2016 Global Investment - ETicaNews · 2016-05-18 · Global Investment Matters 2016 While...

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MattersGlobal Investment

2016

1 Global Investment Matters 2016

16 Response to the low-return environment One of the key elements of our medium- to long-term capital market outlook over the past year has been a view that returns will likely be low in absolute terms, due to a combination of low risk-free rates and elevated asset valuations.

By Jeff Chee

23 Debunking the outsourced CIO mythsThe six most common misconceptions and why we should challenge them.

By Pieter Steyn

26 Don’t get ESG?Asset owners and asset managers are being expected to raise their game in sustainable investing – but what does that mean in practice?

By Jane Welsh

32 Thematic investing in an era of uncertaintyThe job of the asset owner has become progressively more difficult over time as uncertainty has increased in the investment world. We should continue to develop, implement and refine strategies to operate within this changing environment.

By Michael Garcia

2 Introduction from Chris Ford Thoughts from Chris Ford, Global Head of Investment.

4 What is a DC pension without insurance? The ultimate success of a pension plan can only be determined when the member and their dependants have passed away.

By Nico Aspinall

8 Innovation and diversity in investmentWe believe the end saver has been underserved by the investment industry in a number of areas over the years. One such area is the cost of diversifying a portfolio, meaning not just fees and terms, but whether the funds and products available actually meet the investor’s needs.

By Matt Roberts

12 Building bridges Governments are under pressure to produce more compelling investment cases for their infrastructure projects.

By Duncan Hale

38 Investment by numbersKey facts and figures from Willis Towers Watson’s 2015 surveys.

40 Global warming – what does Paris mean for institutional investors?Nico Aspinall explores the implications of the Paris climate agreement for institutional investors and how the investment industry might need to evolve to deal with these issues.

By Nico Aspinall

44 Using ‘big data’ techniques to improve manager research – just a buzzword or buzzworthy?Big data is not just a buzzword that can sometimes help other industries; we are starting to use its technologies to improve our research on asset managers.

By Robin Penfold

50 Sovereign wealth funds – perspective from AsiaSovereign wealth funds (SWFs) have grown in prominence in Asia, but they face slower growth and consolidation, questions over their identity and purpose, and fundamental process issues.

By Peter Ryan-Kane

56 The best of Willis Towers WatsonHighlights from 2015.

58 Global newsKey highlights from around the world.

Contents2016

2 willistowerswatson.com

IntroductionBy Chris Ford

However, in many parts of the world, especially the larger markets, there has been a certain adjustment to the prevailing macro conditions resulting in an economic equilibrium of sorts, although there remain several factors – such as oil prices, the US dollar, Chinese growth and shaky European institutions – which threaten a disruptive end to this economic and market cycle. In the past few years, risky asset prices have continued to weaken, as have economic fundamentals, meaning we still expect low, volatile and negatively skewed asset returns in the next five years. As a result, investors need to have a cautious approach to portfolio risk, especially the many exposed to downside risks.

2016 started with highly volatile conditions and continued with some material rises and falls in asset values, reflecting the uncertainty around global growth and exacerbated by geopolitical challenges.


While investment returns are down and risk is up, global institutional pension fund assets have continued to grow slowly, reaching US$35.4 trillion by the end of 2015 according to our Global Pension Assets Study. These assets have now grown at 5% on average per annum since 2005, when they were just in excess of US$21 trillion, but it is now widely acknowledged that this level of growth is not enough to ensure future obligations are met. While strategies to deal with elevated risk from the persistent economic uncertainty, mainly through various forms of diversification, have gained momentum and are helping somewhat, the more than decade-long search for returns persists.

Against this backdrop, we have written articles for this year’s Global Investment Matters which shed more light on these issues, including investment innovation and diversity, which explores whether the funds and products available to the end saver actually meet their needs, particularly in terms of offering them a suitably diversified portfolio. We also look at some of the myths surrounding the outsourced CIO model, which now – having been used by numerous funds around the world for over a decade – can be shown to have been very effective at risk and liability management as well as at garnering upper-quartile returns.

On the theme of returns, we explore why governments are under pressure to produce more compelling investment cases for their infrastructure projects. The ongoing febrile nature of global capital markets has prompted us to revisit thematic investing and suggest ways to mitigate their uncertainty, in the context of the overall difficult task facing asset owners.

