Amid a surge of investments in alternative products driven by low yields in traditional markets, the ‘increasing complexity’ of those products has become the most significant challenge to institutional investors today, according to a study of investors’ behavior carried out by State Street’s Center for Applied Research.
At the same time, institutional investors believe their key weakness is in lacking ‘a deep understanding of the potential risks’ of such investments, according to the 12-month study of more than 3,300 investment managers and industry participants in almost 70 countries.
The increasing push of institutional investors into complex alternative investments they poorly understand are a result of the current climate of instability and central bank interventions, according to the study. The prevailing instability and ‘rising systemic risk’ is driving institutional investors toward short-term behavior that counters their own long-term interests, the researchers say.
‘Why would institutional investors around the world continue to allocate more to alternative assets when the complexity stemming from the asset class is their number one challenge, and they don’t believe their staff have a deep understanding of the risk?’ the researchers write. ‘We wanted to understand the drivers behind this behavior. What we found is that it has been largely shaped by investors’ growing awareness of the financial system’s instability. Although it may seem counterintuitive, investors’ seemingly irrational behavior is a rational response to the environment.’
The study also shows that increased transparency in markets in general due to greater regulation and scrutiny is having an effect on those markets, although it’s not yet clear how that impact is taking shape. Some 20 percent of institutional investors surveyed say regulation will result in greater transparency and increased reporting requirements, as intended. Another 17 percent believe it will result in increased capital and liquidity while 14 percent say it will force changes in sales practices and 13 percent feel it will force restructuring of activities and business models.
The study further detects a change in the attitudes of institutional investors regarding benchmarking, with 44 percent saying they plan to move away from benchmarking and toward using absolute return as a measure of performance. Around 30 percent say they will focus more on beating the benchmark, while 15 percent say they will focus more on replicating the benchmark.
