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February 2012, iSSue 13

important – thiS doCument iS not For retail inVeStorS.

Feature artiCleS:

• Winners and Losers 2011

• Tail Risk Management

• The Outlook for Emerging Market Equities

• Effective Corporate Governance and Stewardship – A Growing Trend

emea Quarterly update

inVeStment reVieW

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COnSuLTAnTS Raj Goswami James Cameron Michael Cross Paul O’Connor Rupert Brindley Kate Brett nick Sykes

MARKETinG Clare Abbam Mary Voigt inna Ward

EdiTORiAL TEAM

WelCome

happy new year, and here’s hoping that 2012 is a better year for investors than 2011 turned out to be.With the new year we have also renamed the quarterly investment update to the Investment Review. We are generally glad to see the back of 2011, a year marked by a widespread deterioration in the economic outlook with consequent adverse effects on the performance of “growth” or “risk” assets. Our article on “Winners and Losers in 2011” gives a little more colour on this.

The current consensus is very gloomy about the prospects for 2012, with deep concern about the seemingly intractable problems of the eurozone added to ongoing pessimism about the need for continued deleveraging and the adverse effects of policies of fiscal austerity. We have included an article on “tail-risk” hedging as a response to the risks of a further material fall in risk markets that would arise from policy or financial system failure.

is there any cause for optimism? i think there are three possible areas for hope. First, the consensus about the economic and market outlook is very gloomy, as it was at the start of 2009. And 2009 proved to be a great year for investors, as virtually all risk assets rebounded strongly from the lows reached in March of that year. Second, there are two areas where optimism could grow during the year – emerging markets could begin to pick up in 2012 as policy is loosened (see the article on emerging market equities), and inflation looks set to fall back, which could lead to household incomes becoming less squeezed. Third, and nothing to do with economies or markets, we have the London Olympics to look forward to, an opportunity to forget about deleveraging, systemic failure and the euro, and to think about “CiTiuS, ALTiuS, FORTiuS” (“faster, higher, stronger”).

new in the Review for this quarter is the Experts Corner, where topical questions are answered by relevant experts within Mercer’s investment business. The question this quarter is whether it is the right time to buy uK government bonds. We have also included an article on the issue of effective corporate governance and stewardship, which is commonly viewed as one of the factors that can affect performance of institutional investment portfolios.

We hope that you find the issues raised in this edition of interest and we look forward to speaking to you over 2012.

nick Sykes European director of Consulting February 2012

ContentS

FeatureS

expertS Corner 18The Experts Corner is a new section in the Review for this quarter. in it, topical questions will be answered by relevant experts within Mercer’s investment business.

neWS and publiCationS 23The latest news and events from Mercer’s investment business. updates on publications, events across the region, videos, and announcements.

in eVery iSSue

4Winners and losers in 2011

8effective Corporate Governance and Stewardship

14Tail Risk Management

The Outlook for Emerging Market Equities

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WinnerS and loSerS in 2011

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L ooking back over any year, it is generally constructive to consider how easy it

would have been to predict market movements given the gift of perfect foresight (in terms of economic outcomes, for example) at the start of the year.

ThE WinnER(S) …So, here goes … if at the start of 2011 you had been told that the uK’s public sector deficit would reach record (peace-time) levels of c.10% of GdP, inflation would run at more than twice the Bank of England’s 2% target and the status of Britain’s cherished AAA rating for its bonds would be called into question, what would your forecast have been for the returns from the long end of the gilt market? A fall of 10% would seem likely, a fall of 20% possible. And what return did the long end of the gilt market actually deliver? A total positive return of 28%! And although long dated gilt returns were stellar, they were surpassed by long dated index-linked gilts with a positive return of 29%.

Lessons learnt from this experience? Focusing on supply of gilts, inflation rates (vs. expectations) and sovereign debt credit ratings does not tell the whole story (or even a big part of it, or so it would seem when it comes to forecasting bond market movements).

ThE LOSERS …On the other hand, if one had been given perfect foresight as to the turmoil in the eurozone, with Greece at its centre, a prediction of a significant fall in the Greek equity market would have been made with a high degree of conviction – and it would have been correct! Greek equities were one of the worst-performing asset classes, with the equity market registering a negative return of 63% over the year. Similarly, events in Egypt left the country’s equity market in second to last place with a negative return of 47% over the same period.

As the above asset classes illustrated, sometimes the fundamentals play out, sometimes they don’t, and sometimes chance and circumstance can throw you a curveball.

