INSIGHTS INVESTMENT - Hot Topics | March 2018 Leading opinion: Getting more out of investing - Alexander Forbes
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INVESTMENT
INSIGHTS
Hot Topics | March 2018
Leading opinion: Getting more out of investing
HOT TOPICS I MARCH 2018
Contents Page
Setting the scene 5
1. 2018 global themes and opportunities (Mercer Investments) 7
2. 2018 local themes and opportunities 18
3. A look at private markets 25
4. An exciting concept to disrupt the retirement fund industry 33
We would like to thank the following employees who contributed to the drafting of this workbook:
Donovan McKay Zeenat Patel
Deb Clarke Kavindra Naidu
Vickie Lange Lesiba Mothata
Inge West Gyongyi King
Makhosonke Madi
The issues surrounding trustee duties are complex and depend entirely on the particular circumstances facing each fund. Trustees must in all
cases take their own decision on issues based on their particular fund’s circumstances at the time. It is for this reason that trustees can’t simply
rely on what we’ve discussed here today; nor should they regard our discussions as advice. Trustees should get specific assistance where they are
uncertain of the consequences or reasonableness of any contemplated action.
The information in this document belongs to Alexander Forbes. You may not copy, distribute or modify any part of this document without the
express written permission of Alexander Forbes.
Alexander Forbes Financial Services is a licensed financial services provider (FSP 1177).
Alexander Forbes Investments Limited is a licensed financial services provider, in terms of section 8 of the Financial Advisory and Intermediary
Services Act 37 of 2002, as amended, FAIS licence number 711.
Taking action based on information provided
While care has been taken to present correct information, Alexander Forbes and its directors, officers and employees take no responsibility for any
actions taken based on this information, all of which require financial advice.
For further details of our services, please contact our office in Johannesburg:
Telephone: +27 (0)11 269 1800
Fax: +27 (0)11 269 1111
Email: info@aforbes.co.za
3
We’re confident in our abilities because
of our core belief and approach called
Living*Investing, a unique way of
achieving financial goals.
Visit www.alexanderforbesinvestments.co.za to find out more
Alexander Forbes Investments Holdings Limited.
Registration number 1997/022540/06
HOT TOPICS I MARCH 2018
Setting the scene
In pursuit of certainty
Like so many of the years before it, 2017 was an eventful The themes include the move from quantitative easing to
year for South Africans. It’s easy to get caught up in all the quantitative tightening, preparing for late cycle dynamics,
noise that impacts on our lives and markets. The first Hot political fragmentation and stewardship in the 21st century.
Topics seminar of the year focuses on investment issues. These themes help us understand the global macroeconomic
This is an appropriate time to step back, take stock and environment that we’re operating in, as investors. They also
consider the things we think are important for our clients help us understand the trends that are at play, so that we can
and members in the coming years. continue to shape the investments industry from the front.
Our goal is to secure a lifetime of financial well-being for In the second section we provide our own local 2018
our clients. As discussed at many previous Hot Topics themes and opportunities, which we believe will be key for
sessions, this requires us to broaden our thinking around the South African investors. While all four themes identified by
challenges that members face. From a regulatory perspective, Mercer Investments will have an impact on us, we’ve chosen
there have been important developments that will go a long to include quantitative easing to quantitative tightening
way towards improving outcomes for members. Developments and stewardship in the 21st century as common themes.
such as requiring trustees to have greater scrutiny over Quantitative easing to quantitative tightening is likely to
investment defaults, as well as catering for preservation and have an impact on emerging markets, so we give you our
annuitisation for members are positive developments. view of how the South African market could be impacted
on. Over the last few years, we’ve been strong advocates of
An investment approach that moves with you responsible investing. We go into more detail on how this
can help strengthen a fund’s governance in our section
At Alexander Forbes, our Living*Investing approach is a risk- on stewardship. This is particularly important given the
led, forward-looking approach which is ongoing, adaptable, issues experienced at Steinhoff in December 2017 as well
personal and actionable. We believe that investment as concerns raised around the governance practices of a
strategies will need to adapt as economic, market or number of other listed companies in South Africa.
individual circumstances change. We also believe that it’s
important to take a long-term view, which is aligned to the We also take a look at investing in Africa with themes such
long-term investment horizon of retirement funds. as opportunities abound as Africa industrialises and a
more challenging real return environment ahead. These are
It’s vital to maintain a global overview in the world of important discussions, given the recent relaxation of foreign
investments. Our risk-led approach requires us to be aware exchange controls for institutional investors. Investors can
of each cycle and moment in the markets. This allows us now invest an additional 10% into Africa, over and above
to give our investors the confidence they need in reaching the 30% allowed outside South Africa. While we support
their goals. With this view in mind, we start Hot Topics with the changes, we need to be selective around opportunities
the 2018 themes and opportunities from our colleagues at to ensure that we remain on track to meet our clients’
Mercer Investments. These investment themes are intended investment goals. There are also a number of practical
to highlight the forces that we believe will shape economic considerations to take into account before making greater
and market dynamics over the years ahead. Some themes are use of the Africa allowance.
focused on the next one to three years, whereas others are
expected to play out over the course of a decade or longer. One of the themes that we have been cautioning clients
about over a number of years is that we expect investment
returns to be lower going forward. Among other things, this
will require a rethink around including alternative assets
such as private markets and hedge funds, which aim to
provide alternative sources of returns.
