Quek: Diversification of business very much in the forefront

Asian sovereign wealth funds (SWFs), public pension funds and central banks are expanding their portfolios away from their usual preferred asset classes in search of higher yield.

While the primary asset class for central banks remains fixed income, many have diversified their investments, moving from G3 government (US, Germany, Japan) bonds. SWFs and public pension funds, on the other hand, continue to expand into alternative assets across private equity, hedge funds, commercial real estate and infrastructure, according to a study by State Street.

This trend suggests that these institutions are looking to portfolio diversification as a means of dealing with the persistently low interest environment, comments Henry Quek, head of official institutions, Asia-Pacific sector solutions, at State Street.

“A lot of Asian central banks and some of the SWFs have expanded quite rapidly over the last five years into different asset classes and different markets. If you look at the need for diversification into other asset classes, the interest rate environment hasn’t really moved that much. It hasn’t moved enough for these institutions to change the view that there are basically valued spaces outside of the US and Europe. The central banks, SWFs and pension funds are looking for ways to add value to their portfolios and are seeking higher yields elsewhere,” Quek explains.

The study, which included more than 60 senior executives of various central banks, SWFs and pension funds, also showed that the institutions have to be adaptable to cope with new risks and benefit from opportunities arising from a more fluid and volatile investment environment.

“Where regulations are continually shifting, official institutions are required to be more adaptable than ever to new risks and new opportunities,” Quek says.

In terms of portfolio management, while the investment strategy of each institution differs, the State Street study indicates that central banks, SWFs and pension funds now have to face increasingly complex portfolios.

For example, about 44% of the participants in the study say optimizing their investment strategy is a current challenge.

Major sources of worry
When investing in new markets, particularly emerging markets, the challenge is that while yields can be better, the risks are greater and largely unknown.

Another is the low interest rate regime, with participants noting that historically low yields have driven them to new markets and a greater diversity of asset classes to achieve their investment goals.

“Despite concerns about the challenges associated with new markets and asset types, 80% of official institutions surveyed expect to increase their exposure to new markets, and, where they have the appropriate mandate, to alternative assets such as hedge funds, private equity, real estate and infrastructure,” Quek points out.

The trend towards new markets and new asset classes also suggests that these institutional investors are seeking ways to enhance their risk management processes in the wake of market volatility and uncertainties.

“Portfolio complexity is one thing, risk management another. There were a large number of institutions that actually said they would increase their exposure to emerging markets and other FX markets. I think that is an interesting finding given that we still have the Fed tapering story in play, interest rates are still low and then the recent emerging market volatility. It’s suggesting that diversification of business is still very much in the forefront. Emerging markets are also still very much in the radar of research institutions,” Quek observes.

About 51% of the participants in the study say the biggest challenge is correctly measuring and monitoring the amount of currency risk they are taking. “This emerged as the biggest concern for APAC respondents with 44% saying it’s a challenge to combine different risk measures across asset classes,” he adds.

Institutional investors cited that managing risk was the top challenge for them with 86% naming market risk while 73% saying operational risk as major concerns.

“But confronting these risks requires greater investments. Almost two thirds of respondents (60%) plan to increase investments in their risk management systems and processes over the next two years and 32% of respondents report difficulties hiring employees with risk, compliance and reporting skills,” Quek says.