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A TALE OF TWO hALVES …With the news flow currently dominated by doom and gloom, it is easy to forget the resilience the markets displayed in the first half of the year. despite the tragic earthquake in Japan and significant political unrest in the Middle East, risk assets generally recorded positive returns for the first six months to 30 June 2011. This trend can be seen in Chart 1. in fact, it was not until the third quarter that we saw a complete about-turn in investor sentiment as fears over fading global growth dominated the thoughts of investors. From 26 July 2011 to 8 August 2011 the global equity market fell over 15%, while uS Treasuries were up significantly, despite the downgrade of uS government debt by Standard & Poor’s on 5 August 2011.

WhAT GOES uP MuST GO dOWn, ThEn GO BACK uP And ThEn dOWn AGAin …The other big story of 2011 was volatility of returns (and arguably the political process!). The markets turned to the politicians for solutions to the eurozone’s problems but found themselves flummoxed by apparent about-turns and impasses. As a result, one of the most difficult factors for investors in the second half of the year was the scale of daily moves. As an example, during the first half of the year, the FTSE All Share only moved more than 2% in a day (up or down) only on two occasions; in contrast, during the third quarter the FTSE All share fell by more than 2% on nine separate days and rose by more than 2% on seven separate days. Similarly, in Europe, the French and German markets were up over 7% in a single day at the end of October as a deal for Greek debt was announced, only to be scuppered by the announcement of a Greek referendum on austerity measures resulting in double digit falls over two days.

SO WhERE nExT?There has been a marked deterioration in the global growth environment, and risks around a policy error have undoubtedly increased. The European crisis has deepened since early summer and European banks have been almost frozen out of the financial markets. Without a resolution to the euro crisis, it is very difficult to predict where the markets are headed, but we believe that we are likely to see a sustained period of difficult deleveraging

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Returns from 31 december 2010 to 31 december 2011 with the exception of property and hedge fund returns to 30 november 2011. Source: datastream, Barclays Capital, dow Jones Credit Suisse, J.P. Morgan, iPd.

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coupled with continued concerns about global growth. The European region’s future will be determined by political decisions taken in the next few months and the outlook remains highly unstable and uncertain. in addition, we believe there are significant risks of policy fatigue, particularly if the markets grow disillusioned with the tools available to the politicians.

however, that said, corporate balance sheets generally appear fairly healthy and with yields on developed sovereign bonds at, or close to, 30-year lows, we believe that high quality companies, high yield debt, local currency emerging market debt and emerging market equity potentially look attractive over a medium-term time horizon. Even so, we expect that systemic risk and macro headwinds are likely to be the dominant themes for investors during 2012.

n Topn Bottom

Returns from 31 december 2010 to 31 december 2011, except for hedge fund strategy returns, which are to 30 november 2011. Source: datastream, Barclays Capital, dow Jones Credit Suisse

Equities (by country, uSd returns)

Trinidad and Tobago +31.0% Greece -62.7%

ireland +14.3% Egypt -46.9%

Qatar + 8.2% ukraine -45.8%

Equities (by sector, uSd returns)

health Care +9.6% Basic Materials -21.2%

Consumer Staples +8.5% Financials -19.0%

Telecommunication Services +0.5% industrials -9.8%

uK gilts (by maturity)

iLG > 25 years + 28.5% iLG 3 to 5 years + 1.6%

FiG > 25 years +27.7% FiG 1 to 3 years + 3.1%

FiG 15 to 25 years +24.5% iLG 1 to 3 years + 3.9%

Global credit by rating (GBP hedged)

Baa +5.6% C -13.6%

Aaa +5.5% Ca -12.3%

Aa+5.2% Caa -1.8%

Global credit by sector (GBP hedged)

Energy +9.4% Financials +1.5 %

Consumer non-Cyclical +8.6% Basic industrials + 5.5%

utilities +6.4% Capital Goods + 5.6%

Local emerging market debt (by country, GBP)

indonesia +23.4% Turkey -14.0%

Philippines + 17.4% hungary -12.0%

Peru + 12.6% South Africa -10.1%

hedge fund strategies (GBP, dow Jones Credit Suisse)

Global Macro +5.9% Event driven -8.8%

Equity Market neutral +4.7% Long Short Equity -7.0%

Fixed income Arb. +4.2% Emerging Markets -6.6%

Commodities (GBP, S&P GSCi)

Gold +10.4% natural Gas -44.3%

Orange Juice +6.3% Cocoa -31.9%

All Crude +5.3% Wheat -31.4%

Currencies (return relative to GBP)

South African rand +21.1% Japanese yen -5.8%

indian rupee +17.9% Chinese yuan -5.2%

hungarian forint +16.9% hong Kong dollar -0.8%

table 1: top and bottom three performers in major asset Classes during 2011

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tail riSk manaGement

To date, institutional investors have principally relied upon portfolio diversification to protect against “tail

risks” (which can be defined as the risk of unusually large investment losses over a short period). the effectiveness of this approach has, however, been called into question by the high degree of correlation across most risky asset classes during the “global financial crisis” in 2008. this has generated interest in explicit tail risk protection strategies. this interest has been given further impetus by renewed market volatility in recent months, with particular regard to uncertainties over the future of the eurozone.

