A broader view of risk

In the first of a series of contributed articles exclusively for conexust1f.flywheelstaging.com, global head of investment research at Mercer, Deb Clarke examines the decision making of long-horizon investors, advocating that investors incorporate a broader perspective of risk into their decision making.

As we start 2016 it is always tempting to do the obvious of a review of 2015 and predict what might be expected to happen in 2016. In reality, while the turning of the calendar may identify some new themes it does not necessarily mean ‎your investment strategy needs to change. In fact Mercer would argue that one of the aspects of decision making that long-term pension schemes, endowments or defined contribution plans can exploit is their longer-term time horizon.

So what prevents them from doing so?

There has been much discussion about long-term mandates and how investors and managers might work in partnership to create strategies that deliver a long-term return which better matches investors’ liabilities and objectives.

This may look very different to that of the return profile of any given index.

And perhaps therein lies one of the behavioural pitfalls of decision making and the potential for regret risk.

Having to report to your board why one of your managers returned, say, 6 per cent when the market was up double digits is likely to be a tough ask.

In addition, there are questions around how an investor might evaluate managers if they are mandated to generate a return not linked to an index.

We believe it is possible to succeed with this approach if investors genuinely understand, and by implication “buy into” the manager’s strategy, and agree at the outset on the measures that will be used to monitor the progress of the portfolio on a regular (but not too frequent) basis.

This is likely to align investors and managers more closely and make for a much better-informed discussion about portfolio performance, ultimately leading to good long-term relationships and better long-term performance.

Long-horizon investors generally invest in businesses rather than share prices.

They expect the growth of those businesses over the long term to be rewarded in terms of attractive total return to the investor and may even engage with the company to enhance those returns.

Most investors in this category would focus on companies of high quality with strong brands, large market shares, high barriers to entry, low operational gearing, robust balance sheets, etc., and which therefore have the ability to earn higher rates of return on capital employed, well beyond the market’s short-term time horizon.

The second type of long-horizon investor is quite different. This type of investor buys companies which they expect to grow to a much greater extent than the market currently believes they will.

These companies may already have been identified as high-growth companies by the market but this type of long-term investor believes that the market lacks the imagination or time horizon to understand how fast and for how long the business can actually grow.

In neither case is the monitoring of share prices or portfolio performance against market indices a good way of assessing progress over short time periods because of the prevalence of “noise” in those share price movements.

The combination of clarity around decision making and establishment of a clear set of beliefs is critical to success in investing.

But these are not static concepts, and as the world changes there is a need to adapt. There are many new participants in the stockmarket and changes in the economic and political environment.

This is creating patterns of performance and speed of change that have not been seen before. Does this lead to a need for sharper and quicker decision making?

Arguably it does, but investors need to recognise their own strengths; that is, do they have the capacity and skill to speed up decision making, or should they focus on getting their long-term decisions right and seek to benefit from being a patient investor?

One area where Mercer believes change is required is around the need for investors to incorporate a broader perspective on risk into their decision making.

This broader perspective should include consideration of geopolitical, environmental, social and technological change; but what does that mean in reality?

Geopolitical risk is running at an elevated level and seems likely to continue to do so, and we are seeing the impact at both a geographical level as well as at a sector level – for example, the energy sector.

The pace of technological change is, arguably, accelerating and we now have many industries in which the dynamics have changed beyond most investors’ expectations; for example, the largest “hotel” company, Airbnb, does not own any buildings.

Perhaps this faster pace of technological change and the uprising of the shared economy could lead to the landscape of the market, as we currently know it, changing dramatically over the next 10 years with new companies undermining old hierarchies, consumer behaviours changing and government policies adapting.

The current market environment, while presenting a number of uncertainties, does offer the potential for interesting opportunities.

Mercer believes that in order to take advantage of those opportunities investors may need to operate and think in ways that are different from the past. This will be an exciting period, but all those involved in investing will need to be open-minded about how the world may evolve from here.