In this issue, we include an article on sustainability and ESG to reflect the increased consideration of these integral investment components, and describe what we believe they mean in practice for asset owners and managers. We conclude with an article on the increasing prominence of sovereign wealth funds in Asia and the reasons behind their success.

We hope you find this year’s Global Investment Matters thought-provoking and look forward to engaging with you on these and other issues.


What is a DC pension without insurance?By Nico Aspinall

The ultimate success of a pension plan can only be determined when the member and their dependants have passed away. That may sound bleak, but it is only when a household no longer needs to draw upon their pension that we can see whether it provided sufficient protection against the absence of employment income to sustain the quality of life expected and desired.


Insurance and the pooling of risk in defined benefit (DB) pensions protected many individuals from outliving their savings. Under many defined contribution (DC) systems around the world, the historical practice has been not to enforce annuitisation in retirement, allowing individuals to choose between insurance and investment approaches and the risk of running out of money. The failure of DC systems to protect individuals has seen the sentiment turning in both Australia and the US towards annuities. At the same time, the UK has recently torn up its annuity compulsion regime and has enabled full freedom and choice in retirement.

So what chance does DC have of delivering a successful pension on this basis? Moving on from the engagement problems with DC design for now, let us look at what a perfectly rational person investing alone would have to do to succeed in their pension plan, without the possibility of purchasing insurance or pooling risks between other individuals. We will divide what this individual would do into three phases by age.


In the first phase, the individual must estimate some sort of level of income that they need or want from a pension and use that to work out a funding plan, the combination of contributions and returns in the pot from which they will start withdrawing. During their working life they convert their human capital into income through employment and use it partly to build up savings and investments over time. There are risks to their human capital in that they can die, lose their job and so on, but as their savings are lower, the only way to manage these risks is through insurance outside of pension savings, provided either through the State, the employer or by personal insurance. Their main job during this phase is to adjust their funding plan to changes in human capital and returns on their savings.

Secondly, they must decide how and when to start drawing on their savings and phasing down work. This phase can be much more extended and complex given the ability to mix work, savings and pension withdrawals, but essentially represents the phase where human capital is no longer used up in pursuit of income. By the end of this phase all spending must be sourced from their savings. Assessing when this period lands is the concept behind our FiT Age analytics. With this tool we can show employers the range of potential retirement dates for their staff, and discuss with individuals how they can plan for retirement and change their FiT Age.

If the third phase includes the final reckoning of success, the individual saver must plan for their spending and bequest needs and savings to coincide at a zero balance when they die. This is mostly impossible: either the individual overspends when younger and experiences relative poverty when older, or the individual underspends relative to their actual means during retirement and leaves behind a larger bequest than they planned. Without any insurance an individual would have to be extraordinarily lucky, or indeed unusually skilled, to get this right and not suffer a lower quality of life in retirement than might be considered optimal.


So in retirement, can investment design alone improve the optimality of an individual’s ability to succeed in pension planning? It seems to get us a part of the way, but not all the way. Investments that offer a pool of returns uncorrelated to spending risk, and which match the level of investment risk to the level of spending risk, could, on average, compensate for spending risk. However, each individual member will experience one level of success – each under or overspending to a different value before they die.

Better investment designs post-retirement should look to narrow the distributions of potential experience, bringing in the extreme cases and increasing the numbers getting closer to success. But to do this we would need a series of investment returns that were correlated with the expected needs of the individual; that is, increasing in value exactly when expected needs go up. Only a fully correlated return could fully compensate for the specific harms that befall a particular individual and close in on success for everyone in retirement.

Currently, there are no investment products that offer an individual such a high level of correlation to their own circumstances. It is possible these could be developed, a derivative could perhaps, in principle, be written against member events, but only insurance can currently protect against spending risk at present. However, insurance also currently offers homogenous products badly tailored to the specific needs of an individual, meaning that spending patterns are managed more to the features of the product rather than the other way around. Both investment and insurance could benefit from innovation to offer a finer tailoring to member needs and improve the outcomes delivered to DC members.

Investments that offer a pool of uncorrelated returns to spending risk with a matching level of investment risk could, on average, compensate for spending risk.