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tail riSk manaGement

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Aside from portfolio diversification, the main approaches to tail risk management include:

•direct hedging strategies (for example, using derivatives to limit losses on specific assets held)

• indirect hedging strategies (for example, buying assets, or derivatives, that would be expected to increase in value during a tail-risk event)

• investment in tail risk hedging funds (which may use a combination of the above approaches)

ShOuLd TAiL RiSK MAnAGEMEnT BE COnSidEREd?Equity markets experienced severe falls during the global financial crisis. For example, between november 2007 and February 2009, the MSCi World index fell by 54%. Other risky asset classes that were commonly held by institutional investors to diversify equity exposure significantly failed to do so – property investments collapsed in value (the dow Jones Equity All REiT index fell by 65% over the same period), commodities fared nearly as badly (the S&P GSCi was down 53%) and most hedge funds also underperformed (the hFRi diversified index fell 21%).

Government bonds performed strongly in the “flight to safety” that ensued, but most of the other asset classes and strategies that performed well over the same period (including gold, up 20%; dedicated short equities, up 47%1; and credit default swaps) were not widely held by institutional investors.

The events of 2008 alone are not reason enough to spend time on tail risk management strategies. Extreme market downturns are often followed by a market recovery, so long-term investors may not be overly concerned by short-term volatility, even if it is severe. Equity markets did, in fact, rebound strongly in 2009. Arguably, the biggest risk for many investors is not a sharp negative market event but a long-term disappointment in investment returns – and this is not something that tail risk management can address.

Market recoveries are not, however, guaranteed and in some cases it can take years for a recovery to happen. Some investors are not able to wait that long, and a sharp market fall can itself result in other negative consequences (for example, having to inject additional capital). Therefore, putting in place some defence against (what may turn out to be) short-term market falls can be attractive.

arguably, the biggest risk for many investors is not a sharp negative market event but a long-term disappointment in investment returns – and this is not something that tail risk management can address.

1 Gold: London Bullion Market; dedicated short equities: hedge Fund Research, inc., Equity hedge (“hFRi Eh”) Short Bias.

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diVERSiFiCATiOn STRATEGiESMost investors will be familiar with the concept of diversification, and they will also be aware that the traditional approach to portfolio construction (that is, diversification by asset class) disappointed during 2008. however, some physical (that is, non-derivative) asset classes performed well, or at least held their value, during the financial crisis; these included gold, cash and government bonds.

Gold has often been viewed as a “safe haven” investment in a climate dominated by systemic risk issues. At certain times of extreme market stress gold has enjoyed a significant increase in value. Gold may also provide a hedge against currency depreciation and inflation. The downside to gold investing is that it does not provide any ongoing yield and there is no guarantee it will perform well during periods when equity markets decline significantly. Given the limited practical usefulness of gold, its value is largely driven by sentiment, so it is difficult to assess its “fair value” or determine what allocation should be held.

Cash and developed market government bonds have also been seen as “safe haven” investments (at least from a credit risk perspective), but they suffer from relatively low expected returns over the long term, especially given the current level of yields. Events in the eurozone over recent months have also clearly highlighted the need for investors to discriminate between sovereign issuers, even in developed markets. Tail events that are linked to concerns about inflation may also not be helpful for longer-dated bonds. While these investments may preserve value in times of stress, they may not significantly increase in value when equity markets fall and, consequently, we do not consider such allocations to be effective tail risk hedges. holding cash may nevertheless be beneficial as it can be used to purchase assets at distressed levels.

diRECT hEdGESOne of the most straightforward tail risk hedging approaches is the purchase of put options on underlying equity market exposures. The purchase of put options allows investors to retain the upside on market exposure within their portfolio while paying a periodic premium, which will result in a pay-off if the market index declines. This strategy is potentially attractive as it is relatively simple and makes use of highly liquid derivatives contracts.

Cash and developed market government bonds have also been seen as “safe haven” investments (at least from a credit risk perspective), but they suffer from relatively low expected returns over the long term, especially given the current level of yields.

