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I'm Hooman Kaveh, Global Chief Investment Officer at Mercer. Have you ever wondered what it feels like to be speaking at a client conference and get hit with a tricky question in front of a crowd of hundreds of investors? Come with me as we uncover the behind-the-scenes realities of the real life of a chief investment officer beyond overseeing investment portfolios.
Today, I'm meeting with six of our CIOs from various regions and responsibilities to debrief from our Global Investment Forum in Dublin, to unpack the toughest questions that came up from our audience of global investors. Morning, everyone. How are we this morning?
Great.
Good.
Well done on the presentations at the Dublin Global Investment Forum. You did a great job all of you. I am keen though to go through some of the questions we got from the audience. I thought there were some really interesting and challenging questions, so I'd be really interested in getting a chance for us all to deep dive into them and have a conversation about what we think about them. So shall we just go in the order they came, or should we go for random selection?
I think just random.
OK. Well, why don't we go then in the way that they appeared through the monitor when we were on stage at various times? So I think the first one, I'll address that to Kylie. So as we've all been talking a lot about the concentration of the so-called Magnificent Seven in the equity markets, do we see that as a long-term issue, or do we see it as a short-term issue? And also, what does that mean for active management, do you think?
Yeah. Look, I mean, it's a very topical question. Of course, we had that incredible rally in those seven stocks through the course of last year, probably more than any of us might have expected. And look, I think it's also true that active managers didn't really keep up with that, so pretty much across the global.
Equity universe, we've seen a lot of underperformance. That's primarily been driven by underweights to those names. And now you've got active managers in this position going, look, expensive. If I top up those allocations, I've got to buy in what could be elevated valuations.
So yeah, look, I mean, I think it's a really good question. Is it structural? I don't think we know. It's probably too early to say. It's probably going to be around for a while, history tells us, as we go through different economic cycles and regimes that stocks that dominate the biggest names across global equity indices can change and get quite concentrated from time to time, peak oil in the '80s. It would have been oil companies, the dot-com bubble. We had a lot of tech stocks.
So these types of things do happen, although perhaps not quite to the concentration that we've got with these particular seven names. So not sure, but it's certainly something that we need to think about from a portfolio construction perspective. What does that mean?
Well, I think it probably depends a little bit on where you're invested as well. And I think Olaolu maybe from the US, where I know you tend to invest US and non-US. I think we'd say US large-caps not the highest conviction source of alpha.
So maybe if you're a US investor, you could think about doing passive US large-cap and taking your alpha allocations where we think it's richer, in international equities, small-cap EM. In Australia, we tend to invest globally. So that can be a little tricky to have those kind of structures. So we've very much been thinking about it in identifying that concentration risk that sits in those underweights of those seven names.
Is that within tolerance? It is quite big when you add it up. So we have taken some steps to do some risk management activities around that particular concentration risk. But I think the short answer to the question is, is active management dead because of that particular concentration? I think that's no. But certainly some things to think about in the way that you'd construct a portfolio.
Yeah, I think, as you just said towards the end there, in the name of let's call it risk management, I think there may be an argument for having some component of a completion portfolio or something like that to think about.
Good. Next one is for James. Over the last decade, interest rates were incredibly low, which led to cheap financing and easy leverage. This helped boost returns and private equity investments in particular.
With the higher interest rate environment likely to be around, there's a view that private equity returns will be more challenging going forward. What do you think? And what are you doing in client portfolios?
Well, that is a long question.
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So yeah, let's try and unpack some of that. Well, first of all, I think it's a very valid question. It's certainly one that I think we're all being asked by our clients. But I think the key thing to remember is that when we look at high interest rate environments in the past, we have seen strong returns from private equity.
So if we go back to, for example, 2004, that's the last time we saw returns as high as we saw between around 2016 and '19 in this lower interest rate environment of around 20%. But it can happen. Excuse me.
And one of the main reasons for that is that it's not only the debt cost, which affects what that ultimate outcome is going to be. Lots of other things have an impact as well, so for example, the economic environment, the state of public markets, but most importantly, in private markets, the operational, structural, and managerial changes that the private equity manager is able to bring to that.
So we are in a higher interest rate environment. That is going to lead at the margin to some companies perhaps failing. And I think we have to recognize that there will be a period of time where the market reacts to this and we get to that new normal. But I think that level will probably be in the low to midteens. So still very positive returns as opposed to up at that 20% level.
If we think about how GPS are dealing with that, then the highest quality GPS are actually able to navigate this market well. They have done before. And that's where we think it's really important that you're doing the necessary due diligence on the private equity manager.
But it's also creating some opportunities as well. So if you look at the flows of capital at the moment, perhaps new investors are able to access strategies which were once perhaps closed and not available to them. And so by accessing those highest quality managers, perhaps there'll be even better outcomes in the future.
And for existing clients, we're working with them to extend the period of time with which they're looking to exit. That's really just to pair up the buyers and sellers in a better way to maximize the valuations and also looking at other strategies, such as through secondary. So lots of opportunities there. I don't think it's necessarily a bad thing for returns but things to consider with clients.
Yeah, as you say, I mean, prior or predating the low interest rate environment, we saw pretty healthy investment returns from private equity. Garvan, next one for you. Speaking of private markets, are private markets genuine sources of diversification or just an expensive way to disguise volatility and correlation by just infrequently pricing the assets?
Yeah, harsh question perhaps for a private equity team but, no, look, a really important one. And the sentiment behind the question is obviously really important. These private assets are less frequently valued. And that does create perhaps a perception of a more smoothed risk return profile that investors see in their realized experience that is artificial.