5
ALEXANDER FORBES
THE JOURNEY
IN PURSUIT OF CERTAINTY
ACTION, QUEST, STRIVING FOR DESIRED OUTCOME
RELENTLESS PUSH TOWARDS AN ASPIRATION
Private markets will play an increasingly important role consider default strategies, meet the criteria of simplicity
in portfolios. It is important that investors have a good and suitability and allow customisation based on age,
understanding of the nature of these types of investments. income levels and annuity strategies. We’re excited to share
The last article in this section deals with the considerations this ground-breaking approach with our clients and we’re
for investors when considering private markets and explains delighted to welcome Professor Robert Merton, Nobel Prize
the different types of private market opportunities. Laureate, from MIT Sloan School of Management, back to
Hot Topics to share his wisdom on the topic. Watch this
An exciting concept to disrupt the retirement industry space for more exciting developments in the weeks to come.
Our last section challenges the conventional way of investing
We’re working in pursuit of certainty
in a defined contribution fund. Each individual within a
retirement fund is unique, but the way of setting investment Our Living*Investing framework is a risk-led, forward-
strategies within defined contribution funds in the past has thinking investment approach aimed at achieving client
treated everyone of a specific age as the same. Through new outcomes with a greater degree of certainty. Each of
technology, it’s now possible to tailor investment strategies the topics covered in the workbook provide insight into
for each individual based on their individual circumstances. opportunities and challenge conventions to ultimately
This, coupled with more intuitive reporting to members, can improve outcomes for members. All in the name of ‘in
make a meaningful difference to a member’s journey towards pursuit of certainty’.
financial well-being. These new developments are fully
aligned to National Treasury’s proposals that trustees actively
6
H E A LT H W E A LT H CAREER
2018 global themes
1 and opportunities
(Mercer Investments)
PR E PA R I N G
FROM QE
F O R L AT E C YC L E
TO QT
DYNAMICS
After almost a decade of monetary stimulus, The later stages of a credit cycle typically
the world’s major central banks are starting present a challenging environment for
to gradually pull back, led by the US Federal investors, offering lower returns and greater
Reserve (the Fed). In response to low levels risks than the early or mid-cycle periods.
of unemployment and robust growth, the Fed Although we expect the current economic
recently announced a plan to gradually normalize strength (evident across much of the global
its balance sheet over the coming years (referred economy) to continue into 2018, we believe
to as quantitative tightening or QT). In November, that investors should start considering the
the Bank of England (BoE) implemented its first ways in which they might prepare portfolios
rate hike since 2007 and the European Central for the risks and opportunities that the late
Bank (ECB) has announced a reduction in the stage of this credit cycle might present.
rate of asset purchases from January 2018. The
pace and scale of the shift from quantitative
easing (QE) to QT will be critically important
for markets in 2018 and beyond.
STEWARDSHIP
POLITICAL
IN THE 21ST
F R A G M E N TAT I O N
CENTURY
After 25 years of convergence toward the As the finance industry seeks to rebuild trust
political center across the developed world, following the financial crisis, institutional
politics since the financial crisis have become investors increasingly need to recognize the
increasingly divergent, with populists from importance of their role in acting as good
both the left and the right of the political stewards of the capital entrusted to them.
spectrum making significant advances. This requires investors to have a clear set
Symptoms of political fragmentation have of beliefs in relation to environmental, social
manifested in the Brexit vote, elections across and corporate governance (ESG) issues as
Europe, the election of Donald Trump and more well as recognizing and managing systemic
recently in the Catalan bid for independence. risks (such as climate change). An increasing
Investors are likely to face an environment of number of investors will seek to reflect their
heightened political uncertainty for some time. values and to promote the social good when
investing their assets.
Our investment themes are intended to highlight the forces that we believe will shape
economic and market dynamics over the years ahead — some themes are focused on the next
one to three years, whereas others would be expected to play out over the course of a decade
or longer. We would therefore not expect our themes to change dramatically from one year to
the next, but rather to evolve gradually to reflect important shifts in the investment landscape.
Although we present them as discrete themes, in reality they are highly interdependent.
FROM QE
1 TO QT
Against a strengthening economic backdrop, appropriate pace is always challenging, as
Janet Yellen1 announced in September 2017 the taper tantrum in 2013 and the sell-off in
the Fed’s intention to implement a gradual early 2016 (following the Fed’s first rate hike
normalization of its balance sheet by slowly in December 2015) illustrated. However, so far
reducing the pace of reinvestment as assets central banks have navigated a challenging
mature.2 This “unwinding” of the QE program economic backdrop and managed investor
will take place alongside a gradual normalization expectations effectively. A shift away from QE
of interest rates. Other major central banks need not end badly, but there is no historical
are also making tentative steps to withdraw precedent for unwinding an easing program of
stimulus as conditions improve — the ECB this magnitude, and assessing economic and
announced a downsizing of its asset purchase market sensitivities to tighter conditions will be
program and the BoE implemented its first rate extremely difficult. We therefore expect a more
hike since 2007. Having said that, the ECB and, volatile market environment than the unusual
in particular, the Bank of Japan (BoJ) are likely degree of stability that prevailed over 2017.
to remain in easing mode for some time, and
central bankers will continue to adapt policy as In light of this policy shift, we emphasize the
conditions evolve. following considerations:
We would therefore appear to be on the cusp of • As central banks, led by the Fed, begin to
a shift in monetary policy — the end of an era in reduce and unwind the scale of their bond
which central bank policy has been a significant buying programs, this is likely to place upward
tailwind for markets. The open question is pressure on bond yields. This comes at a
whether and when policy might become an time when the sensitivity of assets to yield
outright headwind for markets. movements has increased.3 From an absolute
return perspective, floating rate assets or
The implications of a gradual shift from easing strategies with limited structural duration
to tightening will depend in large part on the (such as private debt, absolute return fixed
speed and magnitude of central bank moves income or asset-backed securities) may
relative to market expectations (markets are be preferable to more traditional credit
currently discounting a very slow pace of strategies that are tied to a benchmark.
policy normalization). Tightening policy at the
1. Jerome Powell will take office as Chair of the Federal Reserve board when Janet Yellen’s term expires in February 2018. Powell is widely
expected to provide continuity with the existing approach to monetary policy, having voted with Yellen, and before that Bernanke, since
he was appointed to the Fed board in 2012.
