For decades, any conversation involving startups and executive compensation conjured images of Silicon Valley and shiny office buildings full of technology virtuosos working for innovative companies striving to be the next billion-dollar unicorn. Now, a new era of global startups is taking root in previously unexpected regions around the world. In fact, recent research reveals that $893 million was invested in 366 startups throughout the Middle East and North Africa. That number represents a $214 million increase from 2017, which saw $679 million in startup investments.1 Similarly, startups are increasing in Southeast Asia, largely driven by "SEA turtles" — locally born residents who studied and worked overseas (mostly in the West, in places like Silicon Valley) and are returning home to launch their own startup companies. The region has experienced a major inflection point, with VC investors in Southeast Asia investing over $7.8 billion across 327 deals.2 There's one key component all these startups need, however: leadership. But attracting and retaining executive-level talent and management teams can be a major challenge for these burgeoning startup hotbeds, especially when it comes to compensation. Corporate Investors Are Changing Executive Compensation Many of the world's most recognizable startups were launched by charismatic, individual founding partners, such as Jeff Bezos, Jack Ma and Mark Zuckerberg. However, the rise of these luminaries and their compelling stories do not mirror the new era of startups blossoming around the world. In the Middle East and North Africa (MENA), for example, investment companies are providing the initial financial backing needed to launch startups. These investment companies are there from day one to ensure the startups have the capital needed to secure subsequent rounds of funding. Additionally, the executives of these startups are not the original founders and, therefore, desire different compensation models to secure their continued loyalty, creativity and commitment. Acquiring top C-level talent for startups can be a daunting task, as the risk level is high for businesses that do not have a proven track record — or any record at all. Traditionally, western-based startups have fashioned executive compensation packages around medium- to long-term benchmarks predicated on the company's expected growth, but triangulating growth models, investment strategies and executive payment packages can be a complicated and tenuous proposition. Since most global startups today are built around investment companies instead of inspirational individual founders, these companies must be diligent when determining how or how much to pay the executives — who can ultimately mean the difference between success and failure. How Much Should Executive Compensation Be? Investment companies naturally want to maximize their profits, which means they want to retain as much equity in the startup and as many shares of the startup as possible. Every dollar, share of stock or option paid to startup executives is money the investment companies surrender to operational costs. However, low-balling startup executives or opting to hire those who aren't as skilled or experienced also comes with the risk of undermining the startup's ability to compete, grow and drive revenue. Financial arrangements that provide management with a potential share of equity (or shadow equity) require careful thought and consideration. An executive compensation plan must act as an incentive and retention device for startup executives while delivering a fair return to investors and shareholders who have funded the company. Investors and shareholders must decide how much dilution of equity they are willing to accept to provide an appropriate equity pool for the management team. This is why many companies decide to execute a scaled approach that decreases the size of the equity pool with each round of funding to accommodate the increasing value of the company. This type of program impacts the dilution of equity and can allow for more creative compensation strategies — particularly when dealing with more sophisticated startups, such as in the pharma and fintech industries, which require the talent and knowledge of more accomplished professionals and leaders. Investment companies can offer either share options, which give employees the right to buy or sell stock at a designated time and price, or full-value shares, which offer employees actual ownership in the company. Both contribute to the dilution of equity, but options typically contribute more to the equity dilution than full shares. For example, an equity pool comprised of options may amount to 15% to 20% of a company's capital, while a pool comprised of shares may amount to as little as 3% to 5%. This indicates the same amount of long-term incentive awards paid in options will lead to higher equity dilution than awarding full shares. Investment companies must determine which strategy best suits their objectives. When to Pay Executives and Management Should investors pay their executives and management teams only after they have received a return on their investments? Or should executive compensation be based on employees performing their jobs to the best of their abilities, regardless of the outcomes — which are often determined by external economic forces beyond their control. Many startups now implement the former strategy, believing that benchmarks for returns on investments motivate executives and provide them with the extra incentive to do everything possible to create shareholder value. In fact, in a majority of cases, long-term incentive plans only pay out when investors receive a return. Alternately, some startups choose to compensate executives and management based on specific, mutually agreed upon corporate goals and objectives. Compensation can then be provided as cash or shares, though there may be restrictions on when those shares can be sold or vested or whether they come in the form of options or full-value shares. Startups are popping up all over the world, ushering in a new frontier of ideas and innovation, as well as investors and executives who will create the next generation of future unicorns. As new trends continue to emerge for how executives in these startups are compensated, global startups will need to review their options with scrutiny to attract the best executive talent while maximizing returns for investors. Sources: 1. "2018 MENA Venture Investment Summary." MAGNiTT, January 2019,https://magnitt.com/research/2018-mena-venture-investment-summary. 2. Maulia, Erwida. "Southeast Asian 'turtles' return home to hatch tech startups." Nikkei Asian Review, 22 May 2019,https://asia.nikkei.com/Spotlight/Cover-Story/Southeast-Asian-turtles-return-home-to-hatch-tech-startups.
The markets across Latin America, the Middle East, Africa and Asia are some of the most exciting in the world, amid a backdrop of economic growth and changes in demographics, investment markets and regulations. Mercer's Growth Markets Asset Allocation Trends: Evolving Landscape report examined retirement plans in 14 of these markets, with a look at current investment positions and changes over the past five years. The study included retirement fund assets of almost $5 trillion across markets in the Southern and Eastern hemispheres. These areas offer exciting potential for asset owners, managers and investors, as almost 70% of global growth now comes from these economies, according to the World Bank. We are also seeing a rapid expansion of the middle class, creating different patterns of consumption and savings. In addition, half of the top 50 global institutional investors are located in these markets.1 The Global Investment Landscape Is Becoming More Robust Because the economies of Latin America, the Middle East, Africa and Asia are large and growing, with a rising share of wealth being held by individuals, they are of particular interest to investors around the world. These markets are also becoming increasingly open to foreign investors. At the same time, regulatory changes within these regions are allowing domestic investors to invest more broadly and outside their home markets. All these developments translate into a more open and robust investment landscape, with increasing opportunities for investors across the globe. The pension and savings systems in these regions are also undergoing reform, with the same trend toward increasing individual responsibility for retirement savings as seen in Western countries. Overall, we are seeing a shift to defined contribution (DC) plans at the expense of defined benefit (DB) plans across both corporate and government-sponsored schemes. These changes further emphasize the need to deliver effective investment solutions to meet future savings needs and ensure trust in the systems. 3 Ways Investors Are Responding Investors and plan managers are responding to the changing environment in three key ways: 1. More investors are putting money in equities. In the past five years, equity allocations rose approximately 8%, from 32% to 40%. For investors in many jurisdictions, the shift was intended to increase expected returns on the portfolio. Investors across the world face challenges amid an increasingly competitive investment landscape and a low return environment. Adding equities to the portfolio mix should offer greater return expectations over time. 2. Market liberalization is enabling more diversified portfolios, through increased exposure to foreign assets at the expense of domestic assets. On average, foreign exposure in retirement plans increased from 45% of the overall equity portfolio to 49% in the past five years. Investors sought greater geographic diversification, especially in Colombia, Japan, South Korea, Malaysia and Taiwan. In some countries, such as Brazil, Colombia, Peru and South Africa, recent changes in legislation now allow increased foreign asset exposure. In Japan, the Government Pension Investment Fund has seen a move to more foreign equities at the expense of domestic equities in recent years. The shift to foreign assets was also present in fixed income, with the proportion of foreign allocations rising from 16% to 23%, in part due to less attractive local interest rates, as well as a search for increased diversification. Significant home biases remain; however, we expect this trend to continue as regulatory changes support broader global investment. 3. Investors are showing slightly more interest in alternative investments. More investors are including alternatives in their portfolios, and Mercer expects that trend to continue on an upward trajectory. Among those investors who provided details on their alternatives asset allocations, more than 70% of the average allocations went to property and infrastructure, and approximately 20% went to private equity. Changing regulations have made alternatives more attractive for investors in some areas. For instance, in Chile, a 2017 reform to the investment regime passed, allowing pension managers to invest in alternatives up to 10%, though specific limits vary by portfolio. The main objective of this enhancement is to boost returns and ultimately retirement incomes. As investors seek to diversify their portfolios and seek return enhancement, we expect alternatives exposure to continue to grow over time. We hope investors use our report's findings as an opportunity to review their own portfolio and determine where they can improve their asset allocation to achieve even better investment outcomes. To learn more, download the full report here. Sources: Top 1,000 Global Institutional Investors." Investment & Pensions Europe, 2016. https://www.ipe.com/Uploads/y/d/w/TOP-1000-Global.pdf
As companies continue to migrate to all things digital, this wave of transformation will inevitably wash over every area of work, digitizing everything from finance functions and tax compliance to data analytics and beyond. Approximately 73% of executives predict significant disruption within their industries in the next three years, according to Mercer's Global Talent Trends 2019 report. This number, up from 26% in 2018, is greatly due to digital transformation. More than half of executives also expect AI and automation to replace one in five of their organization's current jobs. While this might worry some organizations, these two earthquake changes stand to create 58 million net-new jobs by 2022. Business leaders responding to Mercer's annual survey have mixed opinions on the economic growth these technological advances will have across the globe. Digitization may promise increased opportunity, but it also bodes increased competition from a host of new — and possibly more nimble — players. Assessing the Economic Outlook Across the Globe The turbulence within the global economic landscape is compounded by uncertainty over how trade tensions between the U.S. and China are resolved, according to the Mercer report Economic and Market Outlook 2019 and Beyond. The U.S. economy may slow somewhat due to higher interest rates, while the Chinese economy will remain dependent on how the trade tensions are resolved. Other emerging market economies should continue to grow at roughly the same pace, with the possibility of stronger growth when trade tensions ease. Mercer's Themes and Opportunities 2019 research report notes "mounting evidence of over extension of credit" is creating further white-water turbulence, with the uncertainty over how the central banks' retreat from market involvement after massive liquidity infusions will impact economies. The report also notes that there is a distinct possibility "the pace of globalization could slow, pause or even go into reverse" due to political influence, particularly on trade. In addition, there are increasing expectations from governments, regulators and beneficiaries to have asset owners and investment managers incorporate sustainability as a standard action. Digitally Transforming Tax Compliance Companies navigating all these shifting sands will increasingly look to digitization to help manage and respond to both opportunities and obligations — including tax compliance across geographies. This is also a moving target, particularly in Asia, as some countries are now implementing digital technologies to improve their tax collection efforts. In 2015, the average tax-to-GDP ratio for 28 economies in the region was only 17.5%, which is just over half the average tax ratio of 34% among OECD economies. There has been a great deal of progress with the use of electronic filing of tax returns for major taxes in India, Kazakhstan, Malaysia, Mongolia, Nepal, Singapore and China. Moreover, mandatory electronic payments are now required by revenue bodies in the People's Republic of China, Indonesia, Mongolia and Vietnam.1 Digitization and increased tax regulation are also intended to vastly improve collection efforts, though much more push is needed. Governments are making great strides within their tax administration efforts with the aid of digitization — including sending eAssessments to businesses for taxes owed, based on electronic auditing systems.2 If the systems find discrepancies within sellers' monthly tax reports, it automatically issues an eAssessment that includes interest and penalties. Andy Hovancik, President and CEO at Sovos, puts it plainly: "Bottom line — tax enforcement is now embedded in the most important business processes, changing the world of tax and disrupting decades old business processes. As a result, tax is driving digital transformation in finance and accounting departments. Now more than ever, businesses need a new approach to tax automation to ensure compliance."2 Finance executives agree, including Michael Bernard, chief tax officer for transaction tax at Vertex Inc. He states, "Governments worldwide are turning to new forms of compliance, like e-invoicing regulations, which require IT departments to embed workflows in core processes, and real-time VAT compliance checks. In 2019, finance organizations will begin to factor tax considerations into their digital transformation strategies. An effective road map will include actions for using data to link business processes and tax compliance obligations."3 Guiding Business Strategy With Compliance Digitization alone won't enable companies to better comply with new tax regulations — making compliance a central business strategy will. This includes implementing training sessions across the enterprise to help employees develop a state of mindfulness when it comes to compliance. But in this era of increased accountability, Leila Szwarc, global head of compliance and strategic regulatory services at TMFGroup, states that companies should re-imagine the notion of compliance as a "business enabler" that can distinguish it from competitors.4 According to Szwarc, "Compliance should be seen as a business enabler rather than as a drain on development, but this can only happen if businesses work in an integrated way to bring creative solutions to the related organizational challenges." She continues, "As APAC firms face up to a new regulatory era, compliance teams have a key role to play in both protecting their firms' interests and helping to drive long-term competitive advantage." With an uncertain market ahead and vast changes on the horizon, it's more important than ever to get ahead of the curve and think about how your business can not only survive the wave of digital transformation coming but also thrive with it. Start planning your business strategy, placing compliance and digitization at the heart, with these considerations in mind today, and you'll be better off tomorrow. Sources: 1.Suzuki, Yasushi; Highfield, Richard. "How digital technology can raise tax revenue in Asia-Pacific." Asian Development Blog, 13 Sept. 2018, https://blogs.adb.org/blog/how-digital-technology-can-raise-tax-revenue-asia-pacific./ 2.Hovancik, Andy. "How Modern Taxation is Driving Digital Transformation in Finance." Payments Journal, 16, Jul. 2018, https://www.paymentsjournal.com/how-modern-taxation-is-driving-digital-transformation-in-finance/. 3. Schliebs, Henner. "2019 CFO Priorities: Experts Predict Top Trends." Digitalist Magazine, 18 Dec. 2018, https://www.digitalistmag.com/finance/2018/12/18/2019-cfo-priorities-experts-predict-top-trends-06195293. 4.Szwarc, Leila. "Regulatory compliance – The new business enabler." Risk.net, 18 Mar. 2019, https://www.risk.net/regulation/6485861/regulatory-compliance-the-new-business-enabler.