Innovation and diversity in investmentBy Matt Roberts

We believe the end saver has been underserved by the investment industry in a number of areas over the years. One such area is the cost of diversifying a portfolio, meaning not just fees and terms, but whether the funds and products available actually meet the investor’s needs. One of the ways to address these issues is to innovate new products by engaging with fund managers. New products here means products with the fees and terms that the end saver deserves, or where the product is simply better designed to provide the solution the end saver needs.


The diversity challenge

Few would argue with the theory that diversification should lead to a more efficient portfolio and better investment outcomes. However, the practical challenges associated with achieving true diversity can be significant. Our clients raise these issues with us regularly:

GovernanceThe need to hire and monitor multiple managers across different investment disciplines in addition to the complexity associated with some alternative investment strategies.

LegitimacyThe question of whether new ideas will really help when it matters.

Alignment and costsThe higher costs associated with alternative investments, in particular hedge funds and private equity strategies. Also whether sufficient transparency is offered and whether there is any potential mismatch between the dealing terms of the strategy and the objectives of the investor.

Regulation and implementationThe concern that some of these ideas might not fit well with new regulation (for example, the charge cap for DC pension plans and Solvency II for insurers). Or, it could be that the liquidity offered simply does not match what intermediaries require.

So, what can be done? It is hard to see how any of the points can be definitively solved, so it is perhaps more a question of doing everything we can before asking the question again.

GovernanceInvestors have two main options:

�� Develop significant in-house resource and processes.

�� Outsource to an expert third party to manage part or all of the investor’s portfolio.

LegitimacyFor all of the new ideas we propose, we try to ensure that each idea will be beneficial to our investors’ portfolios. The process can also be critical in helping us innovate, as it is this detailed research that enables us to answer the question: ‘Can we improve on what is currently available in the market?’

Alignment and costsThis is all about the right sort of negotiation. We have many examples of successful negotiations across asset classes and it is a key part of our process.

Regulation and implementationWe have to work within the regulations as required, but this does not prevent us from having the right to speak our mind if we think they are slightly off the mark.


There is always more to do. We have made huge strides across equity, credit and diversifying strategies to improve the investment opportunities for our clients, but there are still some sizeable pockets of the investment industry left to work on.

Innovative solutions can address these challenges

What has the industry done to tackle these issues? Multi-asset funds – diversified growth, risk parity, absolute return, and so on. If you test these solutions against the above issues, they go some way to overcoming them (particularly the governance and regulatory points). To this end, they have been a marginal positive for the investment industry, but there is more that can be done through innovation. We have two major tools at our disposal that put us in a good position to innovate: human capital and bargaining power. Our research resources mean that we are well-positioned to engage fund managers to develop new strategies or carve-outs from existing strategies, and our bargaining power means we can negotiate great fees and terms for our clients.

Figure 1. Our tools help us innovate

Carve-outs from existing strategies

Negotiation on fees and terms for

existing strategies

Brand new strategies

Our team and skills Our bargaining power


Brand new strategiesDeveloping brand new strategies is challenging but opportunities do emerge over time as markets evolve. For example, reinsurance has been an established part of capital markets for years, but it was not investable as an asset class. We worked with a number of reinsurance providers on implementable solutions so that our clients could gain access to this really interesting and diversified asset class. Similarly, the global financial crisis led to banks being far less able to offer credit, which in turn has created a whole new range of alternative credit strategies becoming available, offering investors the opportunity to provide the lending that banks no longer can. Our credit research team has been at the forefront of this theme, identifying the best opportunities for our clients to participate in.

Carve-outs Fund managers become tougher to negotiate with when pooled funds become larger. It could be that they have most favoured nation clauses with their existing clients or that they have plenty of interest from other investors, which means that they are less willing to part with valuable capacity at a lower price. Hence, working with a manager to carve out an interesting component or a selection of different components can present very good opportunities for negotiation. The volatility premium, carry, value and merger arbitrage strategies could all be viewed as carve-outs from existing strategies. Some of the work we are doing in niche co-investments in private markets could also be seen as part of this category. Carving out also gives us the opportunity to input on any design features of the product that we believe should be altered to suit our clients better.

Straight negotiation From time to time, we are presented with good opportunities to negotiate better fees and terms for our clients. This could be after a period of underperformance or a result of a lot of demand from our clients. We have done this successfully for many years across many different strategies and we aim to continue to do so in the future.