2. Starting in October 2017, the Fed will let up to US$10 billion of securities roll off the balance sheet each month by stopping reinvestment
of maturing treasuries and mortgage backed securities. The scale of the roll-off will gradually increase over a period of 15 months, up to
a level of US$400 billion per year. The balance sheet unwind is expected to take around five years.
3. This is a direct consequence of lower yields, since cashflows far in the future become a more important component of the present value of
any asset when discounted at a lower rate.
• Equity markets will also be affected by the • Equity and bond markets have delivered
speed and scale of tightening, but the market exceptional returns in the post-crisis period,
impact might differ substantially across while also benefiting from a diversification
stocks and sectors. Defensive sectors and effect due to their negative correlation.5 The
high yield stocks that have been treated shift toward a tightening bias threatens both
by some investors as “bond proxies” could of these characteristics on a forward-looking
be particularly exposed to a rising yield basis. Investors should be prepared for an
environment. Although we continue to environment of lower returns from equities
advocate equity portfolios with a diverse mix and bonds as well as the possibility that the
of style exposures, investors with a significant diversification effect could disappear, with
bias to low volatility equity (especially where equity and bond returns becoming positively
this is captured via an index-based approach4) correlated (as has been the case for long
might wish to review the extent to which their stretches in history). This is an important
equity portfolio is exposed to a rising consideration for investors making use of
yield environment. leverage (for example, risk parity strategies)
and suggests that portfolios dominated by
• A gradual withdrawal of liquidity by central passive equity and bond exposure offer an
banks (following a period in which policy has unattractive prospective risk/reward profile.
been aggressively stimulative) may lead to
increased bond market volatility, creating
both risks and opportunities for investors. In
particular, investors making use of leverage
— for example, within pension scheme liability-
hedging portfolios — should understand the
impact that a sudden sharp rise in yields would
have on collateral positions (especially if this
leads to a sell-off in equities and credit at the
same time). Conversely, oscillations in bond
yields could create opportunities for investors
utilizing trigger-based strategies.
4. Active low volatility strategies are better-placed than naïve index strategies due to their ability to evolve their approach to take account
of risks such as interest rate sensitivity.
5. In fact, equity and bond returns have exhibited a negative correlation for most of the period since the early 2000s. This reflects the fact
that in an environment of low inflation, markets have been driven to a large extent by shifts in growth expectations. In periods of stronger
than expected growth, equities have typically performed strongly and bonds have fallen, and vice versa — hence the negative correlation.
PR E PA R I N G FO R
2 L AT E C YC L E DY N A M I C S
Credit cycles typically move through three As cyclical conditions evolve across the global
distinct phases: (i) early cycle, in which risk economy, we believe the following issues
premia are high but falling, risk appetite is low warrant discussion:
but rising and monetary policy is stimulative; (ii)
mid-cycle, in which risk premia are moderate, • Investors should be wary of reaching for
risk appetite is recovering and monetary yield, especially in credit markets offering
policy remains supportive; and (iii) late cycle, in historically low levels of compensation for
which risk premia compress and risk appetite default risk. In particular, we view investment
becomes excessive, before central banks grade credit and high yield as unattractive,
tighten liquidity, causing risk premia to expand with current yields and spread levels offering
and risk appetite to fall. relatively little upside. Similarly, investors
should ensure that they are able to achieve
We believe that the US is now approaching the a sufficient level of compensation for
late stage of the credit cycle, as the economy illiquidity and complexity when accessing
is growing strongly, unemployment is very low, less liquid parts of the credit markets. More
credit spreads have hit pre-crisis lows, leverage generally, investors should ensure that the
is rising and equity markets are moving into risks inherent within their strategy remain
expensive territory. Europe and Japan are more appropriate given their tolerance for risk.
comfortably in the mid-cycle, whereas many
emerging economies look to be at a relatively • Reduced levels of liquidity in markets (driven
early stage in their credit cycles. The late-cycle to a large extent by post-crisis banking
environment tends to be a more challenging regulations) may increase the magnitude of
period for investment returns, so the extent any sell-off in markets, as illustrated by the
to which the US starts to see inflationary Flash Crash in 2014 and the market falls in
pressures emerge — thus prompting more early 2016. In addition, an increasing volume
aggressive action from the Fed — will be an of assets is now managed in a way that could
important factor over the course of 2018 increase “gap risk” in markets — the potential
and 2019. for large and sudden falls in asset prices
in a short space of time.6 In particular, risk
parity, volatility control and trend-following credit strategies, multi-strategy hedge funds
strategies (as well as ETFs that provide “short and more adventurous multi-asset credit
volatility” exposure) could all amplify a market strategies may offer some exposure to such
sell-off.7 A reversal of retail flows into high opportunities, as will distressed-oriented
yield exchange-traded funds under a spread- private debt and equity strategies for
widening scenario might also contribute investors with a meaningful tolerance
to instability in credit markets. As well as for illiquidity.
reinforcing the importance of stress-testing
and appropriate position-sizing, periods of • Conversely, if central banks are able to
market stress may also create opportunities reduce monetary stimulus without upsetting
for investors who are willing and able to markets, emerging markets (both equity and
behave in a contrarian manner. This supports debt) are likely to benefit from a combination
the case for flexible and dynamic strategies of early cycle dynamics, relatively cheap
that may be able to capitalize on currencies and strong global growth. Under
opportunities and provide some element our central scenario, we expect emerging
of downside protection. market equities to outperform developed
market equities, perhaps for some time.
