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Uncertain market direction has challenged response to return gaps through asset allocation
Political change across developed markets challenges high conviction geographic allocations outside a small number of perceived 'safe haven' markets. Similarly, the staggered shift to QT is creating uncertainty over sovereign forecasts for asset class performance. Additionally, in many cases allocations to illiquid assets were approaching restrictions put in place by investment boards, with little room to further tilt to risk classes.

Such uncertainty over investment strategy means that very few sovereigns are willing to adjust strategic asset allocations, and internal restrictions are a challenge to those that are seeking to change. This can be seen in figure 6, in which an increasing number of sovereigns state they have 'frozen' asset allocations to traditional asset classes.

A focus on business model to drive implementation efficiency and liquidity premium capture
As willingness to take active positions in geographic and asset allocation decreases, the effects of the return gap are compounded. Sovereigns are unable to respond to growing shortfalls through asset allocation alone, and are instead looking at how to evolve their business models to drive more efficient realisation against portfolio objectives, notably through internalisation or investment partnerships to reduce management cost and improve placement efficiency.

However, sovereigns acknowledged that any changes to business models carried trade-offs against execution and investment risk:
- Many respondents have struggled to reach target alternative allocations and the shift to internalise or move to co-investment or operating partnerships may create further constraints
- Over-investing in privately listed assets puts sovereigns at risk of future valuation adjustments while utilisation of alternative deployment models (working directly with operating partners) has implications for governance processes and disclosure
- Reducing intermediation while potentially improving line-of-sight to placement also reduces external objective inputs to asset selection and valuation
- Finally, the tilt to internalisation may not be consistent with geographic diversification objectives, and there is some evidence of an increasing 'home market' bias despite stated objectives to the contrary

While the motivation for business model changes is clear and aligned, there is an acknowledgement amongst participants that not all sovereigns will be successful in executing, with the potential for risk or investment shocks where execution is unsuccessful. As willingness to take active positions in geographic and asset allocations slows, sovereigns must engage with investment boards to include consideration of market conditions (as well as potential outflows) in their return targets to continue to work towards their long-term objectives.

With limited scope to act through allocation sovereigns are focused on alternative levers.

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