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The expected long-term return (that is, annualised option pay-offs less premiums) of a simple put-buying strategy is, however, negative, with various studies concluding that this approach is a losing proposition unless the time horizon is long enough to encompass a catastrophic event like the Great depression, which could justify the many years (or decades) of paying the “insurance premium”. More complex strategies that may offset the overall cost can be constructed; one of the most commonly cited being the zero-cost collar. under this strategy, a put option is financed by selling a call option above the current market level – that is, some potential upside is sold to finance the insurance purchased. A range of variants on this approach can be adopted, tailored to each investor’s requirements.

There is, however, more to consider than simply the cost and direct pay-off of an option strategy. A put-buying strategy is designed to pay off when the equity market is down significantly – providing liquidity at a time when it may be critically needed in other parts of the portfolio and/or deployed to purchase assets at depressed prices.

All option-based strategies present challenges related to comfort with derivatives and governance issues, which include the complexity of implementing and managing these strategies.

indiRECT hEdGESWhile direct hedges can protect against returns in a particular asset class being worse than a specific level over a specific period, this degree of hedging accuracy may not be required or even possible to define and, as noted above, the cost may be prohibitive. indirect (or cross asset) hedges instead exploit the relationships between equity returns and other factors, such as equity volatility or the price of credit default swaps (CdS).

A good example of an indirect hedge is the purchase of CdS. CdS offer a means of “insuring” against a bond defaulting. having exposure to credit default swaps is therefore similar to being “short” credit risk. Equity market stress is often associated with an increase in credit spreads and CdS spreads because rising equity market volatility is often linked to heightened concern over the potential for increased corporate defaults. As such, being “short credit” in this way can be beneficial in a stressed market environment. CdS can also provide a “direct” hedge against tail risk events in corporate bond portfolios.

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Other instruments that can perform a similar indirect hedging role are volatility derivatives (for example, futures or options on the CBOE Volatility index, “Vix”), which have historically performed strongly in times of equity market stress.

TAiL RiSK hEdGinG FundS The complexity of many of the indirect hedging instruments described above means that few investors are likely to want to hold these directly. however, the asset management industry does now offer a number of specifically designed tail risk hedging funds. These funds use a variety of techniques to hedge tail risk. They have generally been developed by hedge fund managers, who have historically had some form of internal strategy in place to hedge their own portfolios. As a result of growing demand from investors to reduce volatility within their wider portfolios and mitigate the risk of tail events, these funds have emerged in the last five years or so as standalone products.

As would be expected from these types of strategies, they exhibit negative carry − that is, the return expectation is negative in normal market conditions – this is compounded by hedge fund type fees.

COnCLuSiOnS•Tail risk management is an important topic that has

attracted significant attention during the period of market turmoil triggered by the global financial crisis.

•Traditional diversification approaches have often not been effective at mitigating downside risk across “growth”’ assets in times of extreme market stress.

•While long-term investors can in theory wait for markets to recover following a tail risk event, for a pension fund, there is also the risk that the event will itself lead to sponsor weakness or even insolvency. Assets may also need to be liquidated quickly to fund other losses or to exploit distressed investment opportunities.

•Specifically designed tail risk hedging strategies may perform more reliably in a crisis than diversification-based approaches.

• investors should consider how and whether they should look to protect portfolios against tail risk events. due to their complex nature, purpose-designed tail risk hedging strategies bring their own governance challenges for investors and should be considered before a tail risk event occurs.

•Most tail risk hedging strategies involve ongoing costs. investors should consider whether they would be prepared to pay a premium to help mitigate tail risk scenarios and/or whether particular tail risk hedging strategies are cost-effective at a given point in time. insurance will always be most expensive when it is most in demand.

More detailed material is available for those interested in exploring tail risk protection strategies further. Please ask your Mercer consultant for further information.

as a result of growing demand from investors to reduce volatility within their wider portfolios and mitigate the risk of tail events, these funds have emerged in the last five years or so as standalone products.

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the outlook For emerGinG market eQuitieS

a diFFiCult year

2011 was an unrewarding year for investors in

emerging market (em) equities. in a year when uS

equities were flat2 and developed market (dm)

equities returned -5%3, em equities returned -18%,

performing even worse than most of the crisis-hit

major european markets.

2 S&P 500 3 All returns are based on MSCi indices, from a uSB basis.

The underperformance of EM equities in 2011 was fairly broad-based, to a large extent driven by the following key themes:

•The slowing of global growth, which hit the most cyclical emerging markets, such as Korea and Taiwan, and explained the tight correlation between EM performance and commodity prices

•The adverse impact of policy tightening on domestic economic and financial conditions in some of the biggest economies, such as Brazil, China and india

•The influence of the eurozone crisis on the economies of Central and Eastern Europe (CEE) − a major factor behind the heavy falls in equity markets in these countries. For example, investors in hungary and Poland experienced losses of more than 30% in 2011

Looking ahead, it seems likely that these and related themes will be the key drivers of EM equity returns in 2012 as well. Below, we focus on the two themes that we think will have the greatest influence on EM performance in 2012: the eurozone crisis and the outlook for growth in the emerging economies.