Africa's unique position as a continent largely comprised of young people who are embracing digital transformation provides banks around the world with a glimpse into the future. This new generation favours agility over bureaucracy and online automation over conventional interactions plagued by human inefficiencies, geographical constraints and a lack of adaptability. In fact, 40% of African bank customers report they prefer to use digital channels for their banking needs.1 This dramatic shift in consumer preference is propelling Africa to the forefront of change and making the African banking sector a hotbed for innovation. In particular, South Africa, Kenya, Nigeria and Cote D'Ivoire are leading the way as they navigate the unprecedented impact and consequences that the digitization of banking and rise of fintech are having on customers, revenue and the future of bank employees. The Rise of Mobile Usage and Digital Banking Mobile usage and digital banking go hand in hand. African banking users prefer digital banking, because they've already integrated digital channels into their lifestyles. In 2017, more than 90% of Sub-Saharan Africa was covered by 2G networks, and more advanced mobile broadband networks are being implemented rapidly throughout these regions, where a third of mobile users — 250 million people — have a smartphone.2 This familiarity with mobile technology and trust for digital platforms make adopting digital banking channels easier. Creating Unprecedented Access to Wealth Faster, cheaper devices and greater access to robust networks are empowering poor countries across Africa to leapfrog into a new era of connectivity, information and online resources. This profound development not only overshadows the impact of landline telephony but also creates a new reality where, in Sub-Saharan Africa, mobile phones are more common than access to electricity. Mobile-money systems that allow people to send cash directly from their phones has elevated the economic fates of populations — lifting, for example, 2% of Kenyan households out of poverty between 2008 and 2014.3 Nigeria (where 60% of the population is under 25 years old) combined with China, India, Pakistan and Indonesia will make up 50% of the 1.6 billion mobile internet users projected to be online by 2025.4 The continued rise of connected and tech-savvy generations of bank users is set to disrupt the entire industry and its workforces. The Challenges of Modernizing Banking Workforces To understand the impact digital transformation and mobile banking are having on banks and their employees, look no further than the recent developments at Standard Bank: Even as one of Africa's most powerful and influential banks, it announced a plan to close up to 91 branches throughout the country, putting more than 1,000 jobs in jeopardy.5 The digitization of transactions and processes that were once performed by human beings is creating profound challenges for banks and bank employees who make a living from increasingly antiquated skills sets. For the global banking industry, Africa represents an inevitable and very near future, and employees are understandably concerned about the viability of their banking careers. As major banks are searching for innovative ways to combat increasing competition and drive growth within their portfolios amid complicated trading conditions, a new generation of tech-oriented banks and fintech organizations are emerging, including TymeBank and Bank Zero. Finding Opportunity in Times of Change With change, there is always opportunity. Mercer's Global Talent Trends 2019 report details that innovation can often present legacy workforces with significant obstacles, but it can also provide unprecedented opportunities for career development and professional growth. Mercer can provide CEOs, CFOs and banking executives with the knowledge and resources they need to implement digitization throughout the finance industry, using lessons from Africa's digital banking boom. Africa's intersection of technology and tech-savvy customers has accelerated the rate at which the digital banking industry is growing, and the potential of this growth can elevate the global marketplace. As tech-savvy consumers across the world demand that banks migrate investments, resources and strategies into fintech and mobile-friendly platforms, Mercer's trusted expertise offers transparency and clear strategies that empower banks — and their workforces — to adapt to a new age of digital transformation. Sources: 1Agabi, Chris. "40% of African bank customers prefer digital channels transactions — Report." Mobile Money Africa, 23 Apr. 2019, https://mobilemoneyafrica.com/blog/40-of-african-bank-customers-prefer-digital-channels-transactions-report. 2Radcliffe, Damien. "Mobile in Sub-Saharan Africa: Can world's fastest-growing mobile region keep it up?" ZDNet, 16 Oct. 2018, https://www.zdnet.com/article/mobile-in-sub-saharan-africa-can-worlds-fastest-growing-mobile-region-keep-it-up/. 3"In much of sub-Saharan Africa, mobile phones are more common than access to electricity." The Economist, 8 Nov. 2017, https://www.economist.com/graphic-detail/2017/11/08/in-much-of-sub-saharan-africa-mobile-phones-are-more-common-than-access-to-electricity. 4Kazeem, Yomi. "Nigeria's young population will help drive global mobile internet user growth over the next decade." Quartz Africa, 18 Sept. 2018, https://qz.com/africa/1393908/gsma-nigeria-to-add-50-million-mobile-internet-users-by-2025/. 5Khumalo, Kabelo. "Customer behaviour triggered Standard Bank move to close 91 branches." Business Report, 15 Mar. 2019, https://www.iol.co.za/business-report/companies/customer-behaviour-triggered-standard-bank-move-to-close-91-branches-19896105.
Private equity (PE) is becoming increasingly important in the Gulf Co-operation Council (GCC) in light of recent intensified economic diversification and development efforts. It is emerging as a relatively new asset class in the region, with interest in "growth capital" rather than the more traditional "buy out" PE has seen in the developed markets of the UAE and Western Europe, in which fund managers take a majority stake. Indeed, venture capital (VC) has seen a surge of fundraising following the success of the region's VC unicorns, such as Careem, and the purchase of Souq.com by Amazon. Private equity can play an important role in driving economic growth. Factors, like the region's increasing wealth, recent important economic reforms and regional governments' strong initiatives to strengthen local entrepreneurship and promote small to medium-sized enterprises, make it highly attractive for PE investments. Governments in the region are attempting to foster further growth in VC by creating incubators and regional hubs with reduced regulations to encourage entrepreneurs to set up in the region. These efforts will ultimately drive sustainable economic growth, greater prosperity, and more highly skilled jobs. However, following the highly publicized case of Abraaj Group,1 the industry is calling for more robust corporate governance in the region. Local PE managers are facing far greater scrutiny as investors are starting to pay more attention to how their funds are handled. Regional investors are asking for a better understanding in gauging the performance of private markets. Buyers and investors want to base their decisions to enter the PE market on proven and tested information, considering factors like past performance and doing their due diligence on investment and operations. While measuring the absolute and relative performance of private markets is critical, it is significantly nuanced. As "value creation" is an important aspect in the private equity story, measurement should be not only accurate but also meaningful. As with all investments, evaluating past performance is always a factor when deciding whether or not to include private equity within the overall asset allocation of a portfolio. However, PE investors must look deeper to determine a Fund's true performance, through rigorous due diligence. A combination of metrics and qualitative measures are important for providing a holistic understanding of the Fund's track record and its future performance potential. In terms of quantitative metrics, the three most commonly used ones are Internal Rate of Return (IRR), Total Value to Paid (TVPI) ratio and Distributed to Paid-In (DPI) ratio. IRR is the most widely cited metric for measuring the performance of a private market investment. This is a time-based measurement which takes into account the investment made and acquired over a period of time. The longer an investment takes to mature (or sell at a given price), the more a given annualized IRR will fall. The second measure, TVPI, considers the total of how much value is received from investments (through dividends and a sale at the end), compared to the initial investment made. The final measure is the DPI ratio, which measures how much of the initial capital is returned (through dividends or other payments) compared to how much was invested initially. DPI is a barometer of realized value, not total value. All three of these metrics play an important role in helping investors evaluate a private equity fund's historical performance. While there is no single answer for comprehensively and accurately assessing the performance of a private equity fund, these metrics when employed together can help get a better understanding of it. Gauging past performance of a fund doesn't tell you much about the performance of the next private equity fund. These commitments have a long life, and it is, therefore, necessary to consider other investment related factors. They could include the stability of the investment team, looking at how the investment team sources deals or how they create value at their portfolio companies. Following the Abraaj case, assessing managers and back office operations have become an essential measure of due diligence. Effective internal controls, strong systems and a well-staffed operations team are also critical for a private equity fund to succeed. Measuring private market performance is certainly more complicated than measuring public market performance. It requires a clear view of relevant metrics and methodologies, is informed through multiple perspectives and demands specificity of analysis. Additionally, it can be subjective, prone to manipulation and ultimately represents an imperfect assessment of the success of a private market investment. However, private market performance measurement is likely to continue to evolve, thereby improving its current shortcomings. The key for investors is to identify investment talent who can generate strong investment sustainably over time. While past performance is useful in evaluating a managers' historical track record, it won't guarantee future results. Hence, an investor needs to undertake deep "qualitative" investment with operational due diligence together to assess the likelihood of future investment success. To learn more about how Mercer can help you with your investment strategies, click here. 1 Ramady, Mohamed, "Abraaj Capital: The Rise and Fall of a Middle East Star," Al Arabiya, July 3, 2018,https://english.alarabiya.net/en/views/news/middle-east/2018/07/03/Abraaj-Capital-The-rise-and-fall-of-a-Middle-East-star.html#.
