Disruptive forces to markets and institutional investors’ own operations will play critical roles in the ways in which asset owners position their portfolios to manage emerging risks and seize tactical investment opportunities, according to discussion and debate among global asset owners and investment consultants at the 18th annual MSCI Institutional Investor Forum.
MSCI has hosted the institutional investor forum in Sacramento, California, in partnership with CalPERS and CalSTRS, for 18 years. This year’s Oct. 25 event served as a venue for investors to exchange ideas on how the changing definition of geopolitical risk and a multi-year period of macro volatility have impacted their portfolios.
Ashley Lester, global head of research at MSCI, argued that these trends — coupled with the long-term effects of climate change — increase investors’ needs for new ways to source, manage and analyze data.
“We have both the necessity, because of a range of investment trends, and the ability to shift risk from being a backward-looking, largely control-oriented function to being a forward-looking and investment-focused function,” he explained. “The point I'm making is not that history plays no role at all — of course it does. All our analytical reasoning is ultimately based on precedent. However, we are dealing with both a complex environment in the short term and new asset classes and questions which extend over a long period.”
The new asset classes to which Lester referred sit in the private markets. Among more than 200 institutional investors surveyed by BlackRock Alternatives this year, private assets represented an average of 24% of portfolios. Seventy-two percent of these investors said that they plan to increase their allocations towards private equity this year, and 52% said they will ramp up their exposure to private credit.
“As illiquid private assets have become an increasingly important part of institutional portfolios, the needs around addressing forward-looking problems with backward-looking approaches have escalated,” Lester noted at the event. “Private equity and private credit price only a few times a year at best, and they are not and never will be as data-rich in the same way as public equities or fixed income. The growth of these markets, despite the challenges allocators face in assessing them, is just one example of how and why investors need greater transparency into new underlying risks in their portfolios. This will require both the very best data on these asset classes – for instance, the data MSCI gained through its recent acquisition of Burgiss, – and a whole range of forward-looking and structured analytics to drive understanding of risk and expected returns.”
The growing investment importance of climate change also underscores the need for scenario analysis of what can happen to investors’ assets through periods of drought, extreme heat, severe storms, flooding, and other weather patterns that are intensifying as the planet warms.
What is geopolitical risk, and how do you measure it?
As the second anniversary of Russia’s invasion of Ukraine approaches, attendees of the forum noted that this conflict is an example of the type of geopolitical event that’s challenging to prepare for in asset-allocation and risk-management strategies.
The Russia-Ukraine war had dramatic effects on global markets, including the exodus of some large multinational companies from Russia and the exclusion of Russian companies from the MSCI Emerging Markets Index. MSCI research suggests that, in a period of geopolitical uncertainty caused by the war, equity-market drawdowns lasted as late as September 2022 for all major global markets.
But macroeconomic concerns, such as energy-price-led inflation and rising rates, were also at the forefront of investors’ minds as the conflict began. Dialogue at the forum showcased how the blurred lines between structural, macro and societal changes since the start of the COVID-19 pandemic made assessing geopolitical risks challenging for investors, explained Raina Oberoi, global head of equity solutions research at MSCI.
“We use the word geopolitics all the time, but today, investors are struggling so much with how to approach this problem that even the definition of geopolitics is a little bit of an unknown,” Oberoi said. “Traditionally, the word was used to describe risks associated with wars and tensions between different countries. But now people are saying climate change is geopolitical, that cyber-attacks are geopolitical, that the COVID-19 pandemic is geopolitical. The scope of geopolitical risk has therefore dramatically shifted, as these new investment challenges are more global and systemic rather than episodic and localized to specific countries or areas, such as emerging markets.”
A call to action from forum attendees was for the financial-services industry to develop new tools and frameworks for investment decision-making to help asset owners navigate geopolitical risks in a more structured, transparent way.
“One key takeaway from the discussion was that investors have to manage and navigate these risks in the short term to be able to generate stable long-term returns,” Oberoi added. “To build and maintain a truly resilient portfolio, investors are seeking actionable insights about their portfolio exposures. Ignoring geopolitical risks could be catastrophic.”
Can investors truly prepare for macro regime changes?
Policymakers are increasingly debating a preference to hold rates at “higher for longer,” a phrase used repeatedly by forum speakers on discussions of everything from climate change to AI. Historic rates of inflation globally since the onset of the COVID-19 pandemic have caused macro volatility — and the central banks monitoring it — to command investors’ attention in the past three years, Andy Sparks, head of portfolio management research at MSCI, observed.
For example, as inflation soared between mid-2021 and early 2023, MSCI research shows that the interplay between bonds and equities abruptly changed, with their prices moving in lock step. Sparks and team noted that, with bonds acting as a dead weight rather than a portfolio anchor, some investors began to question bonds’ diversification benefits.
“A change in such an important relationship is unsettling to investors and underscores the uncertainty in the current market environment,” Sparks said. “In this period of potential regime changes, backward-looking risk analysis may fall short. That's where scenario analysis can offer important perspective on how low probability events — which may not have historical precedent — could impact portfolios. It's become an essential tool in institutional investors' risk management processes.”
What kind of wild card will AI be?
Some of the tools that institutional investors are experimenting with to create a risk-management process that marries “numbers and narrative,” as Lester said, are born from developments in AI.
Peter Shepard, head of analytics research and product development at MSCI, said that, from researchers to portfolio managers to risk managers, advancements in deep learning influence the use case for machine-learning tools across the investment ecosystem. Deep learning leverages neural networks, or layers of variables that adjust themselves to the properties of the data they are trained on.
“When I first started working in machine learning years ago, at that point it was really hard to get the machine to do things that are so easy for you to do that you don’t even know it. Looking at a picture of a cat and knowing it was a cat was a really, really hard problem for machines until about 10 years ago,” Shepard recalled. “Deep learning changed that. Deep learning was a set of really mechanical, ad hoc changes to enable a network that has lots of layers to learn. The development of large language models marks another big step. Now they do the things that you have to think about, that really require your intelligence rather than your instinct or your eyeballs.”
Different machine learning and AI tools can be used in risk management and due diligence processes today, as various technologies are able to read news articles, scan documents and produce models and risk signals based on these data inputs. The next generation of models could potentially allow investors to go from correlation to causation: better understand the drivers of the portfolios’ returns by assessing the web of relationships between traditional and non-financial data that can drive the markets. But questions remain for the investment community as to when, and how, such levels of AI transformation could take hold.
“I don’t think that this generation of machines is going to do the things that smart people find difficult,” Shepard said. “What they can do now is things that smart people find somewhat difficult because they are boring, but the problems that smart people struggle with, this generation of machines can’t help us with. The power of this new generation of models comes into the investment process because those models don’t get tired after reading document after document after document. The amount of intelligence that can be built up from that is going to be transformative for how we invest and how our industry employs people. But for now, forming an investment thesis is still for the smart people and not for the machines.”