EuROzOnE SPiLLOVERS The eurozone financial crisis looks set to overshadow global markets in 2012, as it did last year. Where EM equities are concerned, the most direct effect is through the impact on the CEE markets. The eurozone is a key trade partner for the CEE countries and accounts for more than half of the exports from the Czech Republic, hungary and Poland. Consequently, economic growth in CEE is highly sensitive to growth momentum in the eurozone, which is likely to remain a negative influence on the emerging economies in 2012.

Financial linkages are at least as significant as these trade relationships. The banking sectors in CEE are largely owned by eurozone banks − a key source of vulnerability given the latter’s ongoing and substantial balance sheet deleveraging. Concern here focuses on the risks of asset sales and capital repatriation by the eurozone banks and the impact of adverse funding conditions on the CEE banks’ ability and willingness to lend.

The impact of the eurozone crisis on EM equities has not been limited to the CEE markets. As eurozone bank funding problems intensified in the third quarter of last year and the major eurozone bond markets came under pressure, the crisis shifted from being a European problem to being a global systemic threat. This escalation had a major impact on global risk appetite and played a big part in the dramatic withdrawal of capital from all emerging markets in the autumn and the collapse in both EM currencies and equity markets.

in the near term, both trade and financial linkages to the eurozone look set to remain a significant source of risk for EM equities. it is hard to dispel the view that eurozone growth will remain subdued for a considerable time,

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n South Africa 8%n Russia 6%n india 6%n Other 21%

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Composition of mSCi emerging market equities index

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given the scale of the planned fiscal tightening. it is highly probable that the eurozone will slip into recession in 2012. Furthermore, the process of bank deleveraging is another trend that looks likely to run for a number of years.

One thing that is less certain is whether the combined actions of the European Central Bank (ECB), European Financial Stability Facility (EFSF) and other entities can ease financial market tensions despite this difficult backdrop. The huge scale of debt issuance from European banks and sovereign nations in early 2012 will be a big challenge for markets. however, the ECB’s programme to provide vast amounts of liquidity to the banks (launched in december 2011) should provide some offset. While such policies cannot transform the growth outlook, they do have the potential to reduce market stresses and the spillover from the eurozone into global financial markets.

ThE GROWTh And POLiCY OuTLOOK FOR EMERGinG MARKETSWhile much of the recent weakness in EM equity markets was caused by factors deriving from the developed economies, some EM-specific factors have also been important. The main concern here was the impact of policy tightening on the domestic growth outlook in the biggest emerging economies (the BRiCs4). The good news is that inflationary pressures in the BRiCs seem to have peaked and policy has already moved on to an easing tack. interest rates have been cut in Brazil, indonesia and Turkey, and China’s central bank has lowered its reserve requirement ratio.

Further monetary easing is expected in the emerging economies in 2012. The key question is whether the policy response is decisive enough to overcome the numerous negative influences on EM growth. While the consensus annual forecast of 6.5% real GdP growth for the BRiC economies in 2012 looks encouraging, it is worth noting that this represents a significant slowdown from the rates experienced in recent years (excluding 2009) and that forecasts continue to edge lower as data disappoint.

ChinA WiLL BE KEYEmerging markets look set to remain highly sensitive to economic data and policy measures in 2012. Equities seem unlikely to deliver a significant rally in the absence of a meaningful improvement in growth momentum in the major emerging economies. The responsiveness of policymakers to slowing growth will be closely watched. in this regard, developments in China will be a key focus for EM investors. Opinion on this topic has become highly polarised into the following camps:

•The bearish view: a focus on slowing growth, the risk of a hard landing in the housing market, problems in the banking sector and diminished policy flexibility (compared to when the global financial crisis started)

•The bullish view: emphasising the resilience of growth,5 the economy’s ability to absorb a housing market correction and the view that China still has substantial fiscal and monetary policy ammunition (albeit somewhat reduced in recent years)

Source: Bloomberg consensus forecasts

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At this stage, the evidence seems tilted in favour of the soft-landing scenario. Policy in 2011 was specifically focused on cooling inflation and slowing the property market and success on these fronts has allowed the authorities to begin easing. Further steps in this direction are likely throughout 2012, with fiscal policy playing a major role as well. however, it is clear that the risks are high and that the situation will need to be closely monitored throughout 2012. A hard landing would have major adverse implications for global growth, commodities and emerging market equities.