Times are changing. The world is moving toward an ethical, long-term sustainable way of investing. Forward-looking governments are increasingly emphasizing the role of financial markets in fostering sustainable development. Investor demand for responsible investment (RI) solutions has increased significantly, as observed by the growth of assets being allocated to RI-related investments. Combined with the shift toward low-cost equity index tracking, this has led to an increase in the number of RI indices that are now available. We expect RI indices to become an important first step in integrating environmental, social and corporate governance (ESG) considerations for many investors with existing passive or factor-based investments. At Mercer, we define Responsible Investment as the integration of ESG factors into investment management processes and ownership practices in the belief that these factors can have a material impact on financial performance. Meanwhile, in the GCC region, with efforts to diversify the economy, governments are gaining awareness around the importance of responsible investing. The GCC makes up four of the six Sovereign Wealth Funds (SWF), which founded the One Planet SWF Working Group in December 2017 at the occasion of the "One Planet Summit" in Paris. Within the UAE itself, numerous initiatives — such as The Green Economy for Sustainable Development and Green Agenda — are propelling the country into the future of responsible investing. In keeping with the diversification strategy, these initiatives support Vision 2030 by aligning with the nation's economic growth ambitions and environmental sustainability goals. Abu Dhabi is contributing to the agenda in a major way through various developments, such as Masdar City — a multi-billion dollar green energy project.1 Meanwhile, Dubai set up an energy and environment park called Enpark — a Free Zone for clean energy and environmental technology companies.2 As the business case for responsible investing gets stronger in the GCC, there is a growing demand for incorporating ESG factors or sustainability themes into investment decisions and processes. Institutions are factoring the benefits of responsible investing, not only to their investments but also to their reputation and bottom line. Sustainable investing offers attractive opportunities to tap into the growth potential of companies providing solutions to various challenges of resource scarcity, demographic changes and changes in the evolving policy responses to a range of environmental and social issues. Studies and industry evidence have shown the benefits of integrating ESG factors on the company's long-term performance. For example, Deutsche Bank reviewed more than 100 academic studies in 2012 and concluded that companies with higher ESG ratings had a lower cost of capital in terms of debt and equity. Another study in 2015 by Hsu (Professor at the National Taichung University of Science and Technology, Taiwan) and Cheng (Professor at the National Chung Hsing University, Taiwan) found that socially responsible firms perform better in terms of credit ratings and have lower credit risk.3 With companies operating against the setting of public concerns around environmental and social issues, incorporating ESG considerations is now also considered best practice. Employees increasingly want to work for and invest in companies that make a positive environmental impact. Global initiatives and bodies, such as the CFA Institute, have highlighted the financial and reputational risks of not taking ESG considerations into account. While the GCC is beginning to understand the benefits of applying ESG, the region hasn't been too far from its concept. Sharia-compliant investing has been around for the last two decades. Both frameworks apply the negative screening approach and seek investments which provide a sustainable return. With the combination of ESG factors and Sharia screening, Islamic investors can improve investment performance while meeting social and environmental goals at the same time. As the UAE is now focusing on diversifying its investments, it can highly benefit from creating a responsible investing market and culture where strategy and processes go hand-in-hand as important steps for successful integration. When seeking sustainable growth, an additional layer of insight and oversight is extremely crucial to mitigate emerging risks, like climate change. To that end, implementing ESG assessments will help set clear KPIs and identify where and how projects generate value and mitigate risks associated with them. For example, Mercer applies an Investment Framework for Sustainable Growth with its clients, which distinguishes between the financial implications (risks) associated with environmental, social and corporate governance factors and the growth opportunities in industries most directly affected by sustainability issues. Measuring impact and mitigating risks has become increasingly important and represents a strong investment governance process. The benefits of adopting ESG are numerous. While the GCC has started with the implementation of ESG principles, more work still needs to be done in making sure governments are fully engaged with stakeholders, including investors, and strategies are aligned across the region. Regulatory pressures to meet global standards of ESG integration will only increase in the coming years. Instead of hiding from it, it is time for companies, investors and governments to come together and define a way of working that moves the GCC forward in terms of responsible investing and sustainable growth. 1Carvalho, Stanley, "Abu Dhabi To Invest $15 Billion in Green Energy," Reuters, January 21, 2008, https://www.reuters.com/article/environment-emirates-energy-green-dc/abu-dhabi-to-invest-15-billion-in-green-energy-idUSL2131306920080121 2Energy and Environment Park:Setup Your Company In Enpark, UAE Freezone Setup, https://www.uaefreezonesetup.com/enpark-freezone 3Chen, Yu-Cheng and Hsu, Feng Jui, "Is a Firm's Financial Risk Associated With Corporate Social Responsibility?"Emerald City, 2015, https://www.emeraldinsight.com/doi/abs/10.1108/MD-02-2015-0047
Sovereign wealth funds (SWF) adopt differing mandates based on a country’s macroeconomic profile and the government’s priorities. Saving for future generations – as is the case with the Abu Dhabi Investment Authority (ADIA) or the Kuwait Investment Authority (KIA) – is the widely adopted mandate. But more recently, governments have begun to leverage their funds to transform their economies by adding an economic development component to their fund’s mandate. Consider the Kingdom of Saudi Arabia’s Public Investment Fund (PIF), which has identified several economic development initiatives under its ‘Public Investment Fund Program 2018-2020’, prioritizing maximising the value of PIF’s investments in Saudi companies; launching and developing new sectors; developing real estate and infrastructure projects and companies; and undertaking giga-project initiatives (developments costing more than $10 billion). One reason why countries establish sovereign wealth funds is to both professionalise and institutionalise the way the sovereign invests and manages its wealth. With this in mind, the combination of a strong governance framework and a highly experienced investment team are integral for success. When pursuing an economic development agenda, sovereign wealth fund investment professionals have a complex dual role to fulfil: Not only are they instructed to look after and transform the existing portfolio, but they are also tasked with identifying, initiating and leading new investment opportunities. Transforming a direct investment portfolio occurs through various initiatives aimed at improving the performance of the portfolio companies or monetising some of them. To improve performance, the critical first task is to implement best-in-class governance, often requiring the training or replacement of directors representing the sovereign wealth fund on the boards of portfolio companies. In turn, boards become more business savvy and gain more clarity on shareholders’ expectations, putting them in a stronger position to fulfil their fiduciary duties. When the situation requires drastic actions (for example, when a direct investment operates at a significant loss), the fund needs to swiftly engage an external advisor to identify strategic options, then supervise the implementation of the selected strategy. Such drastic actions can be expedited when the sovereign wealth fund owns 100 percent of the company or has the majority control of the board. Portfolio transformation also occurs when the sovereign wealth fund decides to monetise one of its portfolio companies. This can occur for various reasons, such as the need for cash to re-invest into more promising opportunities, or the need to eliminate excessive downside risk. In the Middle East, the sale of a state asset often requires an intermediary step consisting of corporatising the entity. This process aims to transform state assets or government agencies into corporations with a legal structure and financial statements for the last three or five years. Going through this process is usually the first step towards a sale or an Initial Public Offering (IPO). When it comes to new investment projects, sovereign wealth funds can operate in a structured approach. New viable investment opportunities need to be built on a detailed understanding of the economic sectors and strengths of a country. Once a sector or opportunity of interest has been identified, a more in-depth study should be performed to confirm the opportunity, its profitability, landscape of potential partners, risks, and employment potential of the project. A compelling example is the concept for a downstream aluminum cluster pursued in Bahrain by its sovereign wealth fund, Mumtalakat. One of its portfolio companies, Aluminum Bahrain (Alba), is currently building a sixth smelter line that will add 500,000 metric tonnes of aluminum per year, starting in 2019. In parallel, Mumtalakat is teaming up and co-investing with international partners to create joint ventures in Bahrain that will utilise this additional capacity while creating 2,000 new employment opportunities. By developing a strong understanding of attractive sectors in a country or a region, sovereign wealth funds should be in a position to quickly form an opinion on an opportunity. If an established player from overseas or an adjacent country has a compelling business case for expanding in the Middle East or in the country of a SWF, then the SWF should engage with the potential partner to further assess the opportunity. Funds with an economic development agenda represent a great opportunity to accelerate the development of their economy. Some African countries such as Angola (Fundo Soberano de Angola - 2012)1 and Nigeria (Nigeria Sovereign Investment Authority - 2012)2 set up their sovereign wealth funds over the last decade and both have developmental components in their mandates. Egypt passed a law in May 2018 to establish its own fund3. One of the contemplated objectives for this fund is to manage state companies ahead of listing on a stock exchange. The PIF in KSA has a huge task ahead of itself as it is expected to play a major role in the stimulation of the Saudi Arabian economy. The large and rapidly growing value of assets managed by sovereign wealth funds as well as the leadership expected of them in their countries’ economic transformation agendas is placing them in the public spotlight. It does not come as a surprise that citizens want to know how their public funds are being employed to their benefit. In developed countries, governments have traditionally focused on the regulatory aspect of an industry and then let the private sector flourish. On the contrary, in the Middle East and other developing countries, significant industries have often emerged from the will of the government. Sovereign wealth funds can be an effective tool to make this happen. To learn more click, here. 1International Forum Of Sovereign Wealth Funds https://www.ifswf.org/assessment/angola 2International Forum Of Sovereign Wealth Funds https://www.ifswf.org/assessment/nigeria. 3Egypt Plans Sovereign Wealth Fund-of A Kind https://www.gfmag.com/magazine/may-2018/egypt-swf
The size and scale of China’s domestic marketplace has become one the nation’s greatest economic achievements. From the middle-class explosion to the sweeping impact of digital transformation throughout its population and industries, China—and the global economy—are entering a new era of investment opportunities. There is money to be made by investing in China but opening up the country’s heavily regulated domestic assets to foreign investors entails a learning curve on both sides. Perspective: China vs. Growth Economies The Mercer report The Inclusion of China A-Shares in MSCI Indices: Implications for Asset Managers and Investors, explains why opening China’s domestic market to the global economy has created a wave of excitement throughout the international investment community and marketplace. This enthusiasm is being carefully managed by the measured strategy China and the MSCI are implementing while forging a framework for future growth. The initial phase only weighted 226 stocks at a mere 5 percent of their market cap, demonstrating that this new era will be defined by an incremental, long-term mindset. This cautious approach may be welcome news to competing growth economies in the region. Despite the conservative rollout of Chinese A-shares (domestic assets) to the international marketplace, inclusion in the MSCI Index will profoundly impact the global economic landscape, especially with regard to the influence of emerging economies. Take, for instance, what the MSCI Index will look like with the inclusion of 5 percent of Chinese A-shares, and then at 100 percent inclusion. Growth economies such as India, Taiwan and South Korea may be negatively impacted by the inclusion of domestic China in global indexes, especially if investors shift their focus from growth markets to new opportunities in Chinese A-shares. (Source: MSCI) Change is inherently fraught with breakthroughs, obstacles and the anxiety of the unknown. Though no one can 100 percent accurately predict the future, let’s examine the opportunities and challenges of China’s new status in the global economy, and what it means to equity investors. Opportunities from Inclusion in MSCI: 1. Market Size: The Chinese domestic market is large, comprising more than 3,000 stocks, and is the most liquid in the world. Since the beginning of 2017, the Shanghai and Shenzhen Stock Exchanges have experienced higher aggregate daily trading volume than the New York and NASDAQ Stock Exchanges combined. 2. Diversity: The Chinese domestic market entails a cross-section of companies that represent a broad number of industries, and it is much more diversified at the sector level than the China shares listed in the Hong Kong Stock Exchange (which is highly concentrated in IT and financials). 3. Uniqueness: Historically, China’s A-share market has displayed a low correlation with other equity markets, marking an era of new and unexplored opportunities to create value. 4. Limited Foreign Ownership: With domestic Chinese retail investors comprising more than 75 percent of the free-float market cap—the number of outstanding shares available to the general public—there is a lack of informed institutional owners in the market. The unprecedented nature of the situation can create inefficiencies, but also yield an environment that can be conducive to investors willing to explore new opportunities. Challenges from Inclusion in MSCI: 1. Volatility: Although the market is large and liquid, it is volatile and has experienced periods when liquidity has fallen dramatically in short periods of time. However, China has taken steps to mitigate volatility, including the formation of a “national team” to help stabilize the market by purchasing A-shares in times of market stress. 2. Concentration: There is concern regarding the composition of benchmarks when China A-shares are included in indices at their full weight. Global emerging market benchmarks are relatively diversified at present, but they will become increasingly dominated by China following the full inclusion of the China A-share market. However, to address this issue, many innovative organizations are recruiting analysts and portfolio managers experienced in the region—or are nurturing in-house/hybrid solutions to explore standalone investments and other strategies. 3. Global Uncertainty: Trade tensions between the US and China, and other geopolitical concerns have made some investors skittish about opportunities in China’s domestic marketplace. As markets seek stability over chaos, an unknown future and emerging investment realities and mechanisms will have some organizations choosing to stay on the sidelines. This, however, means more potential opportunities for investors with the portfolios and risk tolerance to explore new opportunities. To learn more about how the inclusion of China’s A-shares in MSCI Indices will impact the global marketplace and create new investment opportunities for your organization, visit Mercer Wealth and Investments (or Mercer Wealth and Investments – China).
