Pension Funds, Endowments, Foundations & Insurance Plans
- Why some allocators believe AI is creating a hidden risk inside quality-factor portfolios
- How AI is breaking traditional sector classifications — and why thematic investing is replacing sector-based research
- The U.S. exceptionalism debate, and the question dividing investment committees across the region
- Where institutions are finding opportunities in international equities despite a decade of U.S. outperformance
- The next phase of infrastructure investing, and why evergreen structures are gaining favor with long-term allocators
AI AND THE QUALITY FACTOR — A MEDIUM-TERM DISRUPTION
Midwest LPs are paying close attention to AI’s specific threat to the quality factor, one of the most widely held factor tilts in institutional equity portfolios. The quality factor seeks companies with sustainable earnings, consistent compounding, and lower volatility — characteristics that historically reflected durable competitive moats. AI is systematically attacking those moats by reducing barriers to entry, democratizing data access, and lowering switching costs across industries that have historically provided pricing power to quality companies.
The practical implication is that portfolios overweight the quality factor are carrying medium-term headwinds they may not be fully pricing in. The earnings impact will lag the competitive disruption — quality companies will continue to report good numbers for one to two years while AI-enabled competition quietly erodes their structural advantages. By the time the earnings compression is visible, the competitive disadvantage will be well-established.
- This is a medium-term dynamic, not a tactical short. Regional investors are not exiting quality factor exposure but are thinking carefully about which quality characteristics are genuinely durable in an AI-disrupted world versus which are artifacts of prior competitive isolation that AI will erode.
- The quality companies most at risk are those whose earnings consistency was driven primarily by information asymmetry, distribution moats, or scale advantages in data processing — all characteristics that AI is directly attacking. Companies with quality characteristics rooted in physical assets, regulatory barriers, or genuine network effects are less exposed.
AI IS BLURRING GICS SECTOR LINES — TRADITIONAL CLASSIFICATION IS LESS RELEVANT
Institutions have noted to Markets Group they are confronting a fundamental challenge in how AI is reshaping asset management. The traditional Global Industry Classification Standard (GICS) framework, designed to group companies with similar business models and competitive dynamics, is becoming less effective as AI’s influence cuts across sectors and industries. Companies benefiting from or being disrupted by AI increasingly appear in unrelated GICS categories, creating portfolio construction blind spots, research coverage gaps, and attribution distortions that sector-based investment teams are often not structured to identify.
The optical networking supply chain provides a clear example. Companies benefiting from the same underlying AI infrastructure theme — the rapid expansion of data centers and the optical connectivity required to support them — are classified across multiple GICS industries and geographies. Under a traditional sector-based research model, these companies may be covered by different analysts, with limited visibility into the common theme linking them. The result is a greater risk of unintended over- or under-exposure to the underlying AI infrastructure factor driving performance across all of the names.
- The same cross-sector theme dynamic applies to energy infrastructure. Gas turbine companies, utilities, and industrial manufacturers all benefit from the same power generation demand theme driven by AI data center buildout, but they appear in completely different GICS classifications and are therefore likely covered by different analysis with no common framework for the shared exposure.
- Thematic investing — organizing the portfolio around themes that cut across sectors rather than sector allocations — is increasingly the preferred framework for regional allocators who are actively managing AI exposure. The themes that matter most currently are AI infrastructure buildout, energy transition and power generation, and health and life sciences innovation.
- Health and life sciences is a specific example where the traditional framework fails. The most innovative companies in healthcare increasingly show up within IT classifications due to their technology intensity. They carry smaller benchmark weights and are deprioritized by IT analysts who have more prominent holdings to cover. A thematic framework surfaced these companies as primary beneficiaries — a sector framework buried them.
- AI tools, particularly large language models used for investment research, are enabling investment teams to monitor a universe of over 11,000 companies for thematic exposure in ways that were previously impractical. Identifying which companies across the global equity universe are benefiting from a specific theme, understanding the shared risk factors across seemingly unrelated names, and avoiding orphan positions in sector coverage gaps are all now achievable at scale.
- The AI infrastructure capital expenditure buildout is not viewed as a bubble by investors who have examined the data. At approximately $750 billion in annual capital expenditure and roughly 20% of U.S. GDP, it is well below the 1.5% of GDP threshold historically associated with bubble characteristics. Natural supply chain bottlenecks — in advanced packaging, high-bandwidth memory, and now glass substrates — have throttled the buildout to a three-to-five-year delivery cycle rather than creating the sudden oversupply that precedes a bust.