• If the monetary policy punchbowl is removed
faster than expected and bond yields
rise materially, companies that have been
supported by ultra-loose policy may face
challenges in refinancing their debt. A rise in
default rates, while painful for existing credit
portfolios, could create opportunities for
strategies that are positioned to allocate
capital to distressed assets. Long/short
6. The classic example of gapping markets is 19 October 1987 (“Black Monday”), when the Dow Jones Industrial Average fell by more
than 20% in a single day. It has been argued that a key contributor to this event was the use of portfolio insurance strategies that
mechanically sold equities when markets fell.
7. This is not to say that investors should avoid all such strategy types. We have had material concerns about volatility control strategies
for some time but continue to believe that trend-following strategies make sense as part of a diversified hedge fund portfolio.
POLITICAL
3 F R A G M E N TAT I O N
Over the period since the early 1980s, there In the face of these political uncertainties,
has been widespread convergence — across we highlight the following issues as relevant
large parts of the developed world — toward for investors:
neoliberal policies, broadly centered on
free trade, free markets and reduced state • The more extreme outcomes arising from
intervention (de-regulation). In recent years, populist policies could include trade and
we have witnessed a backlash against the currency wars. Such scenarios, though
mainstream (“establishment”) politicians and unlikely, would be highly disruptive to markets,
parties that have upheld this consensus, so stress-testing portfolios against large
resulting in the rise of populism8 across large equity, bond and currency movements will
parts of the western world. Disenchantment be important in assessing portfolio risk
with the neoliberal consensus has been exposures. Investors who might struggle to
attributed, in large part, to high levels of tolerate large market movements may wish
immigration, rising inequality and stagnant real to consider approaches to managing their
earnings in many developed economies over the downside risk exposure, including outright de-
last 30 years. risking, defensive tilts or explicit hedges.9
This fragmentation of the liberal free market • The increasingly widespread perception that
consensus creates an environment in which QE has disproportionately benefited the
political uncertainty is heightened, with a higher wealthiest in society via asset-price inflation is
probability of substantial shifts in policy. These likely to have two important implications. First,
political developments come at a time when governments are more likely to relax fiscal
global trade has been relatively weak since the targets (or, in the US, to consider outright
financial crisis, albeit the recent trend has been fiscal stimulus) to appease voters. Second, in
more positive. There is therefore a risk that the event of an economic downturn, a populist
isolationism and protectionist trade policies response could involve a combination of fiscal
(or “deglobalization”) will upset the current and monetary stimulus — “QE for the people”
synchronized upswing in global growth. — designed to put money directly in the hands
of people to stimulate demand. Although
8. Populism typically draws a contrast between “the people” and a group of privileged elites. Populists can fall anywhere on the traditional
left–right political spectrum. Although “populist” is often used as a term of disparagement, we use it here simply to refer to political
groups that have grown in importance by adopting popular policies (such as controls on immigration or seeking to address inequality)
that run counter to the mainstream center-left or center-right positions.
9. Defensive tilts could include reducing equity exposure in favor of defensive hedge funds, senior private debt or real assets with
contractual income streams. Explicit hedges could include a wide range of option strategies designed to reduce an investor’s exposure
to an equity market sell-off.
the nature and impact of any fiscal stimulus pressure on profit margins. Similarly, more
are difficult to predict in advance, they empowered regulators might seek to take
are likely to strengthen inflationary forces action on aggressive taxation policies and the
within the economic system. In the context dominance of large tech firms. Such actions
of a world in which inflation has been largely need not be unambiguously bad for equity
unproblematic over the last 30 years (at least or credit investors — it is quite possible that
in most developed economies), investors intelligent regulatory interventions might
with inflation-linked return objectives should help reduce the risk of more extreme political
review the extent to which their portfolios are outcomes — but they clearly do create some
protected against higher inflation outcomes. tail risks for certain stocks and sectors of
the market.
• As illustrated by the performance of sterling
following the Brexit vote, political surprises
create the potential for large currency
moves. Protectionism and trade tensions
could also lead to currency volatility. This
increases the importance of a clear policy on
hedging currency risk and may also create
opportunities for strategies that can make
use of currency as a source of alpha.
• A fragmenting political consensus, fueled by
a rise in populist resentment of elites, might
also become more openly hostile toward
corporate profits and monopoly power. Over
time, this could lead to a reversal in the multi-
decade trend favoring capital over labor (as
a percentage of GDP), leading to downward
STEWARDSHIP IN
4 THE 21ST CENTURY
Ideas of stewardship and fiduciary duty have • Asset owners should have a clear set of
evolved over the course of history, with the basic beliefs setting out their view on: (i) the impact
concept of a fiduciary being rooted in the Latin of ESG factors on risk/return outcomes;
term “fiducia” — meaning trust or confidence. In (ii) the importance of stewardship and
a post-crisis world, in which trust in the financial engagement activity; and (iii) any investor-
system is at a low ebb, we have in recent years specific factors that might affect their
seen an increasing recognition of the importance approach. Investors should also determine
of institutional investors’ role as stewards of which collaborative industry initiatives
capital as well as a wider discussion around the can help them address related issues in a
role of finance in promoting the social good. resource-effective manner.