Asia-Pacific (APAC) economies experience fluctuations in the global economy in unique ways, because each is defined by particular geographic, societal and financial circumstances. However, the accelerated pace of digital transformation and tightening geopolitical tensions have connected the fates of all APAC growth economies to the ubiquitous effects of globalization. Though APAC economies are projected to experience solid growth of 5.6 percent over the next two years, this optimistic forecast for the region remains prone to serious vulnerabilities.1 The areas of exposure can be organized into four categories: economic, geopolitical, technical and environmental. Let's take a look at each and how they may create challenges for nations poised for growth in the near future. 1. Economic: Debt & Housing In 2016, APAC surpassed North America as the largest contributor to global debt. In fact, APAC accounted for 35 percent of the world's debt, marking a steady and significant rise since the financial crisis of 2008. This debt makes regional economies susceptible to increased interest rates and a potential default crisis. Each economy has specific areas of exposure. In China, for example, nonfinancial corporations and household debt are rising, while in Japan, the primary concern is public debt that exposes its sovereign bond market to risks. India is also facing the impact of US$210 billion in spending on nonperforming assets in state banks. Figure 1: Nonfinancial sector debt as a percentage of GDP across APAC. Housing prices across APAC have been growing faster than income since 2010, especially in places like Hong Kong, Australia, New Zealand and India — where families in Mumbai find affordable housing nearly nonexistent. Though the costly housing situation has the region feeling anxious about a looming asset bubble on the verge of popping, each country has unique credit lending mechanisms and household debt numbers that determine their risk levels. These economies must heed lessons learned from the 2008 U.S. housing market crisis, where private households unable to pay their debts contributed to a global economic crisis that continues to haunt the international banking industry. In fact, Australia currently has one of the world's highest levels of household debt. Considering that Australian bank portfolios are majority grown from mortgage lending — now at levels far surpassing the U.S. housing market just before the 2008 crash — many U.S. and global investors are more inclined to hedge the Australian market. Figure 2: Compound annual growth rate for real residential property price and GDP per capita for selected countries across APAC, 2010–2017 Housing price data from Bank of International Settlement, GDP per capita data from Economist Intelligence Unit. 2. Geopolitical: Protectionism & Inequality In an interconnected global economy, every region is affected by international trade dynamics and tariffs. The escalating trade war between China and the U.S. threatens supply chains across APAC, and a trend toward protectionism could infiltrate the area's closely intertwined network of economies as some countries struggle more than others. Fast-paced geopolitical developments create uncertainty. That anxiety often compels businesses and policymakers to contract and insulate their economy's exposure to negative consequences. In fact, as China and the U.S. redefine their priorities, nations in APAC are forced to decide where and how they fit into this continuously evolving situation. From Australia to India, APAC economies must navigate the complexities of cooperating and competing with other nations without alienating business partners or sacrificing growth opportunities. Figure 3: Wealth GINI coefficient in selected countries in APAC, 2012–2017 Data from the Global Wealth Data book (Credit Suisse). While APAC seeks stability in chaotic geopolitics, many are experiencing seismic demographic shifts internally as a result of global trade and commerce. Access to trade-friendly seaports, modern technology hubs and high-skilled job opportunities has led to the rise of metropolises and megacities. The continued migration of younger generations to urban areas that offer innovative cultures, ideas and infrastructure is marginalizing peripheral and rural communities. This widening disparity between the haves and the have-nots could lead to income and wealth inequality, widespread resentment and civic unrest. Policymakers are attempting to manage the prevailing attitudes and regulations that shape human capital management in APAC. Josephine Teo, Singapore's Minister of Manpower, recently addressed the need for Singaporeans to travel and work in surrounding countries — asking her fellow Singaporeans to keep an open mind about opportunities in other growth economies in APAC, particularly as Singapore strengthens business ties with China.2 3. Technological: Miracles & Menace Technology will shape the future of the global economy. Emerging devices and technologies are developing faster than governments can regulate them, and this gap in oversight will create unprecedented opportunities for economic growth, innovation and crime. Technology has helped APAC increase workforce productivity, advance social reforms and champion environmental sustainability. The impact of digital transformation for ASEAN nations is tremendous, especially in e-commerce, where ASEAN nations accounted for 40 percent of global sales in Q1 2017; in Southeast Asia alone, the number of people with access to the internet and all of its possibilities is expected to triple from 200 million to 600 million by 2025.3 While new technologies will result in the loss of some jobs, these same technologies are set to create many new jobs. In fact, many companies building AI systems have found that human employees play an active role in designing and running AI.4 History reveals that innovation leads to job creation. Take the advent of the computer as an example. While the demand for typist-related roles may have decreased, the demand for computer-based work created new jobs related to developing, operating and programming. These gains, however, come with modern challenges, too. Sophisticated cybercriminals from around the planet will continue to seek and exploit weaknesses in governments, institutions and enterprises of every size. As data and information become as valuable as natural resources, state-on-state cyber-attacks will increase in frequency and complexity. The confluence of alliances between governments and multinational corporations will have life-changing ramifications for populations and their rights to privacy. As different countries adopt different policies regarding human rights and access to personal information, a new generation of cyber-laws will emerge to set protective boundaries and mitigate human fallibility as people become more intertwined with their technologies. Figure 4: Weighing the benefits of technology against its various risks. 4. Environmental: Natural Disasters & Man-made Solutions Environmental factors will determine the future economic prospects and overall quality of life for APAC. Geographically, APAC is the most disaster-prone area in the world. Environmental events, such as floods and tropical cyclones, inflict tremendous damage on coastal areas — where most people, infrastructure and institutions are located. The unpredictability of natural disasters often results in the sudden — and sometimes massive — loss of human life, displacement of populations and widespread social and economic disruption. In the aftermath of such trauma, individuals and communities must navigate their way through emotional grief and destabilized healthcare operations until governments and other agencies can provide relief. APAC must be proactive about implementing integrated policies and systems that can mitigate the devastation natural disasters pose to their people and economies. This is already happening: More mature markets, like Hong Kong, have exponentially increased the ability to align resources and swiftly respond to events, such as hurricanes. As technologies and business interests continue to connect APAC more closely, governments will have to decide what, exactly, their responsibilities are to other nations and the region. Figure 5: Projected vulnerability changes for Asia and the Pacific. Data from UNESCAP On a global scale, APAC plays an integral role in curbing harmful emissions and pollutants. Antiquated infrastructure and lax regulations must be replaced with modern technologies and policies. Change, however, can be slow and expensive. Many APAC economies are still dependent on legacy energy resources, such as coal and other fossil fuels. Yet, strong progress has been made on regional and local levels. China, for instance, has made remarkable progress in implementing green fuel technologies to replace coal and oil and reduce airborne pollutants.5 China's new initiatives to supplant fossil fuels with clean energy resources, such as wind and solar, has led to vastly improved air quality in cities, like Beijing — without negatively impacting the country's economy. In fact, China considers sustainable resources to be the future of energy and is aggressively investing in green businesses, such as high-tech solar panels (two-thirds of the world's solar panels are manufactured in China) and electric vehicles—surpassing even Tesla with a projected 7 million annual sales by 2025.6 APAC, as a region, has also agreed to frameworks and new technologies that promote renewable energy sources to combat air pollution and water scarcity issues that pose a direct and immediate threat. Balancing economic development with progress on climate and sustainability initiatives will be challenging but necessary. Climate change, as with other challenges in the region, will require a new era of cooperation among APAC nations, governments and workforces. With the withdrawal of the U.S. from the Trans-Pacific Partnership (TPP) in January 2017, APAC was compelled to consider a more regional approach to solving global issues. APAC leaders, however, persevered and, in 2018, signed a revised version of the TPP with commitments from Australia, Brunei, Canada, Chile, Japan, New Zealand, Malaysia, Mexico, Peru, Singapore and Vietnam. The new agreement, named the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP), represents about 14 percent of the global GDP (down from the 40 percent the original TPP represented) and not only details new trade dynamics and oversight regulations among the participating nations but also compliance with mutually agreed-on environmental protection laws. Some of the clauses around intellectual property, arbitration and investment dispute resolution have been left out in the new treaty to allow for continuing reliance on ongoing multilateral collaboration on specific issues and local interventions by individual governments needed in public interest. The new treaty does not regulate movement of workers in the region, and member countries have ensured the interests of their agrarian and services economies are protected. An increasingly internally focused U.S. may compel APAC to strengthen their ties to each other, opening up more avenues for business opportunities, talent exchange and shared participation in worldwide digital transformation. With most members set to ratify the new treaty, this represents a glowing bastion of free trade amid an increasing protectionist rhetoric elsewhere in the world. There are many reasons to be optimistic about the future of APAC. Digital transformation offers the economies of APAC unprecedented growth opportunities and the ability to connect workforces to a global surge in technological advances, entrepreneurship and innovation. The pressing need to address environmental concerns and financial headwinds is creating a sense of urgency throughout APAC. The collaborative approach to solving problems bodes well for the future of APAC, as its committed leaders and locally based organisations coordinate their collective strengths to create prosperity throughout the region. As the global economy continues to evolve, APAC is poised to play an increasingly influential role. Read Marsh & Mclennan's 14 Shades of Risk in Asia-Pacific report to learn more. 1Evolving Risk Concerns in Asia-Pacific:, http://bit.ly/2APQVlZ. 2Lee, Pearl. "Ties with China Multifaceted and Strong: Josephine Teo." The Straits Times, 2 Mar. 2017, www.straitstimes.com/singapore/ties-with-china-multifaceted-and-strong-josephine-teo. 3"Asean the 'next Frontier' for e-Commerce Boom." Bangkok Post. https://www.bangkokpost.com/business/news/1249798/asean-the-next-frontier-for-e-commerce-boom. 4Mims, Christopher. "Without Humans, Artificial Intelligence Is Still Pretty Stupid." The Wall Street Journal,https://www.wsj.com/articles/without-humans-artificial-intelligence-is-still-pretty-stupid-1510488000?mod=article_inline. 5Song, Sha. "Here's How China Is Going Green." World Economic Forum, www.weforum.org/agenda/2018/04/china-is-going-green-here-s-how/. 6Jeff Kearns, Hannah Dormido and Alyssa McDonald. "China's War on Pollution Will Change the World." Bloomberg, www.bloomberg.com/graphics/2018-china-pollution/.
