This post sets the scene for a Thinking Ahead Institute research project I will be leading in 2019. I will pose a question that I believe is important, maybe even mission critical, for institutional investors to explore. I don’t have all the answers at this stage (and never will) but in this post I will outline my thoughts on how this question can be approached.
So, without further ado, the question is:
How could the investment opportunity set for institutional investors evolve over the years and decades to come?
What do I mean by investment opportunity set? Simply speaking it is the playground for institutional investors. It is the investable universe that consists of all financial securities and real assets that can be owned and traded by institutional investors. So what does this universe look like?
While not a most up-do-date picture, Doeswijk, Lam and Swinkels proposed a methodology to estimate the total value and composition of the invested market portfolio. It is the aggregate portfolio of all investors. A sub-set of this is owned by retail investors but the entire set can be easily accessed by institutional investors ie it represents the institutional investable universe. They estimated that as of the end of 2012, the entire invested market portfolio was worth more than $90 trillion.
What this chart might look like in say 2029 – ten years from now – could have important implications for how an investment firm operates and organises its resources. At the end of the day, these securities / assets are the raw material for investment organisations to deliver their products – investment portfolios that meet the investment goals of their customers. If we anticipate any major changes to the supply of our raw material – say the decline of a traditional asset class or the rise of a new asset class – we had better prepare for it. It might mean organising our resources to target new growth areas. It might also mean building and running our teams in a different way. It will provide important context to the strategically important conversation of whether the organisation’s competitive edge will continue to be relevant in an evolving market place.
I see two mechanisms though which this opportunity set can change. And I can see at least five driving forces that underpin the possible changes.
One mechanism is what I would call organic growth via new issues and securities retiring. New equities and bonds are issued every year as part of capital formation. A new asset class could also emerge. Equities and bonds can also be retired when they are bought back or reach their maturity date. The overall net effect is continuous change in the investable universe.
The other mechanism is through taking over the ownership of the assets that were previously in the hands of owners other than institutional investors (eg banks or governments). $90+ trillion is not a small number by any stretch of imagination. But it is actually only a small sub-set of the entire capital stock in the world economy. Gadzinski, Schuller and Vacchino suggest that in 2016 the global portfolio of “everything” was worth about $532 trillion.
Private businesses are mainly owned by private owners (in particular outside UK/US) – private equity’s penetration into this $100+ trillion market is still tiny. Loans mainly sit on banks’ balance sheets and only a small proportion of them are owned by institutional investors through securitisation and private debt investments. By far the biggest component of real estate is residential properties and there is nothing, at least in theory, to stop an institutional investor from owning a residential house and letting it to a family. So institutional investors can indeed expand their reach by acquiring assets from other owners.
The next question is what could potentially drive the changes in both the “organic growth” and shift of ownership areas? Here is my thoughts on five themes that I consider important.
The rise of the intangible economy
Corporate investment is increasingly in intangibles. Traditional tangible assets, such as plant and equipment, are a very small part of the balance sheets of some of world’s most valuable companies (eg FANG stocks). It turns out that this shift towards intangible investments can have a profound impact on how companies finance their activities. Intangible assets represent poor collateral for debt, so can lead to a preference for equity financing.
The rise of intangibles is regarded as one of the drivers behind the rapid rise of private equity. Investment in intangible assets are recorded under today’s accounting standards as expenses, dragging down earnings. Public markets’ obsession over short-term earnings therefore leads to reduced propensity to list. The public market disclosure requirement also presents a dilemma for young firms investing in intangibles: if giving too much detail, their competitors can use the information; if giving too little, investors will pay less for their shares. This all contributes to the established trend (particularly in the US) of firms choosing to stay out of the public market, preferring venture capital and private equity investors as their main sources of equity financing.
Addressing the infrastructure investment gap and achieving global sustainability goals
Oxford Economics estimate that between 2016 and 2040, to support global economic growth and to address the risk of climate change, the world needs to spend $94 trillion on infrastructure. Current rate of infrastructure investment is expected to fall short of this level. So far institutional investors have not been a major player in this field (Thinking Ahead Group estimate that institutional infrastructure related investment is currently around the order of $1 trillion). Infrastructure has attractive characteristics that match institutional investors’ long-term investment orientation although better risk sharing between public and private sector via innovative investment vehicles is needed to encourage more institutional investors to act as critical players in this space. In fact, blended finance, the term given to the use of public or philanthropic capital to spur private sector investment, goes beyond just infrastructure investment. If a market of trading ESG / impact factors (eg carbon credits) and pricing externalities takes off, this may in effect create a new asset class for institutional investors.
Regulation affects the investment landscape, both intentionally and unintentionally. For example, banks were historically the primary holders of illiquid debt, spanning residential mortgage loans, commercial mortgage loans, corporate loans infrastructure loans, trade finance, etc. In the wake of the 2007-08 global financial crisis, banks were forced to shrink their loan book to strengthen their capital base, following a series of regulatory changes. Institutional investors are moving to fill the gap. And regulation (eg Basel IV) is expected to continue to drive direct investing in these asset classes in the form of private debt. The term bank intermediation describes the trend that regulatory shift creates a new set of assets that no longer make sense for banks to own and thus will become available to non-banks including institutional investors. In the similar vein, albeit a smaller scale, regulation is driving insurers and reinsurers to increasingly pass on unwanted risk to the capital markets, via insurance-linked securities.
The opening up of the Chinese capital markets
At the end of September 2018, FTSE Russell confirmed that Chinese A shares would be included in their indices. This followed a similar move by MSCI and the expectation that Chinese domestic bonds will be phased into the Barclays Global Aggregate Index from April 2019. Chinese on-shore assets increasingly included in indices is driven by an important underlying trend that the Chinese government is committed to opening up its capital markets to foreign investors. Although technically the opening up of the Chinese capital markets doesn’t change the global investable universe for all investors (domestic Chinese investors always had access), it will have significant implications for all our Institute members, both from a return-seeking and diversification perspective, as the world’s second largest economy joins the global capital pool.
It is impossible for me to predict with any confidence the implications of a technology that does not yet exist today so I will stick to the relatively safe space of extrapolation. Despite the market slump in 2018, cryptocurrency has slowly started to work its way into institutional investing space. Yale University was among investors that helped a new fund focused on digital assets in late 2018. A few months later, two US pension funds also took the plunge on crypto investing. However, while crypto currency is the most-talked-about application of the blockchain technology, it is unlikely to prove to be the most significant for institutional investors. There are other possible routes for blockchain to disrupt institutional investing. Could a new shared ownership model emerge as a result and spur a fractional ownership market for homes or privately-held businesses? That could open the door for significant institutional investment in this space. Indeed, many other types of technologies such as those facilitating peer-to-peer lending have potential to shape investing landscape.
Investment organisations cannot afford to stand still. The only thing I am certain about is that the global investable universe in ten years’ time will be different compared to today. It might be significantly different. And that creates both challenges and opportunities for all of us in the investment industry.
 “Global Infrastructure Outlook – Infrastructure investment needs, 50 countries, 7 sectors to 2040”, Oxford Economics, 2017