THE U.S. EXCEPTIONALISM DEBATE — STRUCTURAL OR CYCLICAL
Allocators across the region are engaged in a substantive and unresolved debate about whether the decade-plus outperformance of U.S. equities relative to international reflects a structural advantage that will persist or a cyclical extreme that will mean-revert. The honest answer from experienced LPs is that both views have merit, and the resolution depends heavily on whether the institutional and cultural conditions that have driven U.S. corporate profit growth — particularly the innovation ecosystem that produces disproportionate new business creation — can be replicated or matched outside the United States.
The U.S. currently represents approximately 60 to 65% of the MSCI ACWI index — down from a peak near 70% after international outperformance over the past 18 months — and accounts for a correspondingly large share of global corporate profits. Those who argue U.S. dominance will persist point to the fact that the profit share aligns with the index weight, since the U.S. actually is generating an outsized share of global corporate earnings. Those who argue for mean reversion point to valuations and the historical parallel with Japan’s peak MSCI weighting in the late 1980s.
- Emerging markets present a more complex picture. Baseline economic growth in emerging markets is higher than in developed markets, but the empirical evidence does not show a reliable correlation between economic growth rates and equity market returns. Entry and exit timing, corporate governance, and capital allocation discipline matter more than GDP growth. Investors are selectively building emerging market exposure with a focus on innovation and entrepreneurship rather than raw economic growth.
- At least one endowment that inherited an overweight international position is using the current period of international outperformance as an opportunity to rebalance toward a more neutral weight, not because they are bearish on international but because the prior 10 years of U.S. outperformance imposed a significant opportunity cost that warrants careful consideration of forward return expectations.
- International valuations are more attractive than U.S. valuations at current levels — a statement that has been true for several years but is becoming increasingly actionable as the valuation gap widens and as macro tailwinds for international, including a weaker dollar, European fiscal expansion, and emerging market earnings growth, gain credibility.
- The dollar weakening thesis is a meaningful tailwind for international equity returns measured in U.S. dollars. Allocators in the region are explicitly avoiding home country bias in their thinking about international allocation, recognizing that an endowment managed in perpetuity should not systematically underweight the 40% of global corporate profits generated outside the United States.
- Japan’s corporate governance reform, still in progress but showing genuine results in some companies, is identified as a potential catalyst for Japanese equity outperformance that has not yet been fully priced in. The industrial restructuring that happened in Europe in the 1990s and drove significant shareholder value creation is viewed as a possible template for Japan over the coming decade.
ACTIVE VS. PASSIVE — A THOUGHTFUL BALANCE
LPs are maintaining a pragmatic blend of active and passive equity management, with the balance varying by market and mandate. For U.S. equities, where the market is broadly considered efficient and passive implementation is cost-effective, allocations are skewed toward passive, with some regional pension funds holding 80% or more of U.S. equity in passive strategies. For international and emerging market equities, where information asymmetry, governance complexity, and market inefficiency create more room for active management to add value, fully active approaches are more common.
- The role of public equities in the total portfolio is being actively reconsidered as private markets allocations grow. When diversification by size, style, or geography can be achieved through private market allocations, the function of public equity shifts toward liquidity provision and market access rather than return generation, which favors passive implementation.
- The ongoing restructuring of equity allocations — consolidating multiple factor-tilted passive buckets into simpler large-cap core indices, while maintaining active management for international exposure — reflects a broader trend toward simplifying the equity portfolio structure and reducing implementation complexity without compromising return expectations.
ALLOCATION DIRECTION — CONTINUING TO BUILD
Institutions with real assets programs covering real estate, infrastructure, timber, and agriculture are at different stages of buildout depending on the institution, but the directional conviction is consistent. Real assets serve an important portfolio function providing inflation sensitivity, long-duration income, and diversification from financial assets that warrants continued allocation. The goal is to reach a mature allocation profile similar to what established endowments and pension funds have built over multiple decades.
- Infrastructure is increasingly distinguished from real estate in terms of allocation philosophy. Core infrastructure, meaning assets with long contracted lives and investment-grade counterparties, is viewed as an evergreen holding, aligned with long-term liability streams, where the structure should match the asset life rather than forcing exits through closed-end fund timelines. This is driving interest in open-ended and evergreen infrastructure vehicles as a complement to closed-end value-add funds.
- The 70-30 split between core and value-add infrastructure, modeled on how mature real estate programs are typically structured, is the target allocation architecture that Midwest institutions are building toward. Core infrastructure provides the stable, long-duration income foundation, while value-add and opportunistic funds capture the return premium from development and operational improvement.
- Co-investment access alongside strategic GP partners is valued both for cost reduction and for portfolio construction precision. For allocators at the scale of large regional pension funds, co-investment allows meaningful check sizes that make them strategically important partners to GPs, generating better terms, better access to information, and better alignment than a standard LP relationship.