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Mercer's top 10 investment trends for 2010

The investment landscape has changed irrevocably since the Global Financial Crisis and investors will be wise to ensure their investment strategies reflect the lessons learned from this period.

Friday, January 22nd 2010, 2:54PM

Going into 2010 Mercer highlights what it sees as the top ten investment trends that investors should critically examine in order to successfully manage their investment portfolios for long-term outcomes.

  1. Changes to regulation could improve the investment environment
  2. Emerging market growth will outstrip developed markets, but equity markets may have priced this in
  3. Environmental, Social and Governance (ESG) factors will reappear on investors' radar
  4. Investors will critically examine their investment strategies in the context of evolving deflation/inflation risks
  5. Dynamic Asset Allocation (medium-term asset allocation tilts) will be de rigueur to capture market mispricing in the medium-term
  6. Investors will undertake more due-diligence on hedge fund strategies
  7. The big "macro" moves may be behind us - time to become "micro"?
  8. Funds will review the role of illiquid assets in their portfolios
  9. A weaker global banking system will create opportunities for private credit
  10. Diversification will remain key.

Martin Lewington, Head of Mercer New Zealand, examines the top ten investment trends for 2010 more closely:

 

1. Changes to regulation could improve the investment environment
The transformation of the local investment market will accelerate as Government-led initiatives in market development, taxation and advice regulation come to fruition. The Prime Minister, John Key, is expected to announce the Government's response to the Capital Market Development Taskforce report early in 2010.

The Taskforce's report was released in December of last year and made a number of recommendations designed to improve the quality of products available to investors and the advice they receive, improve businesses' access to capability and capital, and improve the regulatory regime.

If implemented, these recommendations will result in major changes to the investment landscape with a material impact on fiduciaries. The Tax Working Group will also release its final report early this year.

2. Emerging market growth will outstrip developed markets, but equity markets may have priced this in
The IMF predicts slow growth of 1.3% in advanced countries in 2010 will be out-stripped by growth of 5.1% in developing countries and a very rapid 7.3% in developing Asia.

China and India will be at the forefront of Asian growth but Korea, Indonesia and Vietnam will also grow fast. Looking further ahead, this pattern of faster growth in the Asian region is expected to continue.

However, there has already been a surge in investment in emerging market equities, aided by the availability of ETF funds to retail investors. China's currency peg to the US dollar has resulted in very low interest rates relative to nominal GDP growth, and there is a risk that some emerging markets could move beyond fair valuations into "bubble" territory.

3. Environmental, Social and Governance (ESG) factors will reappear on the radar screen
As emerging markets become wealthier they will not continue to tolerate current pollution levels. They will also attempt to reduce the energy dependence of their growth and green house gas emissions.

A precipitating factor is that investors and their investment managers will need to integrate ESG factors into their process or be at risk of being blindsided. Developing legislation on issues such as climate change will also help to cement ESG into investment agendas.  

4. Investors will critically examine their investment strategies in the context of evolving deflation/inflation risks
Although the threat of sustained deflation in the US and Europe is diminishing, investors are concerned the accompanying policy response risks a renewed outbreak of inflation.

Faced with spiralling public sector debt ratios, and growing long-term budgetary obligations, investors have become sensitive to the possibility that some governments may seek to ‘inflate' their way out of debt. We anticipate few governments will risk such a destabilising option, but will need to quickly begin articulating measures to bring debt down to more manageable levels.

In 2010 investors are likely to begin demanding more credible fiscal exit strategies and begin to discriminate more carefully between leaders and laggards. For investors who believe some governments will still need to eventually print money in order to avoid default, we note typical inflation protection strategies are no longer especially cheap.

We continue to emphasise that the risk of deflation has not yet been fully eradicated, particularly if governments can no longer guarantee the funding obligations of financial institutions.

5. Dynamic Asset Allocation (medium-term asset allocation tilts) will be de rigueur to capture market mispricing in the medium-term
Strategic asset allocation has traditionally been based on an assumption of long-term market equilibrium, but in practice markets rarely reflect ‘fair value'. Dynamic Asset Allocation (DAA) can exploit deviations from long-term averages to deliver improved returns and sound risk management.

This approach replaces the ‘set and forget' school of thought of strategic asset allocation.

6. Investors will undertake more due-diligence on hedge fund strategies
Hedge funds took a major battering in the maelstrom of the financial crisis, with estimates of up to a third of the industry winding-up. In 2010 investors will re-think their approach to investing in hedge funds, seeking improved transparency of underlying risk exposures, less ‘directionality' (or sensitivity to market movements) and more equitable fee bases.

7. Funds will review the role of illiquid assets in their portfolios
Many illiquid investment strategies such as unlisted or direct property, infrastructure, private equity and debt, and a number of other alternative investment strategies can provide access to diversifying - and in some cases unique - sources of return.

Such investments can, therefore, be highly desirable as part of a well-designed investment strategy. However, the GFC highlighted both the benefits and costs associated with illiquid investments. While these assets provided some protection from the tide of negative sentiment that swept across listed markets, there was a reminder that these assets could not be realised for cash at short notice.

While we believe some funds could benefit from greater exposure to illiquid assets, others, particularly super funds, will need to ensure their exposure matches their liability profile.

8. The big ‘macro' moves may be behind us - time to become ‘micro'?
Both 2008 and 2009 have been characterised by massive swings in market valuations, as unfolding economic events drove investors to the brink of despair before hope and confidence was restored.

In this environment, risky assets (equities and credit) were borne on waves of liquidity flows, and ‘micro' analysis of individual companies' prospects seemed at times irrelevant. As the recovery matures it seems likely that investors will become more discriminating, and country, sector and stock picking abilities may once more become pre-eminent.  

9. A weaker global banking system will create opportunities for private credit.
Who will fill the credit gaps created by the decline in the number of banks and their capacity and willingness to lend?
As global economies recover, businesses are seeking new funding and roll-over financing.

Private debt lending rates are already in their low to high teens and at these levels, the supply of credit will be filled by private creditors and investment opportunities in private equity and private credit will grow accordingly. 

10. Diversification will remain key
Traditional investment strategy of diversification abjectly failed to protect investors during the Global Financial Crisis. Misunderstanding the underlying - and interconnected - risk exposures saw many investors unprepared for the magnitude of losses experienced in early 2009.

When faced with uncertainty, diversification will continue to be the primary tool available to investors to improve their chances of investment success. The key lesson here, however, is to seek genuine diversification of underlying return sources through properly identifying the risks involved, and to spread portfolios across as many lowly correlated assets as possible. 

We expect to see continued investor interest in a range of alternative assets classes and strategies as a result of this, particularly ones that are less linked to traditional market movements. These include insurance-linked investments such as catastrophe bonds, agricultural investments and social infrastructure.

We also see further interest in non-traditional equity strategies such as low volatility products and structured strategies that use derivatives to limit extreme downside risk.

« Market Review: January 2010 London CommentaryMarket Review: February 2010 London Commentary »

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