The impact of technology on today’s world has many confused and frustrated. They struggle to determine what information is real or fake, helpful or harmful. The investment industry is not immune to the digital transformation that is impacting how people view themselves, their money and their futures. CIOs need to recognize these changes and determine how to leverage the evolution of technology as it reverberates throughout the industry, and the world. Hype vs. Reality: The Truth Is In The Middle Much of the hype around Artificial Intelligence (AI) and digital transformation has centered on how technology and machines will replace employees in every industry, including the investment industry. AI is revolutionizing the process of interpreting valuations through the instant and comprehensive analysis of financial data and transactions, and stakeholder sentiments expressed across the Internet. AI offers new insights into unstructured data, financial behavior models and market volatility. However, the human element is still critical. As CIOs know, it is impossible to predict the future with 100% accuracy, but a mindful examination of data and research helps provide a sense of control of the unknown. The value of any security or asset is based partly on human perception. An investment team still needs to assess all of the information and data to make strategic, and very human, decisions on how to move forward. Advances in FinTech are benefitting CIOs and their teams in meaningful ways. For example, advanced data and analytical capabilities give them more detailed and enhanced risk dashboards, placing actionable information at their fingertips. FinTech’s insightful diagnostics also help them better understand how strategies are run and how to clearly delineate between luck and skill. But it’s still very much a qualitative game. FinTech is also significantly impacting the role of the consumer, as apps and other technology platforms offer them more control over their financial objectives and strategies. This is a positive development because when consumers pay more attention to their investment goals, everyone benefits. Currently, the speculation over advanced technologies dominating the industry has not come to fruition—and, like many emotionally-charged debates, the truth is usually somewhere in the middle. Robo-advisors Streamline Relationships Robo-systems and automation are helping firms streamline once bloated processes so client information is easier to access and contextualize. Many financial advisors have incorporated robo-advice into their services, providing clients with varying tiers of human interaction. From no-touch to high-touch, these different levels of interaction offer clients a menu of options to accommodate their desire to work with, or without, a live financial advisor. Robo-advisors and other technological advances will disrupt aspects of the industry, but also help financial advisors be more productive and valuable—for example, by leveraging technology that focuses on how advice is delivered to clients rather than how it is formulated. Yet, at the end of the day, many clients are still human beings who wish to speak with a human advisor before making a decision that will impact their and their family’s financial futures. Blockchain and Rebuilding Trust Mercer’s Healthy, Wealthy, and Work-wise report —conducted across 12 countries— examined who people trusted the most. At the high end were family, friends and employers. At the low end were financial intermediaries, banks and insurance companies. This is an issue for investment firms and the industry as a whole. After the global economic meltdown and the Great Recession, people simply stopped trusting the financial community. Many who have been burned by the industry (or know someone who has), tend to leave their money in minimal interest-bearing bank accounts, stuffed under their mattresses or buried in places far from the possible benefits of high-quality investing advice. Cue blockchain. Blockchain technology is a game changer for the investment community and its low trust metrics. Blockchain provides investors and clients with an immutable and secure digital record of financial transactions. Investors are attracted to the prioritization of transparency after an era of intentionally confusing finance structures—such as tranches and the bundling of subprime mortgages—left the world in a tailspin. For an industry that has struggled to build trust with clients and the public, blockchain offers a new age of accountability and means of building profitable relationships. As in other industries, clients and consumers are going online and taking control of the narrative. Businesses are being publicly held accountable for every decision and interaction. This increasing level of transparency will continue to be a compelling motivator for investment professionals and firms to provide the best services and results possible. This greater level of transparency, in truth, may be how the financial industry rebuilds lost trust with the public. Individuals Taking Control Mercer—alongside other money managers and investment advisors—believes that governments, plan sponsors, financial intermediaries, and the industry in general, have a responsibility to help individuals recognize “What good looks like” regarding financial advice and investment products. So, as a service to the investment industry and to promote trust, in multiple markets including Singapore and Hong Kong, Mercer launched Mercer FundWatch.com to accomplish two goals: (1) Provide a rating system for funds that are available to individual investors. This enables investors and their financial advisors to compare funds according to their ratings. These ratings are based on deep-dive, qualitative investment due diligence. (2) Give financial intermediaries that use the site—as an input to their recommendation process for clients—the opportunity to be featured on Mercer FundWatch.com. If an individual investor or financial advisor is looking for a high-quality entity to transact with, they can easily find and access a list of intermediaries using this credible due diligence in their process. Digital transformation is here and accelerating at an exponential rate throughout the world. The possibilities are limitless. Investment firms should embrace the emergence of AI and smart technologies to explore new terrain and chart competitive landscapes. The evolution of technology is forever changing the industry, client expectations and how human beings relate to their money, themselves and their investments.
The globalization of the world’s economy is taking a giant step forward. MSCI is opening the door to the world’s second-largest stock market – China. This development will create unprecedented opportunities and challenges as China and the international investment community nurture this new, remarkable relationship. The domestic Chinese stock exchange (Shanghai and Shenzhen) offers global institutional investors and hedge funds previously unexplored pathways to build value and generate earnings. The Path Towards Global Credibility China’s increasing prominence in the global market underscores the evolution of longstanding policies and cautious perceptions regarding the role of outside investors. The Mercer report The Inclusion of China A-Shares In MSCI Indices: Implications for Asset Managers and Investors, chronicles the journey that China and the international investing community have made together to reach this historic agreement, and what to expect from a new era of growth and collaboration. Before the MSCI breakthrough, the primary mechanisms that granted foreign investors entrance to China’s domestic market were the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Institutional Investor (RQFII) schemes—both of which were heavily regulated by rules and regulations limiting the types and sizes of organizations allowed to apply for a quota and their ability to repatriate capital. Chinese authorities, however, have made opening the mainland equity market a key priority. Executing this innovative strategy, however, required a disciplined and calculated approach to implementing change. China began by creating mechanisms to accommodate foreign investors. In December 2016, the Shenzhen-Hong Kong Stock Connect program was launched, providing foreign investors access to companies listed on the Shenzhen Stock Exchange. This forward-thinking initiative opened up the path to global influence and participation, with both China and the international investment community working together. The Power of Patience & Compromise Inclusion in the MSCI Index started with building trust and goodwill through shared interests and compromises made by both sides. The Shanghai/Shenzhen-Hong Kong Stock Connect programs—together referred to as “Stock Connect”—provided an additional quota to foreign investors and loosened burdensome restrictions. The relaxation of daily trading limits, continued progress on trading suspensions and further easing of regulations—in addition to the creation of new index-linked investment vehicles—led to acceptance by MSCI. China has illustrated its willingness to work collaboratively with the MSCI and the global investing community. In return, the MSCI made several concessions to facilitate the inclusion of the China A-share market. Rather than slowing the process, MSCI offered a more aggressive and streamlined approach to inclusion. The MSCI’s lean but efficient strategy limits stock and country ratings and only allows international investors predetermined exposure in a particular market. These developments are just the first steps to a long journey. The agreement also serves as a powerful symbol for a promising future of growth and mutual prosperity. The weight of China A-shares in the broad market indices will have to increase over time. In perhaps 5-10 years, Chinese A-shares can evolve from partial to full inclusion, much like the Taiwanese and South Korean markets did beginning in the 1990s. The Way Forward for Investors The MSCI acknowledges the volatility endemic to entering such a massive and complex economy. Managing expectations is critical to advancing the initiative. The first phase weighted only 226 stocks at 2.5 percent of their market cap, and the next phase increased the number of stocks by 10 and adds 2.5 percent—at a total of 5 percent of market capitalization.1 The MSCI is clearly taking a restrained approach to promoting growth and inclusion. Though the China A-share market has a number of appealing features, for investors with relatively small or straightforward equity portfolios, it would be quite reasonable to adopt a wait-and-see approach to the emergence of China. Other investors may choose to be more proactive. Investors with a material portion of their wealth invested in emerging market equities, and who seek to evolve their portfolio over time, should consider how they can incorporate the expanding Chinese opportunity within their broader equity allocation. A standalone allocation allows a higher weighting (than allocations dictated by the benchmark) with broader and deeper exposure to the market-enhancing both the return and diversification potential. However, investors must simultaneously address important risks and governance questions, especially considering the unprecedented nature of this developing scenario. To learn more about how the inclusion of China’s A-shares in MSCI Indices will impact the global marketplace and create new investment opportunities for your organization, visit Mercer Wealth and Investments (or Mercer Wealth and Investments – China). 1Pisani, Bob. “Here's Why You Will Own More China Stocks in the near Future.” CNBC, CNBC, 31 Aug. 2018, www.cnbc.com/2018/08/31/msci-adds-more-mainland-china-stocks-a-shares-to-its-indexes.html.
It is human nature to celebrate success. People love trophy ceremonies and hugs, confetti and high fives. Everyone loves a winner. The specter of “winning” associated with highly achieving firms in the investment industry, however, can be dangerous. Sometimes the intoxication of an extended period of laudable returns can lead to cultural apathy, lack of humility and reduced desire to innovate. This collective mindset can ultimately result in future woes. Underperforming firms, in contrast, constantly seek new ways to create value, leverage innovation and force their way into the winner’s circle. CIOs responsible for investing on behalf of asset owners should recognize that underperforming firms could offer tremendous opportunities—especially when currently successful firms have become too comfortable with, well, winning. Below are five reasons why CIO’s should not overlook underperforming firms when seeking new avenues to invest an asset owner’s assets: 1. The Continued Success Fallacy The investment industry is predisposed to viewing past success as an indicator of future success. Reasoning tells us that firms that have generated winning returns in the past have the talent, mindset and resources needed to generate high returns in the future. This bias, however, can be misleading. Continued success is never guaranteed in the investment industry, and could even be considered a liability. People are innately fallible, and investment firms are run by people—who are prone to the familiar trappings of success: apathy, entitlement, hubris and being lulled into complacency by the inertia of the past. The world is full of parables about the many perils of success, and human nature is always at the center of those failures. The Chinese proverb “The spectators see more of the game than the players,” highlights the dangers of tunnel vision and why it is wise to consult outside opinions. Relying solely on proven resources can lead to an echo-chamber of the same strategies, attitudes and insights over time. The investment industry’s tendency to view past success as an indicator of future success is an understandable, but precarious, bias. Replicating effective strategies is a formula for obsolescence in an industry that is constantly evolving. In contrast, underperformers keenly aware of their shortcomings are always thinking about new opportunities on the horizon. Experienced CIOs who have witnessed the inherent dangers of presumed continued success are more inclined to value a focus on inventiveness and creating the future. Just look back at how much the investment industry has changed over the past ten or twenty years. Change never stops. 2. The Complacency Trap CIOs must exercise due diligence on behalf of their stakeholders when evaluating the perceived benefits of working with currently successful investment firms. Complacency is a very strong and common psychological pitfall. After all, if the clients are happy and value is being created, why change? But complacency is deceptively quiet; it creeps in unnoticed over time, almost imperceptibly, and becomes part of a firm’s culture and operational routines. Complacency, as the byproduct of success, can masquerade as success itself and take root as soon as a firm begins patting itself on the back—and showcasing its latest industry awards beneath the bright lights of their lobby display box (you’ve seen them!). The antidote to complacency is vigilance, humility and action. Investment firms must seek out groundbreaking or contrary ideas and learn to leverage evolving technologies and new regulations. Successful firms may ignore the inevitability and sweeping power of change because they are blinded by the glow of their current fortunes. What worked yesterday will certainly work today and probably tomorrow, they think. All investment firms—regardless of their prevailing circumstances—need to focus on what comes next. Firms that experiment with strategies and mechanisms that might give them a competitive advantage are more likely to stay ahead of change instead of chasing it. Investment firms with something to prove to themselves and the market, embrace change as opportunity. 3. The Client Conundrum Contented clients resist change for obvious reasons. Who in their right mind would change a strategy that is currently providing healthy returns? The onus to implement new strategies and a bold vision, therefore, falls on the investment firm. Educating clients today about future opportunities is key to winning tomorrow. An investment committee needs to be sure of its convictions if it wants to deviate from a historically lucrative path. Changing course and going out on a limb will be more difficult if the historic performance of the incumbent has been strong. The client conundrum constrains investment firms with the disadvantage of being trapped in a relationship that is inherently opposed to change. Underperformers, particularly less-established firms that are still making a name for themselves, tend to not have long-term clients, and therefore do not face the same obstacles. Not having to fight the gravitational pull of long-term success frees them to explore new or less traditional approaches to creating value. For investment firms that can only move as fast as their slowest parts, sometimes happy clients create headwinds that, in the long run, work against their interests. 4. Timing Is Everything The investment industry is filled with firms that are at some point in their ascendancy or decline. CIOs, to effectively serve the asset owners that employ them, should strive to be as informed and insightful as possible with regard to timing. They must have the ability to read the tea leaves, so to speak, to identify where the most innovative ideas are coming from and know how to capitalize on those ideas before anyone else. Outperformers could be deceptively close to decline because they have realized their potential, and in an effort to maintain that success, have focused their energy inwards instead of outwards—which is where change and opportunities are born. When determining the best investment strategies for their clients, CIOs should conduct qualitative, forward-looking assessments. The competitive edge could be found in underperformers who offer strategies that provide fresh perspectives. If a CIO waits too long to replace declining outperformers with ascendant underperformers, it could be too late to capitalize on the opportunities ahead. In this competitive industry, news regarding the “newest best thing” travels fast. Timing is key. CIOs who lack conviction can miss game-changing opportunities presented by lesser-known firms. In the famous words of financier James Goldsmith, “If you can see the bandwagon, it’s too late.” 5. Evolving Technology and AI The investment industry is entering a new era of technological experimentation. There will be winners and losers; disruption from modern technologies like AI will be the norm. FinTech is revolutionizing the industry, and it is especially poised to catapult lean, tech-savvy underperformers into new spheres or relevance. CIOs will be increasingly tested on their understanding of how technologies, like blockchain, impact the future of the industry. AI and automation are progressively doing the work of actual people, which means outperforming firms with resource intensive products or services and aging operations are particularly vulnerable to change. This charged atmosphere makes new, and maybe untested, investment firms more prone to seek out alternative sources of information and apply technology in new ways to derive value. Underperforming firms can also use new technologies to leapfrog into prominence, as the digital age has democratized access to information and resources. The history of investing teaches us that the future of the industry will come from unexpected places. Measures of past success such as assets under management and length of time running a particular strategy often counter-predict future success. To outperform through active management, CIOs need to consider underperformers who offer new, innovative strategies and mindsets. The digital transformation of the investment industry is underway and advancing rapidly. Finally, it is human nature to seek the familiar and comfortable. The brand names and reputations of some outperforming firms may offer a reassuring and intangible sense of security. To compete, underperforming firms must offer forward-thinking strategies that differentiate their services from long-established rivals. That fight for survival is what drives innovation and change. And that survival instinct is what many of today’s successful firms can lose as a result of their good fortunes.
