21 June 2023
With forecasts becoming less reliable and portfolio positioning increasingly challenged, a portfolio designed with resilience in mind can help wealth managers weather the storm, provide stability, and help clients navigate this new regime.
Several interconnected risks facing the world could trigger and exacerbate multiple crises over the next decade. According to the Global Risks Report 2023, it is possible that we are entering a low-growth, low-cooperation era coupled with rising volatility across environmental, geopolitical, and socioeconomic spheres. This is elevating the risk of a “polycrisis” involving energy and food supply crises, rising inflation, cyberattacks, failure to meet net-zero targets, weaponization of economic policy, and weakening of human rights.
We believe there has never been a better time to refocus on resilient portfolios that can withstand shocks and uncertainties, adapt to changing conditions, and seize investment opportunities. This is essential if wealth managers are to protect client assets and find the right balance between risk and opportunity.
Capital market return expectations are at their highest in years1 due to last year’s market correction. To better manage tail risks, however, further diversification from a simple 60/40 equity-bond portfolio split is of importance.
The good news, according to our 2022 Global Wealth Management Investment Survey2, is that wealth managers believe one of the biggest investment opportunities lies in diversifying portfolios away from traditional equities and bonds.
To build portfolio resilience and make the most of available opportunities, Mercer believes there are five key considerations that inform how to tackle the potential polycrisis, whatever form it takes:
1. Review portfolio positioning
According to our 2022 Global Wealth Management Investment Survey, respondents expect portfolio SAA to change in 2023, following the already material portfolio changes that have occurred over the past three years.
In our view, 2022 represented an investment regime change: equity and bond markets simultaneously produced double-digit negative returns for the first time in 150 years3 as a result of the pandemic, policy responses and the Russia-Ukraine conflict. We believe the combination of these triggered a shift in investing conditions across several areas. Some of these factors are directly related to the inflation story, while others are not: real interest rates and discount rates; leverage and liquidity; valuations and correlations; and energy and climate transition.
We support bringing SAA reviews forward to reset asset allocation structure, considering the new investment regime. The material change in underlying investment conditions has created a need to reassess medium- to long-term portfolio positioning.
However, we do not necessarily support increasing the frequency of SAA reviews. To justify and support more frequent reviews, wealth managers will need effective, market-sensitive, forward-looking assumptions that are responsive to changes and updated often. This will be a resource-intensive undertaking.
An important point is that we do not encourage wealth managers to simply reweight to focus on equities and bonds because of the stronger returns on offer. Rather, what is required is a full reset to reflect the broader nuances of the new regime.
The opportunities in the wake of last year’s decline in markets are not found only in higher-return expectations for public markets and the potential for a profitable vintage year for private markets. Wealth managers must allow for scenario outcomes outside the central base case of benign inflation and a higher-than-expected return outlook, and they need to consider the risk that correlations might not reset to pre-pandemic levels in the way forward-looking returns may have done.
Therefore, it is important for wealth managers to explore the full range of available investment options, find new sources of portfolio returns, and diversify their portfolios in alternative ways.
2. Improve diversification
Opportunistic investmentsWealth managers that have the necessary governance framework in place can at opportune times benefit from pivoting toward credit dislocation, special situations, and distressed debt funds to respond to short-term opportunities. When markets are experiencing a liquidity crisis, for example, being able to provide liquidity is the value a wealth manager can add.
Dynamic diversificationWealth managers must consider how they intend to approach adding dynamic diversification within a portfolio. They need to think about whether this is best achieved at the committee level, should sufficient governance resources be available, or by using mandates that offer the flexibility to be dynamic or are designed to mitigate downside risks.
Private marketsDue to strong demand, private market products have expanded to include semi-liquid vehicles, evergreen funds, and continuation funds. This is offering wealth managers a variety of options with respect to fund selection and portfolio design, and they could consider what proportion to divert from public markets to take advantage.
3. Assess governance framework
Having a robust governance framework helps mitigate a wide variety of risks that can impact outcomes. It also can reveal where regulatory risk needs to be minimized and controlled, reducing the potential for intervention and costly errors.
Wealth managers experienced a significant increase in complexity in the wake of the global financial crisis. In response, they adapted to new regulatory requirements and diversified their investment range, increasing portfolio robustness and sophistication. However, while diversifying portfolios was the right thing to do, it created a dilemma — more diversification places pressure on governance, oversight, and operational management.