What does the future hold?There is always more to do. We have made huge strides across equity, credit and diversifying strategies to improve the investment opportunities for our clients, but there are still some sizeable pockets of the investment industry left to work on. Distressed debt and private equity are two areas where there is even more we could do to improve outcomes; making more investment solutions available to DC investors is another big, and as yet unsolved, challenge in many regions. Our goal is to continue to innovate ourselves and encourage innovation within the asset management industry so that, collectively, we are able to meet the needs of savers going forward.


Building bridgesBy Duncan Hale

Governments are under pressure to produce more compelling investment cases for their infrastructure projects.


Governments across the globe are looking for ways to plug their infrastructure gap. As they grow, developing economies are looking to build out their infrastructure to improve the services provided to citizens and companies. Meanwhile, many developed economies seek to refresh their current stock of infrastructure to ensure that services remain at acceptable levels. In both cases, the build out or refreshment of infrastructure typically requires an injection of private capital to finance projects, and this offers opportunities for institutional investors.

In our experience, there is a strong interest in financing infrastructure projects only when an asset has a robust and proven funding structure. To explain what we mean by this, an asset is initially bought or sold using financing, which generally includes a mixture of debt and equity. Funding, on the other hand, is the income that an asset produces over its life cycle, and can come from the public purse – such as government contracts or direct payments – and from the private sector. Funding can be a combination of public and private payments. If an asset has a credible funding structure and it is clear how an asset will pay for itself, investors will want to own or lend to it.


Let us look at how this tension between financing and funding can be resolved through the prism of infrastructure developments in three countries: Australia, the Philippines and the UK.

Australian states ride recycling wave

It is widely argued that the infrastructure gap in many Australian cities and regions has now widened to critical levels due to the inability of state and federal governments to fund new investments amid rising fiscal deficits and public debt levels, and a reluctance or inability to levy new taxes. In addition, there is no well-defined co-funding model between federal and state governments, leading to disputes over who will pay for new projects.

However, the Australian federal government’s recent asset recycling initiative has been a positive step forward. It encourages states to sell existing infrastructure assets and recycle the proceeds into new projects. States have taken up the challenge, with New South Wales, Queensland and Victoria in particular privatising established port and electricity distribution assets over the past four years.

The government has implored Australian superannuation funds to support these privatisations and the funds have responded either directly, through direct participation in bidding consortia, or indirectly through investment in Australian infrastructure commingled funds. The competitive tender process instituted by the states has also provided opportunities for overseas investors to participate. The open, transparent and professional processes used to divest these established assets, which tend to have robust funding, has led to strong receipts from the privatisations. These are now being funnelled into new investments.

The fragmented approaches by governments in sourcing finance and funding infrastructure represent a challenge for institutional investors.


Partnership approach in the Philippines

The Philippines has employed a different approach, aware that its status as a developing market means finding financing for domestic projects is more challenging. Supported by the Ministry of Finance, one of the largest institutional investors in the country, the state-run Government Service Insurance System (GSIS), has teamed up with a foreign private sector entity (Macquarie Bank) to create the Philippines Investment Alliance for Infrastructure (PINAI).

GSIS was the cornerstone investor, providing about two-thirds of the US$550 million raised for PINAI, but the initiative could only work by sourcing financing from outside the Philippines – from the Asian Development Bank and the Dutch pension fund manager APG – and by employing external investment skills from Macquarie. The combination of public and private expertise has been critical in developing funding mechanisms that are fit for purpose.

It is a relatively small programme that will not plug the Philippines’ infrastructure gap on its own, but it can serve as a model for future infrastructure projects in both the Philippines and beyond. It demonstrates that external skills allied to effective co-operation between the public and private sectors can help to close the gap between funding and finance. This gap is often wider in developing markets.

Not only is PINAI now looking to deploy further capital, but a number of foreign capital and service infrastructure providers now view the Philippines as a bona fide destination for investment.

UK attempts to aggregate demand

While the UK is the envy of many other countries in its ability to attract financing for existing projects, in recent times the UK government has struggled with its initiatives to encourage institutional capital to assist in the financing of new-build infrastructure to meet the requirements of its National Infrastructure Plan.

One of the challenges is that the UK institutional capital markets are more fragmented than the successful infrastructure financing centres of Australia, Canada and North Asia. The UK government has looked at ways of aggregating capital and creating scale, such as encouraging or compelling pension funds or insurance companies to act collectively to invest in infrastructure. But these approaches have not been a big success, mainly because the funding solutions for many of the assets within the National Infrastructure Plan are unclear; the government’s approach of encouraging collective action has been to try to find a financing solution to what is essentially a funding issue.

