Seventy-eight percent of institutional investors around the world expected stock market volatility to surge in 2018, according to survey results released Thursday by Natixis Investment Managers.

The research found that investors were making opportunistic allocations to active managers and alternative investments to meet average long-term return assumptions of 7.2% in the year ahead.

For Natixis’ sixth annual survey, the research firm CoreData polled 500 institutional investors based in North America, Latin America, the U.K., continental Europe, Asia and the Middle East in September and October.

Seven in 10 investors said the addition of alternatives was important for diversifying portfolio risk, but they assigned distinct roles to several alternative strategies in their portfolios.

To diversify their investment portfolios, 47% of respondents cited global macro strategies, 41% commodities and 40% infrastructure investments as most appropriate.

For fixed income replacement, 55% chose infrastructure and 47% private debt to provide a source of stable income as interest rates rise and the 30-year bond bull market ends.

Slightly less than half of institutions said managed futures and hedged equity were best suited to manage volatility risk.

Seventy-two percent cited private equity as their top choice among alternatives for generating alpha, while 45% thought hedged equity could help meet this objective.

As an inflation hedge, 56% of institutions viewed commodities and 46% real estate as the best strategies.

“The sudden return of market volatility is a healthy reminder that it’s important to take a consistent approach to portfolio diversification,” David Giunta, chief executive at Natixis for the U.S. and Canada, said in a statement.

“Institutional investors are increasingly turning to active managers and alternatives for the tools and flexibility to diversify their portfolios and mitigate risk.”

Indeed, three-quarters of those surveyed said the current market favored active managers. And while alternative investments can present certain portfolio risks, the same proportion said the potential returns of illiquid investments were worth the risk.

At the same time, two-thirds reported that solvency and liquidity requirements had created a strong bias for shorter time horizons and highly liquid assets.

Risks hidden within the dynamic macroeconomic and regulatory market make it even more challenging for institutions to balance short-term opportunities and long-term objectives, Natixis said.

In their pursuit of more innovative investing strategies, 44% of institutional investors reported outsourcing at least some portion of their investment management function.

Among respondents who did this, they outsourced management for 41% of their portfolio. Forty-nine percent said their primary reason for doing so was to access specialist capabilities.

During the next 12 months, 17% of institutions said they were considering outsourcing investment decision making, up from 13% in Natixis’ year-earlier survey.

Growing Importance of ESG Investing

The new survey found that environmental, social and governance factors were playing an increasingly important role in respondents’ investment analysis to help them manage risk and enhance return potential.

Natixis said that in its survey a year ago, the top reason institutional investors gave for integrating ESG was to comply with their firm’s mandate or investment policy.

In the recent poll, investors’ main reason for implementing ESG strategies was to proactively align investment strategy with organizational values, cited by 47% of respondents. Twenty-nine percent included ESG to generate higher risk-adjusted returns over the long term.

In addition, the survey found the following:

  • 59% said alpha was to be found in ESG investing
  • 56% believed ESG investing mitigates risks, such as loss of assets due to lawsuits, social discord or environmental harm
  • 61% said incorporating ESG into investment strategy would become a standard practice within the next five years

“Institutional investors have borne witness to the impact of environmental, social and governance events at numerous companies in recent years and watched as stock values declined right along with corporate reputations,” Dave Goodsell, executive director of Natixis’ Center for Investor Insight, said in the statement.

“Our survey shows ESG analysis is playing a greater role in institutional strategy, with more institutions finding that this approach can help navigate a path to potential profits.”

Natixis noted, however, that an opportunity existed to educate institutional investors who said that ESG still needs clearer definition. Only 14% of respondents saw the full potential of ESG today.

Renewed Focus on Risk Management

The survey found that 63% of institutions faced a challenge to gain a consolidated view of risks across their portfolio.

In seeking to better control portfolio risk, 84% of institutional investors said diversification was an effective strategy, 81% considered risk budgeting efficacious and 46% said integration of material ESG factors was useful for controlling risk.

Chief among institutional investors’ long-term risk concerns was managing longevity risk. As such, continuing improvements in life expectancy heighten the challenge of funding longer retirements, especially during a prolonged low-rate environment.

The survey results showed that prospects for continued interest rate increases were a positive for many institutions, as such increases would help to reduce the present value of their liabilities, but would also reduce present value of bond holdings.

To strike an optimal balance, institutions cited managing duration as their top strategy for navigating a rising rate environment.

— Check out As Market Volatility Returns With Gusto, Keep Your Eye on the Fundamentals on ThinkAdvisor.