In particular, there has been a clear trend in • At the strategy level, asset owners
the treatment of fiduciary duty to increasingly should ensure that their strategic asset
recognize the importance of ESG issues. We allocation is consistent with their beliefs
see this as a positive development, having and policy. Beyond this basic requirement
explicitly stated for many years our belief for consistency, investors should also be
that an engaged and sustainable investment clear on the extent to which systemic risks
approach (in particular, one that recognizes (in particular, climate change) are likely to
the importance of ESG issues and takes a long- impact the risk/return characteristics of
term perspective) is likely to help create and their portfolio. It seems likely that regulators
preserve long-term investment capital. and beneficiaries will increasingly view the
absence of any consideration of the impact
With legal opinions and regulators converging of climate change as a dereliction of fiduciary
toward a view that consideration of ESG issues duty (though this will vary by region).
is consistent (or, at the very least, not in conflict)
with fiduciary duty,10 it is incumbent on investors • At the portfolio level, asset owners should
to have a clear policy in relation to ESG issues ensure that their underlying managers
and to ensure that their strategy and underlying integrate appropriate consideration of ESG
managers are consistent with that policy. issues within their investment processes
and take their stewardship responsibilities
For long-term asset owners, the critical seriously (this applies equally to active and
components of a sustainable investment passive managers).
approach can be considered at three levels:
10. For example, The Pensions Regulator in the UK updated its DB and DC good practice investment guidance in 2017, documenting that:
trustees are expected to assess the financial materiality of ESG factors; stewardship activities are part of a scheme’s investment
governance; and ESG issues are consistent with the fiduciary duties of trustees. This is consistent with the approach taken in Europe
by the EU IORP 2016 update, which states that pension scheme risk assessments should include “risks related to climate change, use of
resources, the environment, social risks and stranded asset risk”.
Moving beyond sustainability and ESG example would be the 2017 recommendations
considerations, there is a wider debate taking of the Financial Stability Board’s Task Force
place concerning what has been described as a on Climate Related Financial Disclosure,12
“crisis of capitalism.”11 As touched on under our which provide a framework for companies and
“fragmentation” theme, this discussion typically investors (including pension funds) to disclose
revolves around issues of rising inequality, the to shareholders, clients and beneficiaries
rent extraction of elites, corporate and investor how they are managing climate related risks
short-termism, and insufficient consideration of and opportunities.
social and environmental externalities.
Stewardship in the 21st century is closely
Although it is far from clear where this debate aligned to the growing industry focus on
will lead, what does seem clear is that politicians sustainability, ESG integration and impact
and policymakers (reacting to a loss of public investing, but also relates to issues of
trust in finance and capitalism) will seek to transparency and fairness in the terms of
find ways to align corporate behavior more trade between asset owners and asset
closely with social well-being. This will apply managers. We recently set out our views on
as much to the investment industry as to any asset manager fees in our paper “Investment
other part of the economy and will require all Management Fees: Seeking Fairness and
parts of the investment chain to be able to Alignment”13 and will continue to contribute
demonstrate their value to society in order to to this debate over the course of 2018.
maintain a “social license to operate.” A recent
11. https://www.ft.com/content/9dbce496-b5ae-11e7-a398-73d59db9e399
12. https://www.fsb-tcfd.org/
13. http://www.mercer.com/content/dam/mercer/attachments/private/nurture-cycle/gl-2017-wealth-investment-management-fees-
seeking-fairness-and-alignment.pdf-mercer.pdf
TA K I N G A C T I O N
The ideas outlined in this paper represent our observations on the challenges,
opportunities and drivers of change present in the current investment
environment. We provide these ideas with the aim of provoking discussion,
but the appropriate response at an investor-level will be heavily influenced
by the specific beliefs, objectives and constraints of each investor. We
look forward to helping investors adapt their strategies as new risks and
opportunities arise over the course of 2018.
IMPORTANT NOTICES
References to Mercer shall be construed to include Mercer LLC
and/or its associated companies.
Information contained herein has been obtained from a range of
third-party sources. Although the information is believed to be
reliable, Mercer has not sought to verify it independently. As such,
Mercer makes no representations or warranties as to the accuracy
of the information presented and takes no responsibility or liability
(including for indirect, consequential or incidental damages) for any
error, omission or inaccuracy in the data supplied by any third party.
No investment decision should be made based on this information
without first obtaining appropriate professional legal, tax and
accounting advice and considering your circumstances.
Investing involves risk. The value of your investment will fluctuate
over time and you may gain or lose money.
Variable insurance products distributed through Marsh Insurance
& Investments LLC; and Marsh Insurance Agency & Investments in
New York.
Mercer, Mercer Investment Consulting LLC, Mercer Investment
Management, Inc., Guy Carpenter, Oliver Wyman, Marsh and Marsh
& McLennan Companies are affiliates of MMC Securities.
© 2017 Mercer LLC. All rights reserved.
Download a guide on key index definitions.
Copyright 2017 Mercer. All rights reserved.
