Sovereign investors’ waning returns force rethink
Sovereign-backed or -linked investors continue to fall well short of annual return goals, prompting a widespread re-assessment of their performance goals, according to a new survey being released today by Invesco.
The research shows that many state investment firms, public pension funds and other such entities have moved to freeze current allocations, avoid targeting new asset types and re-examine their base capital assumptions.
Ninety-seven institutions, with a combined $12 trillion under management, took part in this year's Global Sovereign Asset Management Study*. Notably, all types of asset owners failed to hit their annual investment targets last year, said Terry Pan, chief executive for greater China, Singapore and Korea at Invesco.
“One of the persistent themes last year, which we also saw this year, was that there is a challenging investment environment,” he noted. “There is a lot of quantitative easing still around the world, together with low rates."
The 12 participating investment sovereigns, for example, had on average anticipated a return of 6.3% last year, but only reported 2.6%. Development sovereigns, of which there were 11, had aimed to record 7.7% return, but achieved 4.4%. (See graph below.)
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The survey sought to assess the reasons for the mismatch between expectation and reality. In addition to depressed interest rates and quantitative easing having driven yields developed-market bonds to very low levels, some sovereign funds have had to retain a lot of easily accessible capital as their supporting governments have withdrawn some of their funds. This has forced them to invest more into liquid, lower-return investments.
Another factor was sizeable geopolitical risks last year, in particular the UK’s vote to exit the European Union in June and the election of the unpredictable Donald Trump as US president in November. That led sovereign investors to be more defensive in their strategies, which again resulted in more emphasis on less risky but lower-return assets.
A combination of increased outflows and geopolitical uncertainties led sovereign investors to invest more using their in-house teams, but this has also led to more home bias: they allocated 47% of AUM domestically this year, versus 45% in 2016. That bias risks crimping returns, even as it has helped reduce costs.
Lastly, the time investors expect to take allocating to alternative assets is rising. Expectations around infrastructure investment deployment rose from three-and-a-half years in 2016 to four years in 2017, while it ticked up from 2.3 to 2.4 years for private equity. And the longer the delay in asset allocation, the more time it takes for returns to materialise.
Reducing target returns
Invesco's survey last year revealed that sovereign investors were looking to actively invest more into alternatives. However this year's study revealed that the investors appear unlikely to make further big shifts into new asset types as a result of undershooting their annual target returns.
Instead, most investors have frozen their asset allocations. For example, 73% of respondents kept home-market bond allocations the same, 69% held fast on international bond exposure, 67% did the same for home market equity allocations, and 63% did likewise for international equity.
“One of the key things we found in relation to more developed clients was that they are doing a major rethink from a model standpoint, not necessarily an asset allocation model," said Pan. "They are wondering how they came up with their target return numbers, and whether it is correct for capital assumptions going forward.”
Pan said that this would be likely to lead to sovereign investors re-assessing their target returns downwards. “They will question ‘are we setting the right target and using the right assumptions? Why is a 6% return the right number? If you can’t take much risk there is no way to get a 6% risk-free rate.”
This rethink is at a far more nascent stage among sovereign investors in Asia than in Western markets, but Pan hopes this will change. “Sovereigns here are slightly behind from a maturity standpoint, but as they grow and mature, they should skip some of the steps other investors are going through now.”
One exception to the caution over shifting asset allocations is in real estate, where sovereigns are still putting more money to work. Allocations to domestic property rose from 2.2% of AUM last year to 3.4% this year, while investments into international real estate rose from 4.4% to 4.7%, respectively. (See graph below.)
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But another result of the steady fall in returns is that some institutions are moving into even more niche assets. One example is Korea's Public Officials Benefit Association, which has been exploring farmland, timber land, insurance-linked securities and even royalty products.
Others, such as Singapore's GIC, have also reiterated their belief in the importance of including alternatives in the portfolio. The fund did so at the annual International Forum of Sovereign Wealth Funds meeting in Auckland in November, where it and other big investors, such as China Investment Corporation, discussed how they are coping with the lower-for-longer environment.
Geographic focus
Meanwhile, according the the Invesco survey, sovereign investors have also geographically shifted where they are most comfortable investing, following some of last year’s geopolitical shocks.
While Trump's election has caused some global diplomatic and security uncertainties, it has also led investors to raise their confidence in the US economy. The expectation of more American rate hikes has also added to the country’s appeal. Survey respondents ranked the country 8 out of 10 on average as an appealing investment destination, up from 7.7 last year.
Germany also saw a slight rise, from 7.6 to 7.8, while Japan climbed from 6.4 to 6.6. But the UK took a big hit due to the uncertainty over Brexit; its ranking fell two points from 7.5 in 2016 to 5.5 out of 10 this year.
Meanwhile, emerging markets have grown more attractive to sovereign investors, with their appeal rising from 5.2 out of 10 in 2016 to 5.7 this year. In that segment, China and India saw their attractiveness rankings rise from 5 to 5.2 and 5.9 to 6.1, respectively.
“A lot of sovereign clients mentioned emerging markets and specifically India as a market they are looking into,” said Pan. “We haven’t seen any investing as a result of this interest yet, but more are surveilling it.”
*The Invesco Sovereign Asset Management Study is in its fifth consecutive year. Sovereign investors were interviewed between January and March this year. It gained responses from 97 investors, up from 77 in 2016. The survey was divided into investment sovereigns, focused on making investment returns; liability sovereigns, which invest assets to cover various liabilities; liquidity sovereigns, typically based in commodity-based economies; development sovereigns, which use investments to encourage local economic growth; and central banks.