ASK THE EXPERTSQuarter 3 - 2013

Mercer’s 2013 European Asset Allocation surveyIn this Quarterly Mercer Ask the Experts podcast, three Mercer investments experts Nick Sykes, Phil Edwards and Atul Shinh discuss key trends from Mercer’s 2013 European Asset Allocation survey.

ASK THE EXPERTSQuarter 3 - 2013 Q. Against a continued uncertain macro-economic backdrop with investors facing the challenge of generating real returns while managing risk, what are the key trends that we see emerging from this year’s Asset Allocation survey?

Nick: Well the long term trends that we see are really those that have been in place for a few years; namely less in equities, more in bonds and more in alternatives. The reasons for this are well known - schemes are becoming more mature, less capable or willing to take investment risk and therefore moving out of the riskier asset classes such as equities and into bonds to match liabilities and also diversifying their equity holdings by moving into a variety of alternatives.

ASK THE EXPERTSQuarter 3 - 2013 There has been, to some extent, a pause in the increase in bond allocations in 2012 mainly because yields fell to such low levels that there was a decline in willingness to switch money from equities to bonds. The overall increase in allocations to alternatives doesn’t show up very much in the numbers, but we think that’s because bond markets and equity markets both did quite well in the year, so although there was an increase in cash terms it doesn’t really show up in percentage terms, but as I say the overall trend is more of the same.

ASK THE EXPERTSQuarter 3 - 2013 Phil: Just digging beneath the surface, I think within equity portfolios, we have seen schemes looking to diversify away from domestic exposure, so a continued move towards more global mandates and increasing emerging markets exposure. In terms of some of the numbers, I think the reduction in equity allocations was most visible within UK pension schemes, where we saw the allocation fall this year from about 43% in last year’s survey to 39% this year, and if we compare that number to our 2003 survey, where the equity allocation was around 68%, we can see that this is a trend that’s been in place for some time now.

In terms of bond portfolios it’s evolution rather than revolution. We have seen increasing use of LDI strategies with more and more schemes becoming comfortable with the use of derivatives in their bond portfolio and that’s particularly the case with UK and Netherlands based schemes.

ASK THE EXPERTSQuarter 3 - 2013 That’s really combined with an increasing use of trigger mechanisms, where schemes are looking to introduce a greater degree of responsiveness to changing market conditions and perhaps as yields rise we will see a lot more activity from schemes that do have these trigger based approaches in place.

In the alternatives portfolio I think it’s really been an increase in breadth - this year we collected data on allocations to over 20 alternative asset classes. I think larger schemes are becoming increasingly comfortable with more complex strategies and looking to use more niche and exotic asset classes and strategies, particularly in the hedge fund space. Smaller schemes are following the path of larger schemes, but looking for a broadly diversified exposure to a range of different alternative asset classes and return drivers within a single strategy.

ASK THE EXPERTSQuarter 3 - 2013 Q. Looking at alternative investments, what are the key areas of focus here?

Atul: The key story here has really been the continued increase of interest into multi-asset products and, in particular, diversified growth funds or DGFs. These products seek to provide investors with diversification, new and alternative sources of return, as well as flexibility in the asset allocation. Because they are generally available in liquid, relatively cheap and transparent structures, you can see why investors are interested in this concept.

More generally, outside of the multi-asset space, hedge funds continue to gain some attention, with most of the focus on fund-of-funds and/or multi-strategy funds. This isn’t a surprise, because these structures provide investors with a degree of diversification and a reduction in the specific risk that you might get from a more focussed manager or strategy.

ASK THE EXPERTSQuarter 3 - 2013 Other comments to make; whilst on the whole the allocations to private equity are on the low side, our larger clients continue to have meaningful allocations to the asset class.

Real assets represent a significant proportion of our clients plan investments and that’s of no surprise given that we categorise traditional property within this area. Finally, fixed income growth orientated assets remain popular, with high yield and emerging market debt in particular seeing increased allocations.

ASK THE EXPERTSQuarter 3 - 2013 Phil: I think the only thing that I would add to that is while we have already seen, as Atul said, a significant growth in allocations to emerging market debt and high yield over the last few years, with between 10% and 15% of schemes now having an allocation in one or both of these areas, we have started to see schemes broaden out their growth fixed income allocation to consider areas like senior loans and private debt as perhaps some of the more attractive areas of the market at the current time, given the bank de-leveraging that we’ve seen take place especially in Europe.

Going forward I think we would expect to see further interest in this area with multi-asset credit funds coming to the fore as an attractive way of accessing a diversified exposure, where the manager has the flexibility to move across asset classes in response to changing market conditions.

ASK THE EXPERTSQuarter 3 - 2013 Nick: Just to add to that, I think what’s been driving these trends is the search for yield – we have seen yields on sovereign bonds fall to very low levels and the return on cash has been very low, there’s been a desire to try and find assets offering a reasonably guaranteed flow of a decent level of income into the future. This has focused on the areas of the bond market that Phil and Atul have talked about and also one or two other areas such as real assets and long lease property. In fact we are beginning to see clients look at real asset portfolios in the round and we’ve had one or two exercises where there’s been a mandate out there for a specific real assets portfolio combining a number of different alternative asset classes in a single portfolio, perhaps because the investor is concerned about future inflation.

ASK THE EXPERTSQuarter 3 - 2013 Q. So what are we seeing as the trends for the future? What is the expected direction of travel?

Nick: I do think it is more of the same. As I said earlier, the trends have been less in equities more in bonds and liability matching instruments and more in alternatives and that does seem set to continue as schemes mature and reduce their appetite for risk. However, I think that the pace of change will depend on market conditions – for example, if yields rise materially, then there might be a speeding up of the allocation from equities to bonds.

ASK THE EXPERTSQuarter 3 - 2013 Phil: Just adding a bit of detail in each of those areas; I think within equity portfolios we would expect to see a continuation of reducing domestic allocations with more in global, more to emerging markets and perhaps also more to low volatility allocations where schemes have looked to add some element of downside protection within the equity portfolio. In the bond space we see particular interest in inflation-linked bonds with pension schemes looking to add inflation protection to their asset portfolio to reflect the inflation linkage that many schemes have in their liabilities, and continued interested in LDI strategies to help develop a slightly more sophisticated match to liabilities.  

ASK THE EXPERTSQuarter 3 - 2013 In the alternatives space I think we expect to see continued interest in multi-asset strategies and growth fixed income. As I said earlier, we think that multi-asset credit strategies are potentially attractive to schemes looking to outsource the dynamic asset allocation decision between different parts of the fixed income universe. Finally, within property, we see a marginally negative sentiment across the board, but perhaps slightly more interest in some of the less traditional areas, so parts of the universe like ground leases, which offer some inflation protection, and real estate debt which is one of the more opportunistically attractive parts of the property universe.

ASK THE EXPERTSQuarter 3 - 2013 Atul: Just to add to Phil’s comments in relation to multi-asset, we see the demand for these products as only going one way and that’s up. Defined benefit schemes will continue to use these types of strategy, particularly as they begin the long journey to de-risking; and DGFs have been and will continue to be used as an important component within defined contribution schemes going forward. Having all this demand is all very well, but what is pleasing to see is an increased supply compared to a few years ago when there weren’t as many credible propositions as we have today. Certainly judging by the number of phone calls I receive from managers about new propositions, that trend also seems set to continue!

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