6005804A-GB
ALEXANDER FORBES 2 Summary of local themes
HOT TOPICS I MARCH 2018
From quantitative easing to quantitative tightening Stewardship in the 21st century
The response to the 2008 global financial crash was The events relating to Steinhoff have rightly resulted in
quantitative easing. Now, global central banks are greater scrutiny of governance practices. Environmental,
positioned to tighten monetary policy, which will increase social and governance (ESG) factors can have a material
interest rates from the historical lows in the developed impact on shareholder returns and need to be considered
world. This will have an impact on emerging market within a prudent investment framework. The increased
countries. Given the favourable valuation complex for media coverage on governance issues is evidence of this
emerging markets, relative to developed markets, investment greater scrutiny, with shareholders taking a more activist
opportunities abound in the emerging world. The external approach, and increasingly going public. Well-governed
emerging market environment in 2018 is likely to prove companies need to consider all factors that could affect the
constructive for South African corporate earnings as a result sustainability of their business and their impact on society
of improved global economic prospects. and the environment in which they operate.
Opportunities abound as Africa industrialises
Between now and 2050, half of the world’s population
Mercer’s views resonate with the South African
growth is expected to come from Africa. The continent is set
market too in that our investment themes are also
to have the fastest-growing middle class population in the
intended to highlight the forces that we believe will
world. It also has the highest broadband growth rate across
shape economic and market dynamics in the years
the world. Most investors have been looking at the need to
ahead. Some themes are focused on the next one
build infrastructure in Africa. Until now, private investors
to three years, while others are expected to play out
have played a limited role as a source for funding. Given the
over the course of a decade or longer. We, therefore,
enormity of the funding gap, there is room for big investors
don’t expect themes to change dramatically from
(insurance companies, pension funds, and sovereign wealth
one year to the next, but rather to evolve gradually to
funds) to invest in Africa’s infrastructure drive.
reflect important shifts in the investment landscape.
Although we present them as discrete themes, in
More challenging real return environment ahead reality they are highly interdependent.
Global markets have seen a sustained bull market, the
length of which is unprecedented. The period has been
characterised by unusually loose liquidity and easy money,
caused by a low interest rate environment. The abnormally
high real returns have led to a market environment of
high valuations across many asset classes, both in South
Africa and globally. Returns from traditional asset classes,
however, are likely to be materially lower in the future.
This may necessitate looking at alternative asset classes
to exploit other sources of returns. Investors will need to
consider all the levers available to them to reach their goals.
19ALEXANDER FORBES
From quantitative easing to quantitative
tightening – an emerging markets response
It has been a long and arduous nine years since the 2008 improved communication strategies from central banks,
global financial crash. Authorities responded to the crash policy tightening is unlikely to be eventful. Instead, it will
with a loose fiscal and unprecedented monetary policy, likely reinforce the notion that higher interest rates are a
known as quantitative easing (QE). Now, global central response to solid growth prospects, which ultimately is a
banks are positioned to scale down on asset purchases good thing.
and tighten monetary policy (QT). The intentions of QE
policies were to induce inflation and reignite economic Investment opportunities are growing for emerging
activity. Almost a decade later, consumer inflation in the
Organisation for Economic Cooperation and Development
markets
countries has risen more than 2% year on year for the fourth There are opportunities for EM assets which have seen
consecutive quarter to December 2017. continued demand from global investors. The percentage
allocated to EMs by global investors remains low.
The evolution of inflation in the developed world is uneven According to data from the Institute of International
— momentum behind US consumer inflation is underpinned Finance, EM bonds (equities) now represent 11.8%
by robust wage growth, while Europe continues to produce (13.4%) of global funds’ bond (equity) portfolios. Given the
inflation significantly lower than the 2% target, but there favourable valuation complex for EMs relative to developed
seems to be progress. The resultant outcome is tighter markets (DMs), investment opportunities abound in the
monetary policy, which will increase interest rates from emerging world.
the historical lows in the developed world. This will have
an impact on emerging market (EM) countries. Given the
20The risk factors that determine investment outcomes Since the mid-1970s there have been seven episodes,
including the current one, of uninterrupted bull equity
Research has found that investment returns in EMs are market runs, with an average duration of three and a half
primarily determined by certain macro risk factors — years. There were two short episodes — 1998 to 1999, and
currency, outcomes in DMs, risk appetite towards EMs and 2009 to early 2011, both of which followed massive crises:
commodity prices: the emerging market crisis of the late 1990s and the global
financial crisis of 2008.
Currency risk
The Trump administration has implied a ‘weaker dollar In both episodes, the subsequent bull market was
policy’ in its public statements. With increasing twin deficits underpinned by aggressive monetary policy stimulus. The
— current account and fiscal position — resulting from the effect on EM equity prices waned over a short period.
introduced tax policy, the US dollar might have fundamental
forces pushing it lower. EM currencies are likely to be The other four bull markets proved to be longer and more
supported, which could result in lower domestic consumer sustainable, as they were underpinned by strong global
inflation and interest rates. growth and commodity prices.
Economic market risk After a prolonged period of EMs underperforming DMs
Although valuations are stretched in global markets, and after the 2003 market crash, the current bull market which
subsequent market outcomes are likely to have a lower began in January 2016 suggests, by historical standards,
return profile, economic conditions are conducive for risk that this could be the beginning stage of the bull market in
assets to produce modest returns. EM equities. Given the shallow start, relative to historical
outcomes, there is room for upside performance.
Economic growth risk
Synchronised global economic growth has improved Global fund allocations are underweight South African
commodity prices and the risk appetite towards EMs. The equities relative to the MSCI ACWI index weighting. The
Institute of International Finance expects net capital flows external EM environment going into 2018 is likely to prove
(portfolio flows plus foreign direct investments) to more than constructive for South African corporate earnings. This is
double to US$74 billion from 2017’s US$35 billion. as a result of improved global economic prospects and the
potentially uncluttered economic path for South Africa as
The Bank of America Merrill Lynch has detailed a historical confidence improves.
account of the anatomy of EM equity bull market episodes.