As the investment industry continues to evolve alongside government regulations, client objectives and industry innovations, asset owners face an increasing variety of investment architectures. To describe these options in an accessible and engaging way, let’s employ a metaphor that everyone can appreciate: food—in particular, homemade meals versus pre-packaged meals. The Homemade Meal Investment Architecture The best homemade meals are crafted from the best/most-liked ingredients. From organic eggs, fresh from a nearby farm, to hand-caught salmon flown in from the coast of Norway, picky eaters today can choose from an incredible assortment of foods sourced from a vast array of vendors—from local farmers markets and independent tea growers to European cheesemongers and international supermarkets. In the investment industry, this open access to a wide spectrum of providers and investment options is called an open architecture. This architecture allows asset holders to explore customizable strategies and select specific services and options from a diverse host of providers. Your grandmother knows where to source the best/most-liked ingredients for the holiday meal—eggs from the shop across the river, green onions from the neighbor’s vegetable garden, chicken from the butcher with the toothy smile. Open architecture, likewise, allows asset holders to source the best/most appropriated investment tools and talent, from managers and custodians and trustees to administrators and fund admin providers. In an open architecture, no single provider has a monopoly on quality, talent or innovation. The entire industry is open for business, so asset holders can leverage the full scope of available options when seeking solutions for their investment needs. The Pre-Packaged Meal Architecture Prepackaged meals are part of every culture. In Japan, there is the bento. In India, the dabbawalla. In Brazil, well, the banana (very healthy!). Prepackaged meals are popular because they require limited amounts of time, investment and sweat equity. In the investment industry, the pre-packaged meal is known as a bundled architecture, where the asset holder purchases a combination of services all bound together in a single bundle. The asset holder simply chooses a particular bundle upon determining that the services in that bundle best suit their investment strategy and growth needs. Simply make the purchase and open up your bento box, dabbawalla container or banana. No haggling with the butcher. No dishes to clean. No grandmother repeating the same story for the nth time. Bundled architectures do provide the convenience of pre-packaged services that do not require additional thought or customization; whereas open architectures allow asset holders to alter the pre-packaged services by shopping around and browsing the latest industry innovations being developed and offered by the full diversity of providers. Ultimately, asset holders must consider their own circumstances, their resources, profiles and objectives to determine which architecture best serves their goals… and appetites. Perhaps a mixture of both fits best! Want to learn more about which investment architecture, or combination of the two, can create the most value and returns for your investment strategy? Contact a Mercer investment (and foodie) specialist here.
It is human nature to disagree. From how to make the perfect soup dumpling to which system of government works best, people have always perceived the world (and dumplings) in different ways. Our propensity to disagree makes China’s Greater Bay Area (GBA) Initiative a marvel of human collaboration. The GBA Initiative is an ambitious plan to connect 11 municipalities spanning the Guangdong province, Hong Kong and Macau—and align their financial, cultural, geographic and governmental interests. A daunting, yet immensely exciting challenge, indeed. Background: From Grand Idea to Modern Reality In a 2017 government report released by Premier Li Keqiang, China officially announced its intentions to move forward with plans to develop the GBA—which, before that point, had only been theoretical. The idea was first introduced in the 2011 study, “The Action Plan for the Bay Area of the Pearl River Estuary.” This directive from Beijing thrust the plan into the international spotlight, outlining the “city cluster” strategy that leverages the distinct financial, cultural and economic assets of the 11 participating municipalities.1 However, though the region may be geographically close, the participating societies are remarkably different. For example, differences in regulatory instruments and policies, business practices and tax structures, and cultural perspectives and priorities present challenges to creating a seamless and streamlined alignment of resources and capabilities. The key to success for the GBA is the free flow of everything from talent and information to capital and resources. Significant progress has already been made. China has built the 55-kilometer Hong Kong-Zhuhai-Macau Bridge and expanded the high-speed rail network into Hong Kong. This infrastructure represents only part of a sweeping initiative to facilitate the free flow and exchange of ideas, capital and resources. (Source: Research Gate_W Martin de Jong) Aligning Cultural and Economic Differences Convincing each of the 11 municipalities in the GBA to pursue regional business objectives while prioritizing the well-being of the collective group will require some savvy and diplomatic governance. There will be hurdles to aligning the legal, economic, technical, workforce and geographic complexities of the initiative.2 Companies in the GBA region must be open to innovative thinking. Leaders and policymakers must explore a variety of strategies and business models, from joint ventures and strategic partnerships to mergers and acquisitions. Each region must embrace these issues with a focus on long-term success. The scope of cooperation and transparency required by the GBA is enormous. The comprehensive framework ensures there will be agreeable mechanisms in place to solve disputes on everything from workforce immigration legalities and environmental policies to project development benchmarks and operational standards. However, today, this complex relationship is largely theoretical as many companies from all over the GBA region continue to navigate cultural, regulatory and operational differences. It will take time to integrate the key processes that directly impact cross-border talent. For example, sometimes Mainland staff who work in Hong Kong are stuck in Shenzhen or Guangzhou for days or even weeks as they await visa extensions. Examples like these demonstrate the role human capital plays in the success of the GBA Initiative. Ultimately, figuring out how to manage human capital across borders and cultures will be critical. To address these realities, many multinational companies are increasingly hiring Mainland graduates who studied in Hong Kong universities. These graduates are familiar with cultures in both markets, making them suitable to work on GBA-related assignments. Additionally, many companies are actively working to manage the disruption caused by entrenched but disparate policies: differences in salaries, tax regimes, medical benefits and the quality of education available to employees and their families. A fair distribution of pay and opportunity is essential to ensuring the free movement of talent in the GBA region. Leveraging the Power of Compromise Perhaps the most impressive policy achievement that contributed to the development of the GBA was resolving the territorial disputes between Hong Kong and Shenzhen over the Lok Mau Chau Loop.3 This swath of territory, both geographically and symbolically, separated the people and ideals of western-influenced Hong Kong from the Beijing-centric interests and culture of Shenzhen. The most poignant aspect of this agreement is the display of a true willingness by both parties to compromise in order to advance their interests. The Chinese mainland, after all, offers Hong Kong access to one of the world’s most lucrative marketplaces. For Shenzhen, Hong Kong is the gateway to the global economy. This agreement serves as a proof of concept for the entire initiative – finding creative ways to work together to navigate cultural differences and seemingly divergent business priorities. Together, Mainland China, Hong Kong and Macau can create a revolutionary geographic center for technological innovation, financial influence and international trade. The stakes are high, and the whole world is watching. The GBA, after having surpassed the San Francisco Bay region, ranks second in terms of global GDP for bay-area regions, behind only Tokyo Bay. In fact, with a current GDP of US $13 trillion and a population of 70 million, the GBA region represents 12 percent of China’s entire economy.4 With vastly different political, financial and institutional systems in place, people infrastructure will be key to sustainable and equitable growth for the collective region. Effective cross-pollination requires cutting-edge insights from human capital management experts, thoughtful business leaders and government policymakers. For those of us with expertise in the region, this initiative offers groundbreaking opportunities to build partnerships and negotiate unparalleled collaborations in southern China. It’s all about compromise, except when it comes to soup dumplings; real soup dumplings have 18 pleats. Just ask your mom. For more information on human capital management in China visit: Mercer (Mercer China). 1News Analysis: New Opportunities For Hong Kong in Emerging ... www.xinhuanet.com/english/2017-03/11/c_136121179.htm 2China's Greater Bay Area Puts Hong Kong in the Lead As Super Connector To the World https://www.dorsey.com/newsresources/publications/client-alerts/2018/02/chinas-greater-bay-area-puts-hong-kong-in-the-lead 3Hong Kong’s Startup Scene: the Future Of Mainland–hong ... www.china-briefing.com/news/2017/08/08/hong-kongs-startup-scene... 4 China Is Building 19 'supercity Clusters' Andrew Sheng-Xiao Geng- Fung Global Institute- University of Hong Kong - https://www.weforum.org/agenda/2018/09/how-cities-are-saving-china
In the coming years, government bonds may not be the right defensive asset for protecting investment portfolios. Investors should consider and understand the characteristics of a variety of defensive assets in order to meet their objectives. Alongside geopolitical uncertainty and record-low bond yields, today’s investors are experiencing risk related to tax cuts, increased infrastructure spending, rebounding energy prices, a tight labor market, and the shift from deflation to reflation. Investors may consider a variety of defensive assets to address the components of equity risk, bond risk and inflation risk. Unfortunately there is no “one-size-fits-all” option. Rather, the right approach is likely a combination of the following strategies that address the mix of risk factors underlying a portfolio today. Convertible bonds: This is a relatively small asset class that is often overlooked. Their hybrid structure means they can provide upside capital appreciation similar to that of equities, while maintaining the downside protection of fixed income assets. That said, much of the market is unrated, so investors should research credit quality and default risk before buying. Low-volatility equities: Diversifying some equity risk to low-volatility equities can provide some downside protection. This category includes not only minimum-variance strategies, but also quality strategies and variable-beta strategies where managers have the flexibility to move from equities to fixed income, cash or even gold. Tail-risk strategies: While the above are useful, neither will protect in an extreme scenario. Tail-risk hedging strategies are specifically designed to enhance returns during a tail-risk event. As such, they provide no participation on the upside. Under normal market conditions these strategies can be a drag to a portfolio’s return, but they do free up liquidity to buy assets at distressed prices immediately after a tail risk event. Structured equities: This encompasses tailored and complex1 solutions to help reshape the risk-and-return profile of equity allocations. Though they come with governance considerations, structured equities provide great flexibility in terms of the range of profit and the risk minimization outcomes that can be put into place. Looking at the credit crisis, structured equities did a very good job of limiting the impact of the worst months, but capped returns in the best months. The tail-risk approach is perhaps the most compelling in light of its negative correlation to the S&P 500. However, in reality, none of the above individually will provide the perfect outcome. Combining them is the best way to achieve the desired risk balance under different market conditions. Looking back at 1990, when equity markets produced a positive return, we see that a defensive hedge fund index also returned a positive return 70 percent of the time, albeit not capturing all of the upside. When equity markets fell, the defensive index was up 54 percent of the time. That represents a significant reduction in volatility— without sacrificing return. Defensive Fixed Income Absolute-return fixed income can also be a useful diversifier within a fixed-income