2009 Investment predictions discussed
Head of Mercer’s investment consulting business in Australia and New Zealand, Simon Eagleton, discusses these six trends for 2009.
Tuesday, December 23rd 2008, 8:30AM
1: A clear focus will emerge on capturing opportunistic beta in the medium term
Fear of redemptions, margin calls, and financing commitments, are all contributing to cash hoarding. Less constrained investors with longer time horizons may find a number of bargains in the market. Investors, however, should be selective about these and target the opportunities which are most attractive. In the current environment these opportunities appear across three groups: 1. Technical-driven pricing opportunities. Exceptional and in some cases anomalous market pricing resulting from forced selling and illiquid markets – most clearly evident in credit markets. 2. Sentiment-driven pricing. A dynamic asset allocation opportunity, driven by short-termism among investors has led to a number of attractively priced asset classes such as investment grade credit and developed equity markets. 3. Capital starved investments. Opportunities caused by difficulties in obtaining financing and/or lack of investor support most apparent in private equity markets. 2: Active managers will continue to be important in adding value to investors’ portfolios
Since the beginning of the financial turmoil, it has been a particularly challenging environment for active managers. A pronounced increase in investor risk aversion has led to negative returns from positions held to capture many fundamental active management risk premia. Flight to safety and deleveraging phenomena have resulted in distorted valuations, and judgements based on economic outlook or extrapolation of trends has been fraught with peril. Adding to the angst are high volatility, low liquidity and a market more focussed on governments’ next pronouncement than on fundamentals. In these circumstances an investor could be tempted to throw in the towel on active management.
However, successful active managers are able to apply unique insights to markets and to dispassionately act on those insights. Mercer does not believe that recent underperformance of these managers means that they have suddenly become incompetent.
When we return to economic and market normality, Mercer believes that high quality active managers will be faced with widespread opportunities to capture added value.
Mercer also believes that the recent lack of rationality in markets allows an opportunity to test active managers in terms of their ability to balance discipline with pragmatism and can provide further evidence as to strengths and weaknesses.
Even if we allow ourselves to imagine for a moment that the markets will never return to “normal” again, there will always be insightful and flexible active managers who are able to quickly develop means to exploit what inefficiencies there are in a new reality. 3: Investors will become more active in managing medium-term opportunities through portfolio tilts to long-term strategic asset allocations
The financial crisis is likely to provide further impetus to the implementation of active asset allocation tilts by superannuation funds and other long term investors, just as it as it has precipitated a rejection of the monetarist orthodoxy so favoured by Wall Street for the past 30 years in favour of a more pragmatic Keynesian approach to economic policy.
The traditional "set and forget" strategic asset allocation model favoured by many institutions and their advisers has come under increased scrutiny in an environment where the concept of markets trading constantly at "equilibrium" levels appears absurd.
Both trustees and members of superannuation funds are expressing concerns that allocations based upon long-term return assumptions take no account of current market conditions and prospects, and we have witnessed a tremendous increase in the use of our Dynamic Asset Allocation approach both to control risk and search for improved returns.
This trend, which has been observed for several years, is likely to accelerate as the impact of this year's market turmoil on fund returns prompts investors to focus on the medium-term valuations of the asset markets in which they invest, and adjust their exposures accordingly.
4: The hedge fund universe will see a dramatic contraction
Survival of the fittest is alive and well in the incredible shrinking hedge fund industry. This is supported by hedge fund guru, Ray Dalio, who states in Mercer’s 2007 publication 2020 vision: Investment Wisdom for Tomorrow, that the hedge fund industry comprises "10,000 planes in the air and only 100 good pilots."
The success of early hedge funds attracted a string of new and lesser qualified entrants which made a shakeout inevitable as economic conditions turned south.
However, gradually investors are realising that most hedge funds are not offering a unique source of skill (alpha) that is uncorrelated to global equity markets. Instead, many hedge funds are found to have market exposure (embedded betas).
Mercer sees an industry with greater regulation and transparency, an increase in longer term lockups and pressure on fees.
At the same time there is continued deleveraging which will make certain arbitrage strategies no longer viable. Authorities are keeping a watchful eye on short sellers.
Poor performance combined with 10-15 per cent net redemptions this year will see the industry shrink by one third to perhaps one half by the middle of next year.
Now is the time when hedge fund manager selection becomes crucial. With significant headwinds facing the industry, at this time Mercer prefers managers in the more liquid strategies using exchange traded instruments such as global macro strategies that have proven consistent performance, are less exposed to counterparty risk and can benefit even if markets do not recover. We recommend avoiding highly leveraged and less liquid strategies where securities are becoming increasingly difficult to value.
5: There will be an increased focus on operational risks in managers and security lending in general.
Mercer expects the market will continue to see more interest and scrutiny in the operational arrangements and implementation capabilities of fund managers.
Recent events have led to counterparty defaults creating cash collateral problems for securities lending programs. Exceptionally high volatility has seen unit pricing arrangement under pressure as well as other implementation issues.
These events highlight the importance of operational aspects within an investment program from fund managers’ middle and back office arrangements through to custody and unit pricing processes. The consequences when these things go wrong can be significant.
Mercer does not view excellence in operations and implementation as a reason for investing with a fund manager - this will continue to be driven by their investment idea generation.
We do, however, regard poor operations and implementation as a reason for avoiding managers.
As we predicted in 2008 we saw an increase in the level of pre-appointment operational due diligence of fund managers amongst investors, and sustained interest in reviewing incumbents.
Interestingly, having accepted the obvious benefits to individual fund members and of course those fund managers who can demonstrate the efficiency of their operations, investors have exhibited a preference for revisiting incumbent managers at regular intervals to ensure their continued adherence to high operational standards.
No matter how large or how well regarded an organisation is for their ability to generate alpha, we believe no one is immune from the risks associated with poor operational efficiency.
6: Trustee boards and other fiduciaries will need to ensure their governance arrangements are optimally structured to facilitate timely well-informed decision-making.
Mercer has seen the financial crisis separate strong boards from weak boards. Those boards with strong governance arrangements and effective decision-making processes were able to respond effectively to the daily challenges brought about by the financial crisis.
Those who had given careful attention to the development of their investment beliefs and to their decision-making processes were well placed to make timely decisions in the heat of the crisis.
An environment of fast-changing markets requires fiduciaries to react quickly to take advantage of market opportunities, and minimise threats, while maintaining accountability.
Mercer believes that Board governance will take greater prominence as boards review their own effectiveness and look to strengthen their governance competency to deal with complex and opportunistic investment decisions.
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