21ALEXANDER FORBES
Opportunities abound as Africa industrialises
The investment case for Africa is well documented. Its China leads the way in investing in Africa
robust gross domestic growth, its demographic dividend
made up of a large and rising middle class as well as its Chinese President Xi Jinping, who has been pronounced ‘the
improving political governance structures have made Africa world’s most powerful leader’ by the Economist magazine,
a feasible investment destination for global investors. has been given a mandate to lead China’s ruling Communist
Party for the next decade and his ‘Belt and Road Initiative’
is now enshrined in China’s strategic planning. Beijing,
Solid GDP growth expected through this initiative, plans to invest abroad in railways,
In the latest International Monetary Fund (IMF) World ports, power stations and other big-ticket infrastructure
Economic Outlook, 43 of the 195 countries analysed are projects across the maritime region, including Indonesia,
forecasted to register an average GDP growth of more than Malaysia, India, and Pakistan. It also plans to invest within
5% over the next five years. Of these 43, 21 are on the Africa — with the eastern side of the Sahara earmarked as
African continent. Although growth since the 2008 global a destination. This presents a tremendous opportunity for
financial crisis has been relatively tepid, especially west Africa as China implements this plan.
of the Sahara as a result of lower oil revenues, recovery
is in sight as the global economy experiences a more The long-term investment story of Africa remains intact,
synchronised uptake in activity. although there will be cyclical weaknesses and risks along
the way. Most investors have been looking at the need to
build infrastructure in Africa. The African Development
A growing labour force
Bank suggests that, annually, the continent’s infrastructure
In the latest PwC Annual Global CEO Survey, it was noted needs are between US$130 and US$170 billion, with a
that while Africa currently represents 15% of the world’s funding gap of between US$68 and US$108 billion. More
population and just 3% of its GDP, by 2035, Africa’s than half of the required funding for infrastructure projects
combined labour force is expected to be larger than that needs to be sourced elsewhere.
of China. The IMF suggests that between 2015 and 2030,
29-million new entrants will join Africa’s labour force. That Deloitte, in its 2017 Africa Construction Trends, shows
is a staggering two million people entering the workforce that governments and development funding institutions
every year. Between now and 2050, half of the world’s account for the lion’s share of the funding capital needed
population growth is expected to come from Africa. in Africa. Private investors play a limited role as a source
for funding. The influence of governments in Africa have
Increased connectivity made the financing landscape unique, as there seem to be
a bias towards finance coming from single countries, such
Africa is set to have the fastest-growing middle class as China.
population in the world. It also has the highest broadband
growth rate across the world. These statistics cannot be Despite this outcome, and given the enormity of the funding
ignored, as they present a myriad of opportunities. gap, there is an opportunity for private capital to participate.
As countries seek alternative ways to raise financial
Consistent governance resources outside foreign aid, there is room for big
investors — such as insurance companies, pension
Increasing political stability in Africa has fostered a better
funds, and sovereign wealth funds — to invest in Africa’s
macroeconomic environment. While debt levels in some
infrastructure drive.
countries (Ghana, Mozambique, Cape Verde, Zambia and
Mauritius) are high, especially in foreign denominated
currency, improving global commodity prices have boosted
tax collections. Sound fiscal policy management is being
implemented more broadly, underpinning the sustainability
of the growth.
22HOT TOPICS I MARCH 2018
More challenging real return environment ahead
For the past few years we’ve been advising clients to A typical accumulation or growth portfolio targets returns
moderate their expectations about future investment of inflation +5% a year over the medium to long term. If
returns. We continue to believe this will be a theme that equities are expected to provide returns only marginally
will play out over the years to come, and which will have above that target, this could be a difficult target to reach.
important implications for investors. We have essentially We often get requests from clients for portfolios targeting
borrowed returns from the future. Investment strategies and returns of inflation +7% a year. Going forward, this will be
investor behaviour and choices will need to change to take extremely unlikely to be achieved. We caution investors
this into account. What has worked in the past will not work against anchoring expectations on what has happened
in the future. in the past.
Global markets have continued to reach new highs over Living*Investing is our risk-led, forward-thinking approach
the past few years. During this period – effectively, a bull to investing. One of the core tenets of our Living*Investing
market of nine solid years – global markets have been approach is adaptability to changing market conditions. As
characterised by unusually loose liquidity and easy money, part of our process, we have identified that it is necessary
caused an abnormally low interest rate environment, not to look at alternative asset classes, such as private markets
something we’ve experienced before in financial markets. and hedge funds. Alternatives provide greater levels of
This has been a good backdrop for investors, as real returns diversification, look to exploit other sources of returns to
across nearly all asset classes have been higher than enhance returns, and align strongly with the long-term
average. Over the period June 2008 to the start of this year, investment horizon of retirement funds. By including
the only asset class not to achieve inflation-beating returns alternatives, client portfolios will have increased levels
was global cash investments, as a result of low interest of diversification and increase the level of certainty of
rates. Growth assets have been the best performers, with achieving client objectives.
