Invest Now or Pay Later
Long-term asset holders, such as pension funds, sovereign wealth funds and insurers, hold their capital – and with it the retirement, security and educational dreams of their customers – in conservative financial instruments in perceptually safe markets. These investments are closely pegged to underlying asset classes that have historically proven to be safe, somewhat predictable and almost entirely held in mature, highly liquid advanced economies. Whether these are municipal bonds, commercial property or blends of mature domestic stocks, long-term asset managers are prized for their steady hands and unflinching commitment to a long-term investment horizon. This much is required by the investment mandate to protect, preserve and build wealth. This patient investment model, however, is being tested by the convergence of two broad trends for which long-term asset managers are ill equipped to address using today’s tools and investment yardstick.
The first trend is caused by the diseconomies of scale under which long-term asset holders are laboring. Over the last 30 years’ long-term asset holders have amassed more than $35 trillion in assets under management. This is more money than they are effectively deploying on a long-range risk-adjusted basis, as evidenced by the historically low or insidiously negative yields over the last 10 years. They also labor under a numerator so large that these asset holders have a shrinking number of places to hide from the long arms of risk and uncertainty and the anemia inducing effects of low interest rates.
The return of economic nationalism in Europe and the U.S. only confounds the job of the long-term asset manager creating a sense vulnerability to shock events like Brexit, the election of President Trump and the growing drum beat of war. This not only makes this class of investor too big to fail, troublingly, it makes them too big to hide. The second broad trend assailing the asset management industry is the fact that risk and uncertainty are no longer relegated to developing and emerging markets, but are now firmly ensconced in the advanced economies with profoundly vexing consequences. The convergence of these trends and the desperate search for yield (and shelter) call for novel approaches to rebalancing the traditional risk-reward tradeoff. In short, it is time for long-term asset managers to take some risks.
Nowhere to run, nowhere to hide: As a rule, long-term asset holders understand and are well-hedged when it comes to market volatility – or, simply put, price swings in their portfolios. They address market volatility through their sheer size and ability to create and dynamically manage highly diversified investments. Risk and uncertainty on the other hand are much harder to dispense with using the mathematical models that address volatility. They are even harder to shelter from when your investments are systemically correlated to the entire global economy. In short, long-term asset managers can no longer operate under the presumption of safety by remaining north of the Mediterranean or sheltered between the Atlantic and Pacific Oceans. Ironically, for long-term asset managers to adapt to this new normal, they can no longer hide from risk, but must begin taking measured risks of their own. This investment thesis is not about altruism or philanthropy, but rather about protecting and preserving wealth through a proactive investment model designed to mitigate long-term adverse effects by pre-investing in the very sources of stability these asset-holders rely on. This much is the raison d’être of the Bretton Woods II initiative, which aims to codify these frameworks.
The simplest place to begin is by revisiting investment mandates, many of which stigmatize or directly preclude developing and emerging market capital flows as risk prone loss leaders. Alternatively, and this is a fair criticism given the scale of long-term asset holders, the opacity, comparatively low dollar amounts, and the administrative burden outweigh the potential rewards of these venturesome investments.
The experience of the burgeoning impact investment universe, where funds such as LeapFrog Investments are delivering above market returns and diversification singularly through emerging markets offers a compelling case study for large asset holders.
While the quantum of capital between impact investors and long-term asset holders’ pales in comparison, the experience of deploying risk-managed capital to hitherto “no-go zones” is telling. One of the most powerful yet underutilized tools in this approach is to incorporate insurance as a condition precedent to the deployment of capital. Many asset holders maintain that their negative yield investments in Europe during the height of the global financial crisis were in fact risk premiums on retaining access to European markets. In effect, they were prepared to lose money in Europe, rather than to venture south of the Mediterranean, where the advent of their capital – like LeapFrog’s – might have found the right risk-reward tradeoff, while at the same time having a stabilizing effect on some of the root causes of global instability.
Investment determinism: The historical reliance on “constants” in investments models, such as housing prices being a perpetuity, or the presumed safety of municipal debt are all being challenged. Additional pressure in the form of disruptive innovations, automation, and technologies, are dislocating entire economies and, with them, historically safe and predictable asset classes. Against this backdrop, the long-term asset holder, including the insurance industry, must begin taking measured risks in their capital allocation strategy, which needs to be recalibrated for the age of disruption and man-made risk. No other pool of capital can shape the future quite like long-term asset-holders, whose investment horizons and unmatched purchasing power can drive profound change. Where are these unexploited opportunities to shape the future and deliver stable risk-adjusted returns to investors?
As an asset manager, it is wise to go long on climate change and to short underground parking in Florida. For an industry that looks for modelling certainty, climate change offers both challenges and opportunities. On the one hand, long-term asset managers are exposed to the increasingly severe consequences in their portfolios in the here and now. Record flooding in Houston, which has suffered 3 consecutive 500-year flood events, or weather-related damages to properties, such during Hurricanes Harvey, Irma and Maria or the Tohoku Earthquake, are only likely to increase in impact and severity. It will be difficult for asset holders to rapidly divest from these assets, which have historically been a source of stability and income continuity. However, these operating models presuppose that major urban centers will remain as vibrant as they are today over a 30-year investment horizon. Likewise, artificial intelligence (AI) and automation spell double-jeopardy to the office workers who occupy the center-city properties asset managers love.
Just as the once vibrant industrial base of Detroit spelled ruin for the city when the global economy shifted from production to services. The age of industrial and process automation, fractional asset ownership and disruptive technologies, such as Blockchain, will profoundly shift known investment variables, including labor patterns and therefore downtown property values. Long-term asset-holders will need get out of their comfort zone to anticipate and begin to shape these trends and, therefore, begin recalibrating their portfolios.
Investing in smart infrastructure, transportation and cities that espouse resilience as their goal is a great investment opportunity. The global infrastructure funding gap of $3.3 trillion can only be filled by long-term asset holders. Governments can spur this investment flow by issuing resilient infrastructure bonds that create investor confidence and greater degrees of modelling comfort. However, here too the rising specter of sovereign debt and defaults makes long-term government guarantees hard to rely on even in advanced economies. Similarly, renewable energy, which increases in industrial-scale with each passing year, also plays to modeling certainty, as the carbon-based economy is increasingly a thing of the past. While there is a standards war at play on which renewables emerge the victor, what is clear is that investors cannot take a one-size-fits-all approach, but rather can create a portfolio process for renewables that diversifies across wind, solar, battery and bio-fuels, among others. In this manner investors are exposed to the industry cross section and they can begin to deploy their capital to shape the more stable (lower impact) energy matrix the future demands.
Risk-taking is not merely about market risk and hedging against volatility, it is also a matter of participating in the impressive wave of technology and financial innovations shaping the market. In this process, the long-term asset manager is a scarce figure, and this must change. Technologies such as digital currencies and Blockchain, which can enable a friction-free and trust-based economy offer impressive opportunities to break the pattern of long-armed capital allocation through intermediaries, which only favors scale and the presumption of safety. The advent of financial innovations like the concept of a catastrophe bond for man-made risks, can enable the deployment of much needed capital against a more complex risk landscape that is difficult for insurers to model. Finally, insurance and insurance-linked instruments offer many opportunities to put a fixed price on uncertainty enabling greater geographic and sectoral spread among conservative investors. A changing world demands greater equilibrium in how assets are allocated and investors must confront the challenge of investing now to avoid paying later.