The global financial crisis (GFC) will be remembered as a watershed period for financial markets and the investment industry.
Most in the industry have yet to apply the lessons learned and make changes to their strategic asset allocation, to capitalise on opportunities as markets recover and to mitigate risks.
At Mercer, we undertook a major review of our multi-manager portfolios and sought to understand the lessons to be learned from the GFC. Our observation was that making simple changes to the asset allocation wasn’t going to be enough – a broader rethink on how we approach strategic asset allocation would be required to provide better protection and capitalise on opportunities.
In applying the lessons learned from the GFC, Mercer has adopted a new, industry-leading approach to risk and asset classification to give investors better protection against future periods of extreme market volatility, while continuing to provide competitive returns. These are the key lessons learned and how we have responded:
Lesson one: adapting to the new order
The GFC has accelerated change to the financial world order, yet most investment portfolios are not well placed to deal with this changed world, marked by likely continued high volatility in equity returns and a gathering pace of transfer of power from developed to developing economies.
At Mercer, our response has been to create more truly diversified portfolios better designed to deal with the future. Our approach, which we have already implemented, aims to reduce exposure to equity risk, deliver better risk-adjusted returns and provide fund structures that allow greater flexibility in portfolio construction.
In terms of asset allocation, we have increased weighting to “real assets” (property, infrastructure, natural resources) to lower reliance on equities while achieving growth-linked returns, and increased allocation to emerging market equities. We have also allowed for the potential to gain “opportunistic” investments in these and other sectors and created a greater scope for dynamic asset allocation tilting to capitalise on short to medium-term market trends.
At the same time, we have restructured fixed interest exposure to better manage risk via separation of sovereign, credit and inflation-linked bonds.
Lesson two: it doesn’t always do what it says on the label
The GFC exposed severe shortfalls in the way the industry has traditionally classified risk and assets. The classifications commonly used to describe multi-asset structures are too limited and overly simplistic. The traditional “growth” and “defensive” labels don’t recognise that many investments include both growth and defensive qualities and therefore increasingly failed to fully capture the intrinsic risk of such structures.
We believed there was a need for an improved method of risk classification and as a result we have implemented a new process that delivers a “two-dimensional” classification of assets. Rather than class an asset as either “growth” or “defensive” we have introduced a more sophisticated classification process called growth defensive enhanced (GDE), which analyses and classifies the underlying investments to provide a better measure of the growth and defensive qualities of each of the asset classes in a multi-sector portfolio.
This approach enables a better understanding of risk across a portfolio and we believe this industry-leading approach will become best industry practice over time.
Lesson three: signs are pointing to a possible inflation “breakout”
High inflation is not good for investments in equities and bonds – and we believe the market has underestimated the possibility of an inflation “breakout” at some point over the next few years. The degree of stimulus being injected into the system globally and locally, increasing the use of quantitative easing by central banks and the potential for policymakers to go all out to ensure a recovery, all point to a possible inflation increase.
To protect our clients’ portfolios against such a possibility, we decided it was prudent to build in further inflation protection through holdings in inflation-linked bonds, natural resources, infrastructure and property. We believe there is little or no penalty for retaining such holdings and they provide good insurance in case of a high inflationary environment.
At Mercer, we have already applied these changes to our multi-manager solutions to enable our institutional investors to better manage their risk exposures and operate more effectively in this changed environment. No one will ever forget the events of the GFC, but we hope to look back and remember not only the pain but see that fundamental improvements were made to enhance investment outcomes.