South African equities, as measured by the JSE Shareholder
Weighted Index, returning more than 9% per annum Within alternatives, there are many types of funds and
above inflation. This return is high even when compared to portfolios that could be suitable for institutional investors.
historical levels. These vary greatly in complexity, liquidity and fees. There
are many practical issues that trustees need to be aware
Out of all the countries covered in the Credit Suisse Global of when considering an allocation to alternatives. Trustees
Investment Returns Yearbook, South Africa has experienced need to review their decision-making processes to ensure
the highest real returns from equities between 1900 and they are suitable for these new types of investments. Fees
2017 – an impressive 7.2% a year return above inflation. also become important in a low-return environment –
investors need to look at net of fee returns when justifying
The abnormally high real returns have led to a market adding new investments.
environment of high valuations across many asset classes
– both in South Africa and globally. We believe that returns It is important for investors to remember that investment
from traditional asset classes will be materially lower in the returns are only one of the components of retirement
future. At Alexander Forbes Investments, we recognise asset savings. Investors need to consider all the levers available
class return expectations are an important component of the to them to reach their goals. Every investor is different and
solutions and advice we provide for clients. Over the next investment strategies should be tailored accordingly. This
10 years, we expect a more modest return of 5.25% a year is particularly true in the current environment and investors
above inflation. should track their progress in meeting their goals, taking
corrective action if necessary.
23ALEXANDER FORBES
Stewardship in the 21st century
We have seen a growing focus on governance considerations Furthermore, the number of directorships they hold should
by the investment community over recent months, be considered as this may influence their ability to commit
particularly given the events relating to Steinhoff, which sufficient time and energy to fulfil their responsibilities.
have catalysed greater scrutiny of governance practices.
Auditor independence is an additional consideration. While
A number of industry developments support a greater audit partner rotation is required every five years in line
consideration of environmental, social and governance with the Companies Act, the rotation of an audit firm is not.
(ESG) considerations. These include the amendment to The introduction of mandatory audit firm rotation (MAFR)
Regulation 28 of the Pensions Fund Act, which calls for after 10 years was recently proposed by the Independent
trustees to consider ESG factors as part of their fiduciary Regulatory Board for Auditors (IRBA), signalling a desire
duty; the launch of the Code for Responsible Investing to implement additional mechanisms they believe will
in South Africa (CRISA), which sets out key principles strengthen the independence of the industry.
supporting responsible investing; and more recently the
release of King IV Code on Corporate Governance along with There has also been a development on the remuneration
sector supplements to support governance considerations front. While votes against remuneration continue to be
across a broad range of sectors, including retirement funds. non-binding, under King IV, in the event that more than
25% of shareholders vote against director remuneration,
However, the adoption and commitment to these codes and this needs to be noted and addressed with shareholders.
regulations are slow. This is partly due to the difficultly in
identifying and measuring the potential impact of ESG risks It is worth noting the increased media coverage on
and opportunities in order to include them as part of the governance issues, with shareholders taking a more activist
investment thesis when valuing companies. approach. No longer are shareholders simply engaging
behind closed doors – increasingly they are going public.
But when shareholder returns are impacted as significantly
as they were in the Steinhoff event, it demonstrates that There is clearly a growing appreciation of governance
ESG factors can have a material impact on shareholder considerations. While these need to be considered, along
returns and therefore need to be considered within a with social and environmental considerations, there is a
prudent investment framework. general view that well-governed companies will consider all
factors that could affect the sustainability of their business
The South African equity market returned 21.2% in 2017, and their impact on society and the environment in which
but the market would have provided returns closer to 25% they operate.
had the Steinhoff share price not collapsed. This represents
a loss of 3.8% in returns due to the governance failures One of the key investment beliefs underpinning
relating to only one stock. Alexander Forbes’ Living*Investing framework relates to
sustainability and the consideration of ESG factors. While
This example also speaks to the difference between we do not invest in companies directly, we require the asset
adopting a passive or active approach to investing. Adopting managers we invest with to demonstrate their commitment
a passive approach removes an investor’s ability to consider to integrating ESG factors into their investment process
all potential risks that could have a material impact on their and display active ownership through their proxy voting and
portfolio’s performance and to construct their portfolios engagement activities.
with these risks in mind. Active management allows for the
incorporation of ESG factors, and asset managers need to We believe the asset managers we invest with are best
ensure they are fully applying their minds to all potential equipped to assess ESG risks and opportunities, and make
risks that may have a material impact on the performance of meaningful decisions on proxy voting and engagements,
their investments, as well as act upon these, either through because they are required to have a deep understanding of
their engagement with company management or in their the companies they invest in, including any potential issues
portfolio construction. that may materially affect their share price.
Key governance considerations include considering the As the majority of shares are held directly in the name of
independence of directors, the appointment of auditors, and Alexander Forbes Investments, we accept that ownership
remuneration structures. responsibilities are an extremely important right and
obligation, and therefore adopt a responsible investing
Directors should be independent and have the necessary approach for the benefit of our clients.
knowledge, skills and experience to fulfil their role.
243 A look at private markets
ALEXANDER FORBES
Most traditional asset classes over the past 20 years have made investments in unlisted asset classes known as
have delivered more than double-digit returns, benefiting private markets where there is an opportunity to achieve
investors. It remains the consensus view among market attractive and diversifying returns.
participants that traditional asset classes are expected
to deliver lower real returns going forward and, therefore,
investors should temper their expectations. What are private markets?
Private markets fall under the category of alternative
Navigating a low-return environment and building portfolios investments – in other words, those not defined by
for the future requires a need for alternative sources traditional asset classes such as equities and bonds. Private
of return drivers that are not easily accessible through markets encapsulate a variety of asset classes not available
traditional asset classes. The Alexander Forbes Investments on public markets. These asset classes are less liquid and
Living*Investing framework is a risk-led, forward-thinking require a long-term investment horizon.
investment approach that aims to achieve client outcomes
with a greater degree of certainty. With this in mind, we
Private markets
Private equity Private debt
Agriculture Infrastructure
Direct property
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