% say that they will be less active as a response. EMEA respondents are most likely to reallocate towards bonds and other fixed income assets (42%). They rate non-traditional fixed income as being slightly riskier than equities and commodities and much riskier than alternatives or cash. North American investors turn to equities in response to political and regulatory uncertainty. As in the EMEA region, North American investors rather surprisingly see political uncertainty as the top obstacle to institutional investors meeting their objectives (%). It outweighs, in their eyes, more traditional concerns, including portfolio diversification (37%), the growth cycle (34%) and the mispricing of risk (33%). Uncertainty in the US regulatory environment following the 2016 presidential election and the post-crisis reforms may have led most North American investors to reallocate their portfolios. Just 16% have not felt compelled to do so. Nearly half (46%) of investors have reallocated to equities. In contrast to the EMEA region, where bonds and other fixed income assets are favoured, only 18% of North American investors have opted for bonds. Even fewer have chosen alternatives, commodities, funds or cash. Both strategy and tactics are shifting in reaction to the existing low rate environment and expected base rate increases from the Fed. More than onethird of North American investors say that they are most likely to change their investment strategy duration (37%), while others are planning to How would you rate the level of risk of the below asset classes? (EMEA only) Equities (including Emerging and Frontier markets) 5 Commodities 11 Very high Fixed Income (non-traditional fixed income, bank loans, high yield EM debt, unconstrained fixed income) Alternatives High 17 Note: percentage may not equal total due to rounding. 4

6 Do you anticipate doing any of the following in the next 3-5 years (North America only)? Change my investment strategy duration Expand into new asset classes like alternatives Change my risk exposure levels Change my regional focus 11 No change 10 expand into new asset classes like alternatives (26%). But nearly everyone is planning some manner of response; only 10% of investors say they do not anticipate making any portfolio changes. Investors are also responding to the demographic change taking place, with two-thirds of investors having adopted (at least partially) a more tactical approach to reach their return targets (66%). Most investors in Asia-Pacific plan to reallocate towards high-growth countries in the region. In stark contrast to conditions in the EMEA and North American regions, fewer than one in five investors in Asia-Pacific says that geopolitical uncertainty is a top concern. Instead, they point to financial stability risks (43%) and the economic cycle (40%) as their biggest worries, followed by the mispricing of risk (30%). Given that the Asia-Pacific region is forecast to have higher growth rates than EMEA and North America, most regional investors say that they are likely to increase their portfolio allocations to the high-growth countries of the region (56%). Conversely, about one-third (32%) say they are less likely to do so due to the need to manage risk by diversifying their portfolio outside the region. Many Asia-Pacific investors are responding to demographic change in the region (eg ageing populations and growing Islamic influence) by integrating principle-based investing into their investment process (75%). Investors in Asia-Pacific are split in terms of their reaction to changing financial regulations. About half (46%) say that changing regulations have not led them to reallocate their portfolio towards, or away from, any particular type of asset. And the balance is evenly divided: 22% assert that they have reallocated towards a particular asset class, while 23% say they have reallocated away from one. Most respondents who are likely to reallocate towards high-growth countries in the region say that their investment will take the form of equities (50%). But several other options are attractive: 41% say they will opt for bonds and other fixed income, while nearly as many say they will choose to invest in commodities (%). The global survey reveals signs of significant contradictions between institutional investors goals and the actions they have taken or are likely to take in the near future. The reasons behind these contradictions, and their implications for investment strategy, will be explored in forthcoming reports on each of the three regions. Have you implemented or are you planning to implement principle-based investment into your investment process? (Asia-Pacific only) Yes, I already have this as part of my portfolio allocation strategy Yes, I plan to implement this in the longer term, but do not see it as a strategic issue right now No, I don not plan to implement this into my portfolio allocation strategy 36 5

7 A report by The Economist Intelligence Unit LONDON 20 Cabot Square London E14 4QW United Kingdom Tel: (44.20) Fax: (44.20) NEW YORK 750 Third Avenue 5th Floor New York, NY United States Tel: (1.212) Fax: (1.212) HONG KONG 1301 Cityplaza Four 12 Taikoo Wan Road Taikoo Shing Hong Kong Tel: (852) Fax: (852) SINGAPORE 8 Cross Street #23-01 PWC Building Singapore Tel: (65) Fax: (65) singapore@eiu.com GENEVA Rue de l Athénée Geneva Switzerland Tel: (41) Fax: (41) geneva@eiu.com Whilst every effort has been taken to verify the accuracy of this information, neither The Economist Intelligence Unit Ltd. nor the sponsor of this report can accept any responsibility or liability for reliance by any person on this report or any of the information, opinions or conclusions set out in the report. ECON GES 10/17