Nevertheless, a few high-profile projects, such as the Hinkley Point C nuclear reactor and the Thames Tideway Tunnel project, have been successful in attracting finance from institutional investors. The key to the success of these projects is that they have clear funding models and risk-sharing mechanisms.

Funding first, finance follows

The three approaches described here represent just a fraction of the infrastructure models employed across the globe. The fragmented approaches by governments in sourcing finance and funding infrastructure represent a challenge for institutional investors. With each approach so idiosyncratic and each outcome equally differentiated, investors struggle to appraise the value of each. This challenge has been identified by the G20, which is trying to address it through the creation of its Global Infrastructure Hub (GIH). The GIH works with the infrastructure delivery bodies of both G20 members and other governments to facilitate investment by sharing skills and knowledge.

The solution, however, cannot lie solely with supranational intervention. The onus is firmly on public sector entities looking to raise finance from institutional investors to create robust and transparent funding mechanisms. Those that do are likely to see significant future investment from investors worldwide.


Response to the low-return environmentBy Jeff Chee


One of the key elements of our medium- to long-term capital market outlook over the past year has been a view that returns will likely be ‘low’ in absolute terms, due to a combination of low risk-free rates and elevated asset valuations.

While this is now a relatively consensus view and expectations for low returns have become entrenched in the mindset of most institutional investors, the implications of low returns for an extended period of time differ from investor to investor. In addition, although views regarding future returns are similar across a range of investors, expectations for the prevailing level of risk (particularly downside risk) are quite varied.

As a result, the appropriate response to the current environment will be different (potentially significantly) for different investors. Here we provide an overview of the factors that we believe should influence an investor’s response to the current environment, as well as a global perspective on what actions our clients have taken to date.


A quick review of 2015

Looking at returns across the major asset classes over 2015 (Figure 1), we can see that after several years of strong returns across all asset classes, the thesis of low returns has indeed played out over the past 12 months.

The return of volatility to capital markets following an extended period of calm was also evident, with all asset classes suffering meaningful drawdowns over the course of the year. What is important to note is that the sorts of falls observed over the year are ‘only’ equivalent to around one standard deviation move based on normalised estimates of volatility.

Therefore, material further falls are possible and, in our view, are in fact relatively likely due to the fragility of the global economy and capital markets. As communicated in our Five-year capital market outlook 2016, we assign a material probability (around 400%) to some sort of downside scenario unfolding over the next five years.

Total returns over 2015 Full year Peak to trough

US equities 1.4% -12.0%

European equities 7.3% -19.2%

UK equities 1.3% -14.2%

Japanese equities 12.1% -18.0%

Australian equities 4.2% -15.1%

Global equities (USD) -0.3% -13.7%

EM equities (USD) -14.7% -26.6%

US 7-10 year government bonds

1.6% -4.9%

German 7-10 year government bonds

0.9% -5.8%

UK 7-10 year government bonds

0.7% -5.4%

Japanese 7-10 year government bonds

1.3% -2.1%

Australian 7-10 year government bonds

2.7% -5.1%

Global 7-10 year government bonds (USD, hedged)

1.8% -4.0%

Global IG credit (USD, hedged)

-0.2% -3.7%

Global HY credit (USD, hedged)

-2.0% -7.4%

EM debt (hard currency) 1.8% -5.2%

Figure 1. 2015 returns across the major asset classes

Source: Bloomberg LP, Willis Towers Watson

What is important to note is that the sorts of falls observed over the year are ‘only’ equivalent to around one standard deviation move based on normalised estimates of volatility.


Mission and other high-level settings remain key

The starting point for our investment process is to consider an investor’s mission and then examine all investment decisions through a lens of assessing whether they are accumulative to the likelihood of mission success and other high-level settings, including an investor’s beliefs. A similar approach can be taken when considering how an investor should respond to a prolonged period of low expected returns. High-level factors that we believe should impact the response to a period of low expected returns include:

�� Time horizon – a longer time horizon allows an investor more flexibility to continue to operate its existing strategy through the current period and/or to ‘ride out’ the impact of downside events.