The scope of portfolios has expanded beyond traditional investments in developed market equities and government bonds. Fixed income now includes sophisticated strategies such as multi-asset credit and private debt, while the breadth of equity market strategies has expanded to include sustainable themes, listed real assets, and China A shares. Moreover, there are additional investment-related challenges and complexities, including investments in private markets’ net-zero targets and a sharp increase in market volatility.
Just as an SAA review may be timely, wealth managers seeking to improve their governance and maintain control over their portfolios should consider whether they are clear enough on the fundamentals of their portfolios, asking, “Is our portfolio and its allocated assets assigned to suitable managers who have been researched thoroughly?” A back-to-basics refresh could help ensure that portfolios remain fit for a new environment, effectively manage rebalancing and cash flow requirements, have sufficient governance and reporting frameworks, and are abreast of any regulatory compliance that may have changed recently.
4. Evaluate portfolio implementation process
Clients are unlikely to achieve their desired outcomes if the fundamental building blocks of their portfolio implementation are flawed.
Wealth managers have not faced such challenging conditions when implementing investment portfolios for a long time. Margin pressures, legislative changes, increased operational requirements, greater demand for internal resources, and a change in the investment regime are happening in tandem with increased systemic risks and opportunities and a proliferation of investment strategies. But there is a way forward.
Wealth managers should review portfolio implementation both across and within asset classes. And there are some key questions to address as part of this process:
Are you using a principles-based approach4 when constructing an equity portfolio to ensure you have exposure to a variety of return drivers? Can you realize the full potential of multimanager portfolios?
Can you access the full breadth and depth of private markets across regions and sectors? Do you have access to highly rated managers and lower minimums for mass-affluent and lower HNW clients?
Does your investment framework allow access to the right operational structure and investment vehicles?
Do you have the ability to implement medium-term asset allocation views in a portfolio to create value and mitigate downside risks? For dynamic asset allocation to be successful, a structured framework must be followed. Strong investment governance should facilitate investment decision-making, especially in crisis situations.
Are you taking a total portfolio approach to reducing carbon emissions over a multi-year period?
5. Engage third-party assistance
Many wealth managers are considering a variety of engagement models to augment their in-house expertise in the face of crises.
Our 2022 Global Wealth Management Investment Survey revealed that wealth managers are actively exploring a continuum of engagement models across a wide range of functions. By working with external partners, firms have been able to spend more time serving clients and their increased demands as well as spending more time developing new business.
From outsourcing to extension of staff, traditional consulting, insourcing, and strategic alliances, there is a broad range of potential solutions to challenges around margin pressure, rising fixed costs, and increasing regulatory requirements.
Wealth managers can maintain control over their portfolios through a fully outsourced model or a hybrid approach. By delegating day-to-day management decisions to a trusted team that can ensure portfolio resilience through robust risk management and strategic positioning, wealth managers can focus on other challenges faced by their firms.
Depending on the size and market position of the strategic partner, the right engagement model might help reduce costs. Strategic partners may be able to assist in fee negotiations with fund managers and other service providers, thereby helping them to reach goals more quickly or reducing time and money in a portfolio resilience refresh.
Highly customizable models make investment solutions suitable for portfolios of all levels of complexity. The best engagement models are flexible and adaptable, providing wealth managers with tailored solutions that align with their specific client investment objectives, portfolio development, management, and monitoring.
To build portfolios that are more resilient and better prepared for a polycrisis, wealth managers should focus on these key areas:
A clean slate through an SAA review is a first step. Together with a thorough governance review and frank assessment of the portfolio implementation plan, this can provide the basis for addressing long-term goals and remaining responsive to short-term opportunities.
From that position, managers can and should explore diversification, particularly into areas they may not have explored before, whether in terms of dynamic diversification or looking to new avenues such as private markets.
While the way to seize these opportunities may not be clear, engaging with the right partners could help with portfolio planning or delegating day-to-day management. An extra pair of hands and a little more headspace could aid wealth managers in crafting a position that is fit to tackle any crises coming our way.
1 Mercer Capital Market Outlook, January 2023.
2 Mercer 2022 Global Wealth Management Investment Survey.
3 Morgan Stanley Investment Research, 2023 Global Strategy Outlook — The Year of the Yield.
4 Mercer. “Mercer’s Equity Guiding Principles and What They Mean for Your Portfolio.”