Home / Mercer sees index headwinds against a passive tidal wave

The global shift to index investing is unlikely to rewind despite unfavourable conditions for passive allocations across asset classes, according to Kylie Willment, Mercer Australia’s chief investment officer.

Willment, who made several investor presentations last week in New Zealand, said the secular move to passive exposure had been driven by a number of forces, including: equity market capacity issues in larger pension funds; smaller funds following suit “perhaps for less valid reasons”; and, the proliferation of cheap, liquid exchange-traded funds.

She said in the “fee-constrained world” institutional investors had focused risk and fee budgets away from mainstream assets to alternative strategies such as private markets and hedge funds.

“Investors start to focus less on beating an index and more through improving the market via stewardship/active ownership,” Willment said. “If ‘alpha’ comes back – which we have seen over the past six months – I’m not convinced that we’ll see a complete reversal of the trend to passive.”

However, in its recent ‘Global themes and opportunities’ 2018 report Mercer says bond and equity markets would likely deliver lower returns as monetary conditions tighten and inflation ramps up – a scenario that could also see the two asset classes becoming positively correlated.

That outcome would challenge both leveraged strategies and “suggests that portfolios dominated by passive equity and bond exposure offer an unattractive prospective risk/reward profile”, the Mercer report says.

Willment said Mercer favours “active management where markets demonstrate inefficiencies and where you have the skill and fee budget to engage active managers”.

For example, if – as the Mercer report suggests – bonds lose their equity diversification powers, absolute return fixed income strategies would come to the fore.

“Investors should also look for other ways to build defensiveness into portfolios,” she said. “This can be done through currency exposure, especially for investors with ‘risk off’ base currencies. Option-based risk management strategies offer other tools, although they typically come at a cost (or insurance premium).”

The Mercer paper outlines four fundamental themes that will underpin investment markets in the year ahead: tougher monetary conditions as ‘quantitative tightening’ takes hold; “late cycle dynamics” featuring lower returns and more risk; “political fragmentation” where long-held global accords fray; and, the rising importance of “stewardship” for institutional investors.

“Many of the techniques [such as absolute return fixed income, alternative assets and dynamic asset allocation] and in the themes paper are in the context of higher interest rates and a more volatile market,” Willment said. “Be diversified, dynamic and defensive. Investors with specific inflation sensitivity in their liabilities could look to explicitly hedge that risk through inflation-linked assets.”

The Mercer study notes the ‘stewardship’ obligations for institutional investors extends beyond adopting responsible investment styles to contributing to the broader public debate around the ‘crisis of capitalism’.

Issues such as “rising inequality, the rent extraction of the elites, corporate and investor short-termism, and insufficient consideration of social and environmental externalities” were now seeing all industries facing intense public scrutiny, the report says.

“This will apply to the investment industry as to any other part of the economy and will require all parts of the investment chain to be able to demonstrate their value to society in order to maintain a ‘social license to operate’,” the Mercer study says.

Willment said while many parts of the investment value chain might be obscure to the broader public, “stakeholders” increasingly push for higher standards across the industry.

“For asset owners, it’s their members or constituent base, for asset managers it’s their clients, for companies it’s their customers and shareholders,” she said. “There is an increasing need for all those participants to meet a hurdle that is arguably higher than legal or regulatory compliance.

“They are expected to behave in a manner that is consistent with community expectations, or in other words to gain and maintain the social license to operate. If they don’t the reputational and business implications are likely to be high.”

David Chaplin, Investment News NZ