COnCLuSiOnThe outlook for EM equities in 2012 is unusually complicated. The policy cycle in the emerging economies is moving into an easing phase, but not yet enough to reverse the decline in economic momentum. The longer-term fundamental outlook is equally uncertain. The positive long-term attractions of the asset class are counterbalanced by the likelihood that many developed economies face a prolonged phase of deleveraging and subdued growth.

A sustained rally in EM equities will require a meaningful improvement in some of these key drivers. The growth outlook for the developed markets seems unlikely to change significantly, which means that a bull story on EM equities requires a belief in some form of EM-dM decoupling. The feasibility of this will arguably depend upon progress in two key policy areas:

• European policymakers must succeed in easing financial market tensions, to the extent that deleveraging in that region is no longer a systemic threat.

• The policy response in the emerging economies has to be decisive enough to stabilise economic momentum and to offer the promise of a recovery in domestic demand.

On balance, we expect a positive resolution on both fronts in 2012, which should ultimately allow EM equities to deliver reasonable returns. however, the outlook is unusually uncertain and markets will remain vulnerable to both economic shocks and policy errors. Expect surprises.

at this stage, the evidence seems tilted in favour of the soft-landing scenario.

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the experts Corner is a new section this quarter. in it topical questions will be answered by relevant experts within mercer’s investment business. below is our first question and answer.

Before the financial crisis of 2008, uK government bonds seemed to be a slightly dull, risk-free asset class offering unspectacular returns to conservative investors.

however, recent turmoil in the structure of financial markets has driven investors to seek out “safe havens”. To the surprise of many market participants, gilts have benefited dramatically from these changes to become the strongest-performing major bond market during 2011.

Pension funds have several reasons to monitor the gilt market. First, they will want to review existing bond holdings. Second, they will want to put some context around the alarming increases in their reported liabilities. And last, they will want to consider whether this is sending important signals concerning the prospects for growth-seeking strategies.

The rally in gilts is superficially surprising in the light of an unprecedentedly large uK budget deficit. This has caused the size of the gilt market to more than double since September 2008, thereby reducing the scarcity premium that has supported prices historically.

however, this new gilt supply has been readily absorbed by a combination of the following:

•Quantitative easing (QE) by the Bank of England, currently committing up to £275bn to purchases (that is, more than 20% of the entire market)

•Commercial bank buying in order to meet increasingly onerous Basel liquidity rules

•Overseas buying, in part reflecting a desire to diversify away from euro-denominated assets

expertS Corner

is this the right time to buy uk government bonds?

investors must now consider whether investment at current prices is a sensible de-risking strategy, or rather represents a “reckless prudence” that squanders resources through over-payment.

Examining market prices at the beginning of 2012, we observe that the yields from gilts are consistent with a 1% annual rate of return for the next five years, followed by a 3.5% per annum return for the subsequent 45 years.

When contrasted with market expectations of a 3.5% per annum inflation rate over the long term, we see that interest rates are expected to be held at severely depressed levels for several years. This is designed to facilitate the reduction in the real burden of uK personal debt, albeit at the expense of investors and savers. Thereafter, nominal rates are expected to just cover inflation once the economy is in a more robust condition.

We need to ask whether these yield levels are now low enough to provide evidence of “financial repression”, whereby the authorities are effectively requiring financial institutions to buy government securities irrespective of price.

Some evidence in this direction has been provided by the Bank of England, which stated that the explicit aim of quantitative easing was to reduce gilt yields (that is, make gilts more expensive than they otherwise would have been). While this evidence might seem compelling, it flies in the face of record gilt-buying by foreign investors in October and november 2011.

Pension schemes might also perceive that the actuarial funding discipline imposes a mild form of financial repression, since deficit calculations reflect prevailing gilt yields. hence, increased pension deficits arising from lower gilt yields can result in additional employer contributions, some of which at least are likely to be invested in gilts, potentially reinforcing the downward move in yields.

The key players in the gilt market have been the following institutions:

•The Bank of England (presumed to operate on a “buy and hold” basis, but with an option to increase QE if needed)

•Commercial banks (presumed to be stable holders for regulatory reasons)

•Foreign investors (presumed to be more fickle holders, awaiting greater calm in the eurozone before switching back)

•Pension funds and life insurers (largely bystanders during the recent rally, but potential buyers as further de-risking of schemes is sought)

Valuations appear fairly unattractive from a historical perspective. A substantial further re-rating of gilts would therefore seem to require either deterioration in the financial crisis, or sustained multi-decade financial repression.

in the short to medium term, it therefore seems plausible that gilt yields will increase as the holders of “safe haven” assets look elsewhere, and as the credibility of the uK coalition government’s deficit reduction plans are tested.

