How retail and institutional investment objectives are evolving

While retail investors use some of the same funds as institutional investors and many managers will offer institutional and retail versions of the same strategy, there are differences in investment objectives and regulatory regimes. These mean there are also many products and markets institutional investors can access that, to date, are less common or absent from the retail market.  

One key difference is the use and structure of active and passive management. Retail investors have historically held higher proportions in active management, particularly within equities. Twenty years ago, the institutional market also used a much higher proportion of active funds – probably close to 100 per cent. 

However, in recent years this has much reduced, primarily due to the weight of robust research, which questions the ability of active managers to deliver sustained outperformance in efficient markets, net of the additional costs involved. This has meant that institutional investors have shifted a material proportion of assets into cheaper passive management.

Although this has not meant active management is no longer used, far from it, investors have simply become more selective in their application of its use.

Now, instead, their focus is often on areas outside developed market equities, or setting up active investment mandates with very specific objectives, where traditional index tracking is either unavailable or unattractive.  

Institutional managers have also developed a far wider range of index-like funds in which to invest. This allows investors to target specific parts of a market. For example, within equity markets, a key development — now relatively mainstream in the institutional market — has been the use of passive “factor” or style index funds, such as value, quality or momentum.

These indices enable investors to actively rotate their portfolios in a similar way to active mangers, or to invest on an ongoing basis across a range of diversified factors. Either way, these funds allow investors to gain exposure to features or factors historically associated with actively managed funds — that is, returns potential above traditional benchmarks — but at a significantly lower cost. 

Factor investing likely to grow

To date, the use of factor investing has been relatively limited in retail markets but, over time, this will most likely grow as investors look to enhance returns while managing cost.

In turn, active management will become increasingly targeted at areas where there is greater evidence that additional value can be added net of the additional cost, or where investors’ specific objectives or targets cannot be met through diversified passive or factor-based indices. This might include areas like responsible investment.

RI is another area where we are likely to see the retail market take its lead from its institutional equivalent.

Investors typically take one of two approaches: exclusion or active engagement. An exclusion approach has the advantage that it can be easily defined and measured. To date, this has been the more common approach within retail funds and is perhaps better used for ethical investing, where investors want to avoid specific sectors such as tobacco or gambling.

In addition, although some institutional investors take an exclusionary approach, for some time now most have focused on active engagement – encouraging fund managers to invest in companies that are taking positive steps to shift their business model. Transparency and data (for example, voting patterns) have been key to institutions assessing the merit of this approach.

Over the next year, the introduction of the sustainability disclosure requirements will broaden retail investors’ choice of funds to include those where active engagement is a key feature. 

The final “institutional into retail” trend that we could see is one that will take more time to come to fruition. It relates to targeted outcomes-led investment strategies.

Institutional investors have, for some time, had to structure distinct and specific investment strategies that meet accumulation and decumulation objectives (or a mix of both), whether this be in pension funds, insurance companies or endowments. 

Over the next year, the introduction of the sustainability disclosure requirements will broaden retail investors’ choice of funds to include those where active engagement is a key feature

In contrast, the retail market has been built primarily on meeting the needs of accumulation clients. As the age profile of advised clients increases and defined benefit pension payments become less common, retirement income needs will become more significant for individual retail clients.

This means that the toolkit adopted in the institutional space to meet the needs of mature pension funds and insurance annuities — focused largely on paying a defined stream of future cash flows or income — can be adapted to meet retail needs.

A key challenge here is that the retail market is structured on open-ended rather than limited lifetime funds or target-date funds, which are more commonly used in defined contribution schemes.

As we look ahead, the use of income products and the development of funds adopting specific drawdown objectives rather than generic bond benchmarks will help the retail market evolve to meet this growing need.

William Marshall is chief investment officer and head of tailored model portfolios at Hymans Robertson Investment Services