We know the underlying risk return factors typically are higher. Realized return is typically lower. And the underlying economic exposure is the most important thing to consider when we are looking at how you manage the risk return profile.
A couple of things in terms of the diversification point. Probably a critical one is that economic exposure. If you look at the type of asset you're owning, that really can be materially different than the asset you get exposure to in your public market portfolios.
And over the last 20 years, there's been a huge reduction in the number of publicly listed companies. There's about 50% less publicly listed companies in the US today than there was 20 years ago. Of the whole market of companies valued over $100 million in the US, 85% of them are under private ownership.
So if you really want to get access to certain sectors, certain types of growth companies, you really need a meaningful exposure to private markets to capture the opportunity of economic returns. So I do think there's meaningful diversification by sector and by asset. And James touched on it a little.
Also the format of active management you get from private markets is different. There's hands-on value creation through active ownership of companies and delivering that through improvements of financial performance and managing and delivering that through private companies or private assets in the case of real assets infrastructure, real estate, for example.
So we certainly believe there's a firm place for private markets. And they do offer meaningful diverse risk return drivers. How those are measured in your portfolio can sometimes look artificially smooth.
And the risk return analysis you do needs to be a bit more holistic than just looking at realized volatility or indeed return outcomes. But the diversification benefits and opportunities are real. And they should form a part of your portfolio considerations.
No, absolutely. I think whatever we say about that artificial short-term pricing sort of diversification, in the long term, you get genuine underlying diversification in the portfolio, I think.
The next one is for Rachel. US and European real estate markets have had a tough time of it in the last couple of years, particularly in the office sector. Would you buy real estate today for your clients, and why?
So I would add Canadian because I'm from Canada. And as we are speaking today, the market is adjusting to the new reality that James touched on. interest rates are significantly higher versus where they were. And there's a lot going on.
So, for instance, on top of the real estate, the adjustment to higher rates, we also have the adjustment to work from home environment. So the office space is not as attractive as it was before the pandemic.
So we broadly classify real estate into three categories, core, which is mostly stabilized assets. We don't view those as particularly attractive. However, it is not a bad entry point for opportunistic and value-add categories.
Personally, I would still be cautious on the office space. This category perhaps will continue to have a tough time. However, there will be significant opportunities when it comes to putting fresh new money to work in the opportunistic and value-add categories.
Yeah, no, I absolutely agree. I think outside of the office sector, there are a lot of opportunities in the real estate space, so we should continue to look at that carefully. The next one is for Olaolu. And speaking of higher interest rates, US dollar cash rates are now above 5%. And so that means they're probably meeting the disbursement thresholds for many endowments. Would you allocate a sizable portion of clients income-producing portfolio to cash and short-term treasuries?
Sounds like a yes, no question. But what CIO would I be if I don't say it depends.
It depends.
So at the end of the day, our focus truly is to encourage clients to invest for the long term and also to invest based on the objectives of the specific pool. Now, whether you're an endowment, you're a foundation hospital client, what have you, they have multiple pools. It's either working capital or it's meant to support some type of CapEx. It's meant to support research, you name it.
And if you were to go through time, we are coming off a period where we had significantly low rates, near zero negative, for a very, very long time. And clients did not meaningfully change their investment strategy or their pools based off of that.
So if you look at where we are today, depending on the objectives and if you bifurcate them into two, if it is meant to support working capital or if the objective is to be more liquid, 5% in cash and money markets is not outrageous. Actually, that's where you would encourage that type of investment, so it's safe and protects capital.
However, if you are looking at a more diversified portfolio, then the answer would probably be no because you have to rely on the principles of diversification, make sure you have different sources of risk, and really earning and leveraging the portfolio and the alpha that can be generated. So it depends.
No, absolutely. I have to say just like you were referring to it though. 5% with perhaps inflation at 3%-- maybe we don't go to 2%. But at 3%, that's still-- a return of 2% is not bad. And the final one is for Niall. And over the last 10 years we've seen the emergence of private debt as a very popular alternative asset class. Do you think private debt assets have moved into bubble territory?
So I think one of the really nice things about the questions we are looking at today is not only are the questions that we're grappling with but that the questions that the billions of capital downstairs are also grappling with.
And to some extent, you could divide them into two camps. The question you were asking about the higher levels of interest rates, that's what's caused some of the more maybe negative sounding questions that went to Garvan and then went to James, and then went to Rachel. But the other side of that is obviously the higher return that is possible in the interest rate side, which is the question that Olaolu and I are having.
So clearly, with that increase in interest rates with the amount of payment available increasing, there was going to be more capital attracted in. And that is what has happened in private credit. The key question is, is too much capital being attracted in?
And I think when we think about that, I throw out something that I was looking at the other day. If you were to look at 2023 and look at the buyout activity that happened, it was of the order of about $400 billion globally.
If you were to compare that to 2012, there was only half as much buyout activity, so a lot less. But the bank lending that was done in 2012 was actually more than last year, which tells you what is going on, changes in rules, changes in the way that banks are being governed.
The move to being a little bit more like utilities generally is causing banks to pull away from some of the areas that they would regard as more risky. And that is providing the gap for private credit to move into.
So as long as that remains the case, then you can say it should be healthy. Indeed, it's arguably a good thing that private credit is coming in to fill the gap. That's not to say that they're not worries. They are definitely tourists who have entered the industry and possibly don't know what they're doing.
There are definitely a need to make sure that you have a skin in the game when you're lending to the person. But crucially, if you're providing a liquidity, you want to make sure you're getting rewarded for it. And for now anyway, we think that you continue to be so.
It makes sense. I think as you say, private debt has been displacing bank lending rather than being additive to that Thanks, team. I thought it was a great discussion. Let's get back to work.
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