We feel that now is the time to explore proxies for gilts, which are cheaper than gilts themselves, and to wait for any sell-off before increasing liability hedge ratios.

Should you have any questions that you would like to be covered in this section, then please contact your Mercer consultant or email Clare Abbam at clare.abbam@mercer.com.

the outlook for the market

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eFFeCtiVe Corporate GoVernanCe and SteWardShip

a G r o W i n G t r e n d

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Mercer believes that effective stewardship, exercised through shareholder voting and engagement activities with investee companies, can help the realisation of long-term shareholder value. Where companies have inactive/disengaged shareholders, the chances that company management will act in ways that are detrimental to shareholders’ interests are greater. indeed, in its analysis of the global financial crisis, the Organisation for Economic Co-operation and development (OECd) reported that “failures and weaknesses in corporate governance arrangements … did not serve their purposes to safeguard against excessive risk taking”. 6

Following the Walker review into the governance of uK financial institutions, commissioned by the uK government following the financial crisis, in July 2010 the uK’s Financial Reporting Council (FRC) published The UK Stewardship Code for institutional investors.7

The UK Stewardship Code is designed to “enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders and the efficient exercise of governance responsibilities”.

The UK Stewardship Code is primarily addressed to FSA-regulated asset managers, for whom it is a mandatory requirement to disclose publicly a statement detailing the extent to which they comply with that code. The UK Stewardship Code is designed to be complementary to the FRC’s UK Corporate Governance Code, which is directed at uK-listed companies. The UK Stewardship Code has seven underlying principles, which are indicated in Table 2, and operates on a “comply or explain” basis.

however, the FRC strongly encourages all institutional shareholders, including asset owners such as pension schemes, to issue a compliance (or non-compliance) statement.

There is currently a growth in the introduction of such codes, particularly in Europe. Within Europe, additional principles-based codes have been introduced by the European Fund Asset Management Association (EFAMA) and the dutch Corporate Governance Forum, Eumedion.

•The EFAMA Code for External Governance – The EFAMA Code for External Governance (The EFAMA Code) is directed at European asset managers and provides a best practice framework for asset managers to engage with investee companies. The EFAMA Code is based on six key principles.

•Best Practices for Engaged Share-Ownership – Best Practices for Engaged Share-Ownership (The Dutch Code) was introduced to the dutch market in 2011 by Eumedion. The Dutch Code comprises 10 principles with a focus on stewardship activities with dutch companies and applies to dutch institutional investors and investment managers.

pension scheme trustees have a duty to act in the best long-term interests of their beneficiaries. there is a growing view among academics and investment professionals that environmental, social and corporate governance (eSG) issues can affect the short- and long-term performance of institutional investment portfolios. pension scheme trustees, in complying with their fiduciary (or equivalent) responsibilities, therefore need to give appropriate and due consideration to these issues as a core part of their deliberations.

6 OECd, 2009, The Corporate Governance Lessons from the Financial Crisis (www.oecd.org/dataoecd/32/1/42229620.pdf)

7 FRC, The uK Stewardship Code (http://www.frc.org.uk/corporate/investorgovernance.cfm)

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Mercer is proud to be the first investment consultant to sign up to The UK Stewardship Code and within the first 18 months, over 230 investment managers, asset owners and service providers have also signed.8

We would note that it is still early days in the objective to improve engagement and Mercer believes that it is important for pension scheme trustees (both for defined benefit and defined contribution schemes) to monitor and assess their investment managers’ compliance with The UK Stewardship Code (and other regional codes) and consider issuing a statement of compliance as an asset owner, where appropriate. Pension scheme trustees in the uK should also ensure that their scheme’s Statement of investment Principles (SiP) is updated to reflect the introduction of The UK Stewardship Code and the changes to the UK Corporate Governance Code as appropriate.

table 2: key principles for each Code

Key principlesuK

CodeEFAMA

Codedutch Code

Policy outlining how stewardship responsibilities will be discharged ✔ ✔ ✔

Robust policy on managing conflicts of interest in relation to stewardship ✔ ✘ ✔*

Monitoring of investee companies ✔ ✔ ✔

Establishing clear guidelines on escalating engagement activities ✔ ✔ ✔

Willingness to act collectively with other investors ✔ ✔ ✔

Clear policy on voting and disclosure of voting activity ✔ ✔ ✔

Reporting periodically on stewardship and voting activities ✔ ✔ ✔

Casting informed votes on all the shares they hold at the general meeting of these investee companies**

✘ ✘ ✔

not borrowing shares solely for the purpose of exercising voting rights on these shares**

✘ ✘ ✔

* The 10 principles that comprise the dutch Code include two principles focused on the management of conflicts of interest.