�� Ability to withstand downside risk – investors with a larger ‘cushion’ above key downside thresholds will have greater tolerance for tail risks and can potentially afford to remain at full risk; conversely, those with a narrow margin will have an incentive to take steps to reduce the impact of adverse market outcomes.

�� Mission versus objectives – most investors focus on their investment objectives, which are an articulation of their investment mission but may not capture all of the non-investment ‘levers’ that can be used to drive mission success.

�� Governance and resource – as always, the extent of internal investment capability will affect whether certain options are feasible or not for an investor.

20 willistowerswatson.com20 willistowerswatson.com

Investor response

Broadly speaking, the potential investor responses to a period of low returns can be grouped into two categories – those that focus on non-investment issues and those that look at ways the portfolio can be modified in order to improve the chance of mission success.

Non-investment responses Investment responses

�� Retain current investment strategy but understand and communicate implications

�� Reduce return objectives/targets (or equivalent)

�� Increase funding (or equivalent)

�� Reduce investment costs

�� Reduce level of investment risk

�� Increase level of investment risk

�� Add downside protection strategies

�� Change portfolio construction

�� Increase use of active strategies

Figure 2. Investor responses

Looking across our global client base, most investors have chosen to retain their current investment strategy whilst also assessing and communicating the implications of the return outlook to key stakeholders, with only a minority of investors adjusting their portfolio-level risk settings. Alongside this, clients have typically reduced investment or other objectives and have also looked to adjust the risk allocations within their portfolios, particularly to reduce dependency on equity risk.

Clients have typically reduced investment or other objectives and have also looked to adjust the risk allocations within their portfolios, particularly to reduce dependency on equity risk.


We discuss some anecdotal evidence from clients across different regions below.

EuropeThe European (including the UK) client base is predominantly made up of defined benefit (DB) pension schemes whose missions are defined in terms of their ability to fund benefit payments. Recent market movements have resulted in a deterioration in funding positions, which limits the scope to reduce investment risk at present. In addition, recognition of the risk of mission impairment meant that a reasonable proportion of our clients, in UK clients particularly, already had downside protection strategies in place and had neither the appetite nor the time horizon to take on a greater degree of investment risk.

Other trends amongst these clients have been revisiting allocations to credit, including moving into more illiquid and ‘higher octane’ strategies. In addition, our European endowment clients have looked to reduce their spending rates in line with lower expectations for future returns. Some clients have started to look at reducing investment costs – over the next year, we expect clients to continue to focus on this as well as revisiting their funding plans in light of lower expected return assumptions.

USIn the US, the response to the low-return outlook over the past 12 months has been limited for a number of reasons, including:

�� Regulatory forbearance for DB schemes, which means that contribution requirements for most schemes will be muted over the short term.

�� Compensation at the corporate level being linked to accounting outcomes that are improved by retaining higher-risk portfolios, which in turn have higher expected returns and result in lower measured pension costs.

�� The home bias of US schemes combined with the recent strength of US asset classes and the US dollar (relative to other major markets).

As a result, US clients have largely retained their existing strategies and focused on reducing costs; however, the current inertia is showing signs of fading and clients are starting to look at diversifying their equity-heavy portfolios.


AustraliaIn Australia, the majority of our institutional clients are DC superannuation funds offering a range of risk-graded investment options. As a result, the scope for materially adjusting the level of risk is limited as individual members have effectively bought into a particular risk profile. In addition, the highly competitive landscape means that many schemes have already negotiated hard on manager fees, meaning that the scope to reduce fees further without significantly simplifying strategies is limited.

However, the individual nature of savings means that simple, clear communication of the implications of lower returns on projected retirement outcomes is essential so that members can adjust their settings accordingly. Most funds have also chosen to lower their return objectives in order to set out a more realistic expectation for members. A small number of more sophisticated clients have also added downside protection strategies, ranging from increasing currency exposure through to option protection.

Over the coming year, we will be working with clients to help articulate and quantify the impact of the non-investment ‘levers’ that are in the control of their members and can (to a greater extent than changes to investment strategy) help improve retirement outcomes.

AsiaThe Asian client base is highly diverse, ranging from DB pension plans to endowments and also a number of large sovereign funds. As the Asian economies and capital markets are usually (but not in all cases) less sophisticated than developed markets, so too are the portfolios typically employed and internal teams are generally relatively small. Investors in this market have often been reluctant to reduce risk as this will reduce the probability of reaching their return targets, but they have also not sought to increase risk in recognition of downside risks.

