How following four simple principles may help investors shape allocations.

From the pen of Gareth Anderson

 

There will inevitably be winners and losers at different points during the equity market cycle. However, as I highlighted to attendees at Mercer’s Global Investment Forum (GIF) Europe, four simple principles of portfolio construction may help investors position themselves to benefit from the anomalies present in listed equities, while helping ensuring their portfolios are sufficiently robust to navigate the twists and turns of markets over time.

 

Those principles are invest broadly, invest sustainably, invest actively where appropriate, and invest in diversifying return drivers. 

Invest broadly

The first principle, to invest broadly, may be uncontroversial, but the rationale is clear – exposure to the equity risk premium is most efficiently gained by allocating to a diversified range of sectors and countries, including emerging markets. 

Investor home bias is a very real phenomenon and one of the most prominent elements of inefficiency across investor portfolios. This contravenes the fundamental principle about the need to diversify to reduce risks, but also limits the scope of opportunities available to investors.

 

Yet this shortcoming is apparent across the investment world. To illustrate an example, the average allocation among continental European institutional investors to their regional equity market is approximately 45%1, whereas MSCI’s All Country World affords Europe only around a 10% weighting. This level of concentration ultimately heightens the risk profile of an investor’s portfolio.


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Invest sustainably

The second principle – invest sustainably – is one that many GIF attendees heard about. At Mercer, we believe there are significant risks associated with the scenario of a global temperature increase of more than 1.5 degrees. It is, therefore, up to investors to take action to mitigate and manage the impacts of climate risk within portfolios.  

 

Managing the climate transition within an equity portfolio does not imply naïve divestments from entire industries and countries. As I outlined to GIF attendees, the ability to wield positive influence has a crucial role to play in investing sustainably, particularly in relation to managing climate risk. I do not believe strict divestment aids the transition to a low-carbon economy, but that the best outcomes for investors and the planet are likely to be achieved through stewardship and active engagement with companies.


Invest actively where appropriate

I believe investors should look to active strategies. After all, Mercer believes active management can add value to some degree in most markets, but this comes with a caveat. Active investment approaches will not be suitable for all investors and should only be considered where appropriate.

 

The lesson I hoped to provide GIF attendees was not related to the virtues of active management, but to the appropriateness of investing actively. In many situations, the benefits of an active approach can be outweighed by other factors, including costs (especially management fees) and efficiency in certain markets.

My key takeaway for investors is to turn to active management in markets where a hands-on approach could add value to equity investments. While it can be hard to justify the additional costs of an active manager, I offered three tips to GIF attendees:
 

  • Set out a clear set of beliefs about what you expect from an active manager.
  • Establish a time horizon that can accommodate some degree of underperformance.
  • Put in place a governance process and a clear strategy for identifying highly-rated asset managers. 

Invest in diversifying return drivers

I had the unenviable task of presenting just before the first evening drinks session of the GIF, but I believe my final point resonated with attendees, regardless of whether they were considering what to get from the bar, as it encompasses many of the principles I previously explained.

 

The principle of diversification encourages the spreading of risk. At Mercer, we extend this belief to include allocating to return drivers that have both academic and empirical backing, but that combine neatly in a portfolio setting to add value.
 

There are three primary return drivers we advocate exposure to – quality, value and momentum – but I believe quality should be at the heart of all active equity portfolios. GIF attendees diligently noted that quality is an ambiguous term, but Mercer’s take on quality is defined by strategies that exhibit a consistent bias towards profitability, such as returns on equity or assets.

 

Among active strategies that employ a quality-oriented approach, we look for long-term investment horizons, for sustainability to be embedded in investment decision making, and for active ownership to be the principle tool used in managing climate transition risk.

 

Specialist exposure, including allocations to low volatility equity or listed real assets, is a valuable ingredient in the pursuit of diverse drivers of value or management of risk. Portfolio coverage of geographically diverse markets, such as Emerging Markets, onshore China and small-cap are also important inclusions. GIF attendees heard of the structural benefits of China A-Shares in the session The great debate on equities: US or China. 

 

Fundamentally, this equity framework is intended to be used as a guide, designed to help investors truly consider the factors that shape successful portfolios that meet their needs.

 

1 Mercer European Asset allocation survey

Gareth Anderson
Gareth Anderson
Equity Manager Research, Mercer Investments

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