portfolio. These strategies look to achieve positive returns in all market conditions, including when credit spreads widen and interest rates rise. They are less dependent on the fixed income markets and more dependent on manager skill. Interestingly, good funds will be highly correlated during periods when the market or risk assets are doing well, but lowly correlated when growth assets are doing poorly. This type of strategy looks for around two to four percent gross return, but with a volatility of around three to six percent. They are generally liquid and can be easily incorporated into a portfolio. Thus investors who are concerned about the impact of rising yields should consider this type of strategy. Growth Fixed Income With monetary policy driving yields to record lows and liquidity being withdrawn from the markets, banks are less able to provide credit facility in certain areas. This translates to a good opportunity for longer-term investors to step in and be providers of capital. How much is this worth from an investor’s perspective? For a triple-A secured credit, you can pick up around 75 basis points over the requisite liquid credit. Within the lower levels of investment-grade credit, you can pick up 300 basis points. In addition, many of these investments are based on floating rates, so they can be considered less sensitive to interest-rate risk. Private Markets An allocation to private markets helps diversify the equity risk premium that exists in many client portfolios. In an environment of heightened inflation, real assets— energy-oriented commodity funds, opportunistic real estate or infrastructure—can provide a high degree of protection. In addition, similar to secured credit, much senior private debt is floating-rate, as opposed to fixed rate. Client Examples The following examples of an endowment client and an individual-savings client illustrates how we bring the above concepts to bear. An endowment’s predominant objective is to meet its mission, which is often strongly dependent on its ability to meet annual spending requirements—any permanent loss of capital will affect the mission. Headline risk is also a critical consideration. This $200 million endowment was looking for a return of CPI plus four percent. With an unconstrained mandate, the client was able to allocate funds to asset classes with higher long-term expected returns, most notably private equity. Their allocation to real estate and infrastructure is also sizable, at 25 percent. Their hedge-fund allocation provides a bit of additional diversification, but the overall portfolio remains relatively liquid. Turning to an individual’s savings as another example, it’s important to think about the individual’s age. A younger investor wishes to maximize returns, while those approaching retirement are concerned with transitioning from a return-seeking portfolio to a combination return-seeking/income-oriented portfolio. The accumulation portfolio aims for cash plus 3.5 to four percent, so we see confidence in long-term investments in equities, embracing some of our ideas around global equity constructions of small cap and emerging markets. Property and infrastructure are also brought in, in the form of listed global property and listed infrastructure. The whole portfolio remains very liquid, with low fees. The retirement portfolio, by contrast, focuses more on capital preservation and aims for cash plus two percent. We again see the principles discussed above in action, such as low volatility in terms of risk management and some allocation to diversifying equity risk in the form of absolute-return fixed income. Takeaways Historical relationships between asset classes may not prevail going forward. We would like to challenge investors to question the status quo and stress-test their portfolios against multiple economic scenarios. In addition, investors should proactively review their investment guidelines and consider adding more flexibility in order to capture market opportunities or protect against risks. In times of crisis, preventive measures generally fare better than reactive solutions, transitioning from a return-seeking portfolio to a combination return-seeking/income-oriented portfolio.
It’s a fact of life that nothing works well all the time. That’s where multi-asset strategies have a valuable role to play in investors’ portfolios. Yet deciding when, for whom and how multi-asset strategies should be implemented is a complex calculus. Here we detail the four main types of multi-asset strategies and their benefits compared to traditional static allocation approaches, as well crucial considerations for those implementing multi-asset strategies. The strength of multi-asset strategies lies in adopting varying approaches to asset allocation, with contrasting views and contrasting bets on the future. To implement multi-asset strategies, however, investors should understand not only the reasons they can be beneficial, especially in the current market environment, but also the different styles of multi-asset strategies that exist and how to successfully implement them. The Case for Multi-Asset Strategies Asset allocation is typically the most significant driver of a portfolio’s return, but is typically determined by a single individual or committee and a single framework. By contrast, large teams are deployed to focus on manager selection and security selection—despite the fact that this generates less value, net of fees. This disparity in resources and concentration of decision making power arguably represents a vulnerability to most investors’ portfolios. Many multi-asset strategies, on the other hand, seamlessly blend a wide variety of approaches and parameters into a single strategy. Types of Multi-Asset Strategies A highly diverse population of multi-asset strategies has emerged, but the strategies can be grouped into four basic categories. 1. Core: These strategies are predominantly driven by traditional beta, with relatively limited tactical asset allocation. 2. Idiosyncratic: More focused on absolute returns, idiosyncratic strategies provide access to a broader range of return drivers and are more dynamic in their asset allocation, resulting in greater downside mitigation than core strategies. 3. Risk parity: These encompass a broad range of approaches to building a risk-balanced portfolio, often by leveraging lower-volatility assets. 4. Diversified inflation: These attempt to build an inflation sensitive portfolio, typically with an absolute return target. Example holdings include treasury inflation protected securities (TIPs), natural-resource equities and commodities. Many investors have been disappointed with the performance of multi-asset strategies in recent years. This perceived underperformance is in part due because investors compare these strategies to a traditional 60% equity: 40% fixed income portfolio. With rising equity prices and falling bond yields, the 60:40 portfolio has proven difficult to beat since the global financial crisis. Multi-asset strategies have also lagged due to more diversified sources of return. So why bother with multi-asset strategies? Here are four reasons: 1. Mean reversion: It’s unlikely that the 60:40 portfolio will continue to be upheld as a standard of measurement. Bonds and equities can no longer be considered cheap, which makes it challenging to repeat recent successes. 2. Rising correlation between bond and equity returns: This reduces the diversification within a traditional 60:40 portfolio and indicates that portfolios with a broader range of return drivers and less reliance on beta will be the norm going forward. 3. Reflation: Even modest inflation could challenge traditional portfolios given low bond yields and current equity valuations. 4. Forward-looking risks: From politics and rising protectionism to the unknown impact of central banks shrinking their balance sheets, a number of factors suggest the future may look quite different than the past. To highlight the potential benefits of holding a more diversified portfolio in the hypothetical example shown here, we compare how a 60:40 portfolio may perform relative to a portfolio that takes 10 percent away from both equities and bonds and allocates it into an idiosyncratic multi-asset strategy, chosen because of the diversification benefits and opportunity set such a strategy may present to today’s investors. In a downside scenario—one where a 200-basis-point upward shift in the yield curve is complemented by a 15% fall in equity prices—the 60:40 portfolio returns -13.9 percent, whereas the portfolio which has a small allocation to an idiosyncratic multi-asset strategy returns -9.8 percent, even assuming the multi-asset manager underperforms its investment objective. In a base case, where bonds return their current yield and equities deliver in line with Mercer’s capital market assumptions, the performance is virtually identical, and including a multi-asset strategy may improve the outcome by about 30 basis points. In an upside scenario, where equities return 15% and the yield curve moves up by only 50 basis points, we see an 8.3% return for the 60:40 portfolio, while the portfolio including the multi-asset component only underperforms by around 30 basis points. The argument for including a multi-asset strategy within a broader diversified portfolio is compelling. Doing so offers more robustness in significant downside scenarios, slight outperformance in all market conditions, and only slight underperformance in strong market conditions. Landing Multi-Asset Strategies Several issues deserve consideration when thinking about using multi-asset strategies. First, it’s important to take a forward-looking approach when thinking of combining these strategies, based on a good understanding of investment approaches used and the typical biases within those strategies. Typically we look for correlations below zero when blending managers, but in the multi-asset space, aiming for the 0.4 to 0.6 correlation band is a realistic figure that will still provide meaningful diversification benefits over time. The second factor to consider is client characteristics, which a couple of examples will help illuminate. Mercer typically recommends allocating to a diversified hedge fund exposure, but this may not always be realistic for all clients. This is where multi-asset strategies can come into play. For a client with an established strategic asset allocation dominated by traditional beta, idiosyncratic strategies bring the biggest bang for the buck in terms of diversification and downside mitigation. However, some core and risk-parity strategies also confer benefits, given their unique risk/return profile. Again, the choice comes down to taking a forward-looking approach and determining whether these strategies continue to perform given the market backdrop. By contrast, consider a client who has a static asset allocation with fixed income, mostly government-bond and investment-grade credit, plus some equities, and cannot go beyond these asset classes because of governance, resources and even lack of expertise. In this case, multi-asset strategies bring in additional diversifying exposures and introduce some dynamism into the tactical allocation, without the complexities of introducing a tactical asset allocation overlay. A third important factor is the risk of manager diversion. Investors often compare multi-asset strategies to traditional 60:40 benchmarks—an inappropriate comparison that nonetheless may lead managers to abandon their discipline and focus on outperforming the 60:40 rather than their own strategy benchmark. As a hypothetical example, consider two multi-asset managers, both with cash-plus benchmarks. Manager A retains their discipline, but Manager B, possibly under pressure from clients, manages the strategy by not straying too far from the 60:40 portfolio. If equity markets were to crash, Manager B would significantly underperform Manager A. Following that, Manager A, despite being aware of Manager B’s poor performance, may be afraid to cut their equity allocation for fear of underperforming the other managers on the equity-market rebound. Looking at calendar year returns in 2008, the median idiosyncratic strategy returned -9.6 percent, compared to -24.6 percent for the 60:40 portfolio. So in a market environment like the global financial crisis, losing discipline can cost you around 15% in returns. Finally, in order to truly make the most of multi-asset strategies, clients need to gain comfort with relatively unconstrained investment guidelines, in particular the use of leverage and derivatives. This is particularly true for strategies that have a low equity beta, as there is a need to lay off the non-idiosyncratic risks to take advantage of idiosyncratic opportunities or lowly correlated investment ideas. Having a wide variety of instruments broadens the opportunity set and gives the manager discretion to implement in the most efficient manner. By contrast, the opportunity cost of not gaining comfort with leverage and derivatives is substantial. Without exposure to those lowly correlated assets, a portfolio would be at risk in the event of an equity or bond market crash. Multi-asset strategies can play an important role in diversifying investors’ asset allocation frameworks and philosophies, while also broadening the set of return drivers and diversifiers to improve portfolio robustness.