As a result, the focus has been on ensuring that clients have the correct strategic risk settings and then understanding the gap between their objectives and likely return outcomes. A relatively small proportion of clients have shown some interest in both increasing the level of diversification in their portfolios to reduce concentration of macro risks, as well as increasing the use of active strategies in their portfolios.

Conclusion

In summary, the response of clients to the low-return environment has been measured to date, with most investors focusing on reviewing their strategic settings and ensuring that their objectives remain appropriate and achievable; a small, but meaningful, proportion have been looking to adjust the risk allocation within their portfolios. With this process having been completed, we expect more actions to be taken over the following year, particularly:

�� Increasing the input side of the equation – whether this be sponsor funding for a DB scheme, member contributions in a DC scheme or other input variable.

�� Adding downside protection to portfolios, catalysed by the return of volatility in the second half of 2015 combined with market movements in early 2016.

�� Further work on reducing investment costs/improving value for money.

The response of clients to the low-return environment has been measured to date, with most investors focusing on reviewing their strategic settings and ensuring that their objectives remain appropriate and achievable.


For schemes that do not have in-house capabilities, the Outsourced CIO (OCIO) model is a means of filling the gap between the resources required to run efficient investment strategies and the typically constrained governance budget of a pension plan. The OCIO (also known as a fiduciary manager) implements an investment strategy within boundaries set by the trustees, allowing high-level decision-makers more time to focus on key strategic issues and long-term scheme goals.

The concept is fairly simple, but the implementation can be less easy to visualise. For this reason a number of myths have arisen around the OCIO. Let us take a look at what we believe to be the six biggest myths and examine how much substance they actually carry.

Debunking the outsourced CIO mythsBy Pieter Steyn

The six most common misconceptions and why we should challenge them.


Myth 1: OCIO is expensive

It is understandable that this criticism is levelled at the OCIO model. After all, plans are asked to spend more money on a service that was previously a relatively small part of the annual budget. But in aggregate, across the scheme, employing an OCIO does not mean costs rise, and they often fall. Why? Because an OCIO commands the scale and has developed the partnerships to source investment management and other services more cheaply than plans can do alone. In addition – and most importantly – outcomes for plan sponsors and members often improve as a result of professional risk and return management.

Myth 2: OCIO outperformance has been lucky

Outcomes experienced by pension schemes that have hired OCIOs have been markedly better than those that have not. Comparative data over the past seven-year period shows funding outcomes of OCIO schemes in the UK very substantially outperforming the average scheme and also displaying much lower funding level volatility. Some pensions industry participants argue that the OCIO schemes got lucky because they hedged liabilities – principally interest rate risk – just as yields slumped. As a result, the growth portfolio has served to improve their funding levels rather than offset losses in hedging portfolios. Is this really luck? Certainly OCIO schemes hedged liabilities at just the right time, but they also considered a range of risks that schemes face across their life cycles and interest rate risk was just one of them. The OCIO schemes have undergone a professional risk management process and identified interest rate risk as one of many risks that needed addressing. It is interesting to note that while liability hedging techniques such as swaps or specialist LDI funds have been widely available for a number of years, many schemes have yet to adopt them.

Myth 3: OCIO is only for small schemes

If that were true, not as many multi-billion dollar schemes in the UK and US would have an OCIO model. The model is less about size and more about how feasible it is to build sustainable in-house resource to cope with the considerable demands of institutional portfolio management. Sometimes resource is allocated from the sponsor’s finance function. Although this can appear a natural fit at first glance, many corporates have discovered that finance professionals are not always best suited to assessing risks within an investment environment. In addition, finance functions today are often shared services, so allocating individuals to the pension scheme can leave the function short of resource. Of course, the very largest schemes do have the option of developing an in-house team and some have exercised this option. But for most other schemes, the OCIO is likely to improve their investment governance and outcomes.

Myth 4: OCIO is a new and untested concept

While the terms OCIO and fiduciary management are relatively new, the ideas that underlie them are not. A multi-asset approach to managing pension fund portfolios is nothing new. However, across the industry the multi-asset approach is often implemented through a range of specialist mandates. This is unwieldy as it requires a high level of governance on the part of the plan. In the outsourced model, governance is considerably strengthened and mandