Author: Rich Nuzum, Executive Director, Investments and Global Chief Investment Strategist

Participating in Mercer’s Global Investment Forum in Melbourne over the past few days has given me a chance to reflect on the current state of mind of global institutional asset owners. (It was also wonderful to be with our clients, my colleagues, and asset managers exchanging views and ideas live, in person.  Much better than zoom for debate and discussion.)

 

The current market environment feels starkly different from what any of us have lived through in recent memory.  This is forcing many asset owners to fundamentally reconsider three main areas of investment strategy.

 

Where are we now?

If we focus on rolling annual calendar year periods, the 10 years ended 31 December 2021 were the best 10 year period in recorded history for a relatively undiversified US$-denominated 60/40 stock/bond portfolio1.  By contrast, 2022 year-to-date has been challenging.  The Chinese curse “may you live in interesting times” applies.  Stocks and bonds are down and we have stagflation in fact2.  There is the fear of uncontrollable inflation and growing expectation of recession going forward.  We continue to experience the impact of two major stagflationary supply shocks in Russia’s invasion of Ukraine and the impact of COVID policies on China and supply chains, with neither being easy to forecast or straightforward to address.

 

In the last two major global market crises (Global Financial Crisis and early COVID), strong bond returns offset some of the impact of stock market declines as interest rates dropped.  Stocks also recovered relatively quickly, within months or weeks, from their worst3.  Monetary and fiscal policymakers threw non-traditional levels of stimulus at the crises – to great near term effect.  Many of us worried about the long-term impact of these levels of stimulus, but in the near term the economy carried on and capital markets were propped up.  Not this time. This time feels different.

 

In the context of this market environment, we see three main areas in which asset owners are fundamentally revisiting their investment strategies:

 

  1. What is our investment objective, really?
  2. How and where can we find new investment opportunities to help us achieve this?
  3. What is our ESG journey, exactly, and how do we better explain that to our stakeholders?

Assessing investment objectives

The revisitation of investment objectives is being driven in many cases reactively, with a great deal of sensitivity to the time horizon over which results are evaluated. In many countries and for many client types, less diversified investors, and in the US those with home country bias, had tended to outperform. In my experience, there are strong commercial and psychological tendencies that can drive underperformers relative to any peer groups they’d picked for benchmarking to chase the sources  of past success. From what I have seen over the last 30 years, because markets tend to move in cycles, with reversion to the mean, chasing past success tends to end badly. In this context, the recent YTD outperformance of “better diversified” investors has come just in time to help some asset owners avoid throwing in the towel and bailing out of diversification at what would have been a really bad time to do so.

 

Other areas being revisited are:

 

  • LDI strategies, which are being called into question due to the consensus wisdom that “interest rates are going to rise”
  • The aspirational level of some absolute and real return objectives, and the ability in defined contribution or retail implementations to achieve certain target income replacement ratios
  • An aggressive search for new and diversifying investment opportunities, with increasing demand for private markets and a revisitation of hedge funds and other liquid alternatives

“Is now the right time to buy?” 

Many investment committee members feel they have been taught that a market downturn is inevitably followed by a recovery, and should present a buying opportunity.  “Is now the right time to buy?” is a common question.  I was taught early in my career that “the cardinal sin for an investment consultant is to exceed your client’s real risk tolerance”.  Where a client is asking whether to take more risk now, we ask how they will react if markets drop another 10, 20 or 40% in the near term?  Would they regret taking on more risk, or would they then want to add even further to their risk level?

 

It isn’t clear to me, nor to my colleagues on Mercer’s dynamic asset allocation committee, that capital markets will necessarily bounce back quickly from here.  Nonetheless, we remain long-term believers in the power of global capitalism, and most institutional asset owners have, at least in theory, extremely long-term investment time horizons. Where short term risk tolerance can support additional risk taking, beginning to dollar cost average into that higher risk level now would be appropriate in my opinion.

 

Questions on ESG

Asset owners and managers are increasingly drawing scrutiny for allegedly doing less than they’ve claimed. At the same time, some players are drawing criticism for doing too much without adequately explaining the connection to risk and return. Positively, this means that both the content and articulation of ESG integration is becoming more nuanced and multi-dimensional. It also means that every organization needs to work out exactly what its ESG story is, and be able to articulate that to its stakeholders4.

 

Where can one find “the free lunch?” 

We believe asset owners will benefit from the insights we’re all able to access from some of the leading practitioners in the investment industry as part of the virtual Learn, Share and Connect sessions offered on 19-20 September following our Australia Global Investment Forum.  These sessions allow our asset manager partners to present a range of different ideas that asset owners can consider acting on to help meet their investment objectives. Recordings of some of these sessions are held on MercerInsight®Community, for those that are unable to participate live. If you are not yet a member of MercerInsight®Community, our digital platform for strategic research, I encourage you to discover more opportunities by joining now.

 

With best wishes amidst what are indeed interesting times,

 

 

Rich Nuzum

 

 
Footnote

1.  Source: Excess return is on a portfolio of 60% stocks (as represented by the S&P 500) and 40% bonds (as represented by the 10-Year US Treasury) over cash (as represented by the Fed Funds rate). Stocks & bonds data as of 10-year period to 31 December 2021: Robert J. Shiller (Data Used in “Irrational Exuberance” Princeton University Press, 2000, 2005, 2015, updated) http://www.econ.yale.edu/~shiller/data.htm). Cash data: Board of Governors of the Federal Reserve System (US) VIA FRED. For illustrative purposes only.

 

2.  Source: MSCI ACWI and Bloomberg Barclays Aggregate returns as of 31 August 2022.

 

3.  Past performance is no guarantee of future results.

 

4.  ESG investing refers to environmental, social, and governance considerations that may have a material impact on financial performance, and therefore are taken into account, alongside other economic and financial metrics, in assessing the risk and return potential of an investment. Thematic investing involves investing with a goal, at least in part, to achieve an impact on an environmental, social, or governance issue, alongside generating return and mitigating risk. As always, the decision whether to invest in ESG-themed options, like all options, must be made pursuant to a prudent process with the objective of advancing the financial interest of the plan and its participants.

 

 


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