Mercer Investment Consulting has produced its foreshadowed paper on global equities, which urges clients to have a major rethink about their benchmarks and portfolio construction. Greg Bright spoke with the paper’s main author, Nick White. Mercer’s ‘Blueprint for Improving Institutional Equity Portfolios’, the result of a review of global equities which began last year and involved staff from several offices around the world, raises some fundamental questions for pension funds.
The first is whether the standard MSCI World benchmark, with its massive skew to developed markets, is still appropriate for a properly diversified portfolio.
The second is whether there are better ways to apportion a fund’s risk budget to provide more defence against down markets, which leads into the question of whether asset allocation should be approached according to risk premiums rather than traditional asset class allocations.
The review was foreshadowed by Andrew Kirton, Mercer’s London-based head of investment consulting, in this news service in June.
Nick White, Mercer’s director of consulting, Asia Pacific, penned the final document with input from European and North American researchers and consultants says that it not just about looking to increase weightings to the developing world.
“We have gone with the weight of the argument, with emerging markets. That doesn’t mean it’s not going to be a bumpy road. Some of our colleagues thought we could have gone further,” he says.
“We have thought about diversification and what happens in stress conditions. As we have seen, everything becomes correlated in stressed environments. We have tried to look at it from a risk premia allocation rather than an allocation to markets.”
As part of the total equation, the paper recommends funds look at having a significant allocation to low-volatility stocks, which White says can be implemented in various ways.
State Street Global Advisors, for instance, has in the past few months publicised a ‘minimum-variance’ index, which can be offered as an investment vehicle. The work behind this index shows that over a very long timeframe, stocks which have lower volatility not only offer higher returns but also better downside defence.
White points out that some other strategies can achieve a similar level of diversification, including a tilt to ‘quality’ stocks, which tend to be those large caps which have strong pricing power.
“Low volatility is probably better described as ‘defensive’,” he says. There are three components: stocks of a defensive nature which perform relatively well in down markets; those which are deliberately diversifying from emerging markets, when risk is off the table, which is a subtle difference; and those which will keep up with the developing markets over the longer term.
Another example of a defensive strategy, in single-manager mandates, could be allowing the manager to move to a fairly high cash weighting if it believes equity markets are headed for a fall. Such mandates are rare after 20 years in which pension funds have embraced manager sector specialisation, largely at the urging of their consultants, it should be pointed out.
From an asset allocation perspective, the paper takes funds down a thought path which heads, firstly, towards embracing an MSCI ACWI (all world) index and then on to an all-world investable markets index which includes a higher weighting to small caps too.
It says: “The period which is now being called ‘the Great Moderation’ is over and a return to these favorable conditions is unlikely in the foreseeable future. Thus, the sort of approaches that have worked well in equity investment in most of the last 20 years may not be well placed to be as effective in the next 10-20 years.”
White says that while US pension funds possibly have the most to heed from the world’s changes, given they are most overweight to US equities and bonds, those in Europe and Asia-Pacific should also think about their equities exposures.