Regulations fostering greater consumer protections, tax transparency and better conflict and risk management are being implemented across the globe. Experience in markets where changes have already taken place suggests that wealth managers must adapt their business models, often at reduced profit margins, to survive. With these changes on the horizon in Asia, the region’s wealth management industry will need to find ways to adapt. Regulatory compliance will be the Asian wealth management industry’s biggest focus for strategic spending over the next few years. The region expects to spend 42% of strategic budgets on regulatory compliance, whereas the US expects to spend 10% and Europe 13%, largely because many countries have already transitioned into new regulatory regimes1. The relative youth of Asia’s asset management industry and increasing age of its populations point to more regulations designed to protect consumers in line with what has happened in the US and the European Union (EU). Asian wealth managers can learn important lessons from how wealth managers have responded to similar changes in other countries. Fundamentally, Asian wealth management firms should prepare for increased scrutiny and decide whether to outsource compliance or bulk up their staff to avoid problems and/or penalties. Transparency in fees and investment advice is the most important aspect of potential regulation from a client’s and regulator’s perspectives. A global CFA survey in 2015 showed transparency in fees/commissions was the most important driver of client trust in investment firms2. We can expect regulations similar to the new US Department of Labor Fiduciary Rule of 2016 that requires advisors to work in their clients’ best interests and disclose revenue arrangements clearly. Such a regulation could encourage advisors to offer simpler advisory arrangements, especially where retirement assets are concerned3. Additionally, this kind of regulation will promote competition, which could result in lower wealth management fees and put pressure on revenues. Technology is helping to democratize the investment industry by giving smaller investors access to more investment options. This development is happening globally, including across Asia. These changes make client acquisition easier and cheaper; however, they also make regulators anxious, leading them to further emphasize consumer protections and ensure certain suitability standards are met. We expect to see more regulations around fiduciary responsibilities in selecting products and new disclosure requirements for product providers. For example, the Hong Kong Securities and Futures Commission has several pending consultations and research papers aimed at improving consumer protections and promoting competition. Cybersecurity and privacy presents another compliance challenge. In May 2016, the Hong Kong Monetary Authority introduced the Cybersecurity Fortification Initiative, aimed at reducing the risk of cybersecurity attacks in Hong Kong’s banking sector, which includes a Cyber Resilience Assessment Framework, a professional development program and a cyber intelligence-sharing platform4. In the same month, the Monetary Authority of Singapore launched the Singapore Cyber Risk Management Project at the Asia Cyber Risk Summit.5 Although these initial efforts are mostly aimed at banks, we foresee others in the near future aimed at the broader financial sector, including asset and wealth managers, investment banks, corporate treasury operations and large asset owners. In addition to regulations aimed at protecting cyber space, we expect additional scrutiny aimed at protecting customer data. Technology and cloud computing allow wealth managers to adopt new technologies and providers to remain competitive, improve processes, enhance service offerings or improve distribution. Because cyber risks are introduced through such arrangements, regulators will want to ensure that appropriate measures are taken to vet suppliers and monitor their privacy and security standards. It is not a matter of if cyber breaches occur, but when. Consequently, clients will want assurances that wealth managers have robust processes to identify risks, protect their assets, detect problems, respond to breaches and recover any losses. Multijurisdictional residence/assets and tax reporting are becoming the norm. The “Panama Papers” revealed only the tip of the iceberg of offshore arrangements used to mitigate tax reporting. Countries such as Germany, the UK, China and the US have recently stepped up efforts to repatriate taxes owed from offshore citizens and corporate entities. Tax transparency and compliance with domestic and international tax laws are requisite for most Asian wealth managers; however, meeting these obligations is becoming increasingly expensive and complex. Managing conflicts of interest is increasingly important. The financial services industry is prone to conflicts of interest, especially at large universal banks that raise and invest capital, as well as trade on the information. A PwC report found that the following types of conflicts are rife in financial services: nepotism, gifts, outside employment, self-dealing, insider trading, bribery/kickbacks, current or prior relationships with issuers and unjust enrichment6. Some Asian regulations regarding these conflict areas are weak, or regulations are not yet actively enforced7,8. To attract new capital and remain competitive internationally, the Asian markets and regulations will need to change. Regulators are becoming more involved. Wealth managers have important roles in advising clients and investing assets. Wealth managers and their clients regularly face risks9. Consequently, regulators are concerned with wealth managers’ abilities to work in their clients’ best interests, as well as ensuring the integrity of the capital markets. Again, we can look to global markets to see a regulatory pattern emerging, which is likely to have some impact and influence on Asian regulations. The US Securities and Exchange Commission (SEC) and US Financial Industry Regulatory Authority are training their analysts to use big data on a real-time basis to look for patterns across the industry and time periods to form the basis of investigations and insights into system abuses against which they can regulate. The SEC has also modernized private fund registration and reporting post global financial crisis. More recently, the SEC finalized reforms for money market funds. In March 2016, the SEC released four proposed rules and one request for comment related to revising existing regulations and incorporating several new pieces of regulation. These cover data reporting for investment advisors and mutual funds, exchange-traded products, liquidity risk management and derivatives. Proposals for stress testing and industry transition-planning regulations were also issued last year10. The asset management industry in Asia is deemed to be behind in regulating this behavior. It seems likely that more regulations similar to those in the US and/or the EU are in the future for many Asian countries. Industry experts estimate the additional costs of regulation over the next few years for the wealth management industry may add 50 to 100 bps to fees11, which the firms would like to pass on to their clients. However, new regulations promoting competition and fee transparency may make passing through 100% of cost increases very difficult, resulting in squeezed profit margins. Examination of the wealth management markets in the US, UK and Switzerland show that wealth managers bear significant portions of these incremental costs and need to consider their operating models and strategies for handling them12. For smaller managers, outsourcing compliance and reporting to third parties may be the solution, assuming they have done their due diligence on the suppliers and are committed to monitoring them. Larger industry players have already been growing their internal compliance functions. Their size positions them to set standards around cybersecurity and privacy protection, while their market clout affords them influence on regulators that leads to fairer, simpler rules. Whichever strategy firms choose, doing nothing is not an option: regulation and enforcement are only expected to increase, and with those, the consequences for falling out of step with compliance. 1 EYGM Limited. Could your clients’ needs be your competitive advantage? The experience factor: the new growth engine in wealth management, 2016, available at www.ey.com/ Publication/vwLUAssets/EY-could-your-client-needs-be-your-competitive-advantage/$FILE/EY-could-your-client-needs-be-your-competitive-advantage.pdf. 2 CFA Institute. From Trust to Loyalty: What Investors Want, 2015. 3 Sutherland Asbill & Brennan LLP. “DOL Fiduciary Rule,” 2016, available at www.dolfiduciaryrule.com. 4 Hong Kong Monetary Authority. “Launch of the Cybersecurity Fortification Initiative by the HKMA at Cyber Security Summit 2016,” available at www.hkma.gov.hk/eng/key-information/press-releases/2016/20160518-5.shtml. 5 Monetary Authority of Singapore. “‘A Bold Approach to Cyber Risk Management’: Opening Address by Mr Bernard Wee, Executive Director, Monetary Authority of Singapore, at the Asia Cyber Risk Summit on 16 May 2016,” available at www.mas.gov.sg/News-and-Publications/Speeches-and-Monetary-Policy-Statements/Speeches/2016/A-Bold-Approach-to- Cyber-Risk-Management.aspx. 6 PricewaterhouseCoopers. “FS viewpoint: A matter of trust: Managing individual conflicts of interest for financial institutions,” 2012, available at www.pwc.com/us/en/financial-services/publications/viewpoints/assets/pwc-financial-institution-conflicts-of-interest.pdf. 7 Macrothink Institute. “A Global Comparison of Insider Trading Regulations,” International Journal of Accounting and Financial Reporting, Volume 3, Issue 1 (2013), available at www.macrothink.org/journal/index.php/ijafr/article/viewFile/3269/2976. 8 Conventus Law. “Anti-Corruption in Asia Pacific,” 2015, available at www.conventuslaw.com/report/anti-corruption-in-asia-pacific. 9 Deloitte. “Investment Management Outlook 2017,” 2016, available at www2.deloitte.com/us/en/pages/financial-services/articles/investment-management-industry-outlook. html#. 10 U.S. Securities and Exchange Commission. “SEC Accomplishments: April 2013–October 2016,” 2016, available at www.sec.gov/about/sec-accomplishments.htm. 11 Robeco. The future of asset management, 2016, available at www.robeco.com/images/201604-the-future-of-asset-management.pdf. 12 McKinsey and Company. McKinsey Global Wealth Management Survey 2014.
In our current investment and political climate, asset owners face numerous challenges with their investment portfolios. Market volatility and political uncertainty challenge the usual ways of investing and managing risk. These factors have also increased pressure on executives to protect investments while creating real returns. Suboptimal investment arrangements can lead to eroded returns and the failure to capture timely market opportunities. By keeping these trends in mind, particularly related to governance, investment committees can put themselves in an optimal position to generate returns even in a low-yield environment. This article discusses how to navigate these uncertain times. Greater Focus on Governance and It’s Linkage to Better Outcomes Mercer believes improving the investment governance of the asset owner increases the probability of achieving a better investment outcome. We think of this as a journey rather than a single project, built around several aspects: Clearly articulating the asset owner’s beliefs and objectives Objectively reviewing the skills and strength of the decision-making committee and comparing those to governance requirements Ensuring a sensible balance between strategic and manager discussions Building a framework to ensure speed of investment execution (within defined parameters) Committing to ongoing oversight to independently reassess the operating framework Identifying improvements Ensuring sufficient time is apportioned to the management and oversight of the assets Lower Expected Future Returns Until relatively recently, simply being invested in the “market” was sufficient to earn a decent investment return (the context of the return and liabilities varies). Looking forward, the consensus for returns for most assets is significantly lower than it has been for the last 10 years; therefore, clients need a framework or governance structure and exposure to a wider range of investments to improve their future expected returns. This improvement can be achieved in a number of ways, including additional asset classes, more dynamic portfolio management and active management in less efficient segments of the market, such as global small companies. Increased Market Volatility and Uncertainty Many consider increased market volatility a negative. But this ignores the many opportunities available in such an environment. The two significant Western political events of 2016 — Brexit and Donald Trump’s presidential victory — have increased market uncertainty. We encourage our clients to recognize that the corresponding rise in market volatility may present them with opportunities (without losing sight of long-term objectives). Many of our clients have established a governance framework that allows for greater speed in decision-making and execution by delegating responsibility to Mercer. For example, late in 2015 and early in 2016, we saw a very attractive value opportunity in high-yield bonds. Within our discretionary portfolios, we increased our allocation in December 2015 and January 2016, which we have since modestly reduced. Increased Complexity of Investment Options There has been an increased focus on and acceptance of more complex investment solutions to address the challenges of the low-yield environment. Allocations to alternatives, both liquid (such as hedge funds) and less liquid (such as private equity and private debt), have materially increased. Although these allocations are appropriate for some of our clients, they have their own unique challenges, including the need for more in-depth investment as well as operational due diligence and administrative implications (such as dealing with capital calls and distributions for private market investments). Clients that implement this exposure find that their portfolios benefit from this diversification over a number of funds and vintages. Reassessment of Internal Versus External Implementation In an environment of low expected returns, cost and expense management is an increasing focus for many of our clients. A thorough review considers the cost and time expense of internal resources, such as legal and compliance; investment reporting and operational resources; investment and risk; and third-party expenses, such as investment manager fees. Commingling assets provides much greater purchasing power. Combined with an efficient implementation solution, investors can significantly reduce costs, lower volatility and improve the overall investment outcome. Periods of uncertainty and volatility also come with tremendous opportunity. A strong and clear governance framework improves the decision-making process; provides the opportunity to expand the scope and diversify the portfolio; and, most critically, provides the framework for an improved investment outcome and lower volatility.