** Principles are encouraged within the uK Stewardship Code and the EFAMA Code as a matter of best practice; however, the dutch Code explicitly details these as mandatory requirements.

8 FRC, december 2011, developments in Corporate Governance 2011 (http://www.frc.org.uk/images/uploaded/documents/developments%20in%20Corporate%20Governance%2020116.pdf)

Please ask your consultant if you would like additional information on stewardship and corporate governance.

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neWS and publiCationS

On 7 March 2012 we shall be hosting our annual Mercer Walk in Edinburgh. The walk coincides with the nAPF investment Conference. We would be delighted if you would join us at the South hall, Edinburgh university, from 9:30 am for a light breakfast followed by a leisurely walk up Arthur’s seat, ending with lunch.

ThE SECOnd PORTuGuESE inVESTMEnT SYMPOSiuM – 9 MARCh 2012 Following last year’s inaugural Portuguese investment Symposium, we take great pleasure in announcing that we will be hosting a second investment Symposium on 9 March 2012, in Lisbon. Gathering local and foreign asset managers, pension sponsors, foundations and other institutional investors, Mercer has designed this event to provide relevant, practical ideas and insights that will help our clients manage their investments through these uncertain times.

CAPiTAL PuniShMEnT – RECEnT dEVELOPMEnTS AFFECTinG EuROPEAn FinAnCiAL inSTiTuTiOnS’ PEnSiOn ARRAnGEMEnTS This recent publication considers in detail the recent developments affecting European financial institutions’ pension arrangements and how they can be met in the current economic environment. The publication:

•Outlines tighter capital adequacy and financial reporting standards to protect customers

•demonstrates to the capital markets that equity capital promises attractive returns and that debt capital is secure

in the latest edition of our Perspectives on Bond Investments, we highlight a variety of investments and challenges that investors face in the world of bonds and fixed income.

•Alternate universes: high-quality and short-duration high yield universes•EM corporate credit: The new “new” thing•Eurozone sovereign debt: A silver lining but no silver bullet•understanding the uS inflation-linked market

You can download this edition and other editions in the Perspectives Series – Perspectives on Alternatives, Equities or Real Estate at http://www.mercer.com/boutiqueperspectives or contact your consultant for more information.

merCer Walkif you would like to attend, please contact irene Callinan at irene.callinan@mercer.com.

portuGueSe SympoSiumPlease contact nuno Silva at nuno.silva@mercer.com if you are interested in attending.

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REGISTER NOWThe theme for Mercer’s 2012 Global Investment Forums is Let’s Not Lose the Decade – Stepping Up to the Investment Challenge, allowing us to bring to the fore discussions on sound investment principles and practices necessary in constructing portfolios that can withstand or even profit from the coming period. Steering a successful course through the economic and investment minefields ahead will require skill and diligence.

The Forums will highlight fundamental principles of diversification, capital preservation, inflation hedging, risk management, the use of scale and efficient application of active management and will explore other positive actions that may be pursued to grasp opportunities and constrain risks.

Forum agendas are tailored so that attendees come away with practical knowledge and information that will help them achieve their investment and risk management objectives. Senior Mercer investment professionals, institutional investors, plan sponsors, investment managers and other members of the industry also get the opportunity to interact informally, network and build new relationships or strengthen existing ones.

We look forward to seeing you there.

Registration is now open. Please visit our website at www.mercer.com/investmentforums2012 for more details.

Please contact the following individuals with any questions you may have.10107-IC

Tokyo29 March

Sydney2–3 April

Washington DC 21–22 June

London4–5 September

Mercer’s Global Investment Forums is a Mercer Signature Event. www.mercersignatureevents.com

You should be aware that the receipt of revenue from an investment manager will not result in any preferential treatment by Mercer when evaluating or recommending managers, their affiliates, products or strategies. Mercer is limiting places to two attendees per investment manager, per Forum.

Global Package Managers and Washington DCMaura Cozza +1 201 284 6126maura.cozza@mercer.com

Sydney and LondonIsabel Carrasqueira+44 (0)20 7178 3378 isabel.carrasqueira@mercer.com

TokyoAlison Smith+44 (0)20 7178 3164 alison.smith@mercer.com

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Copyright 2012 Mercer LLC. All rights reserved. 10351-IC

For further information, please contact your local Mercer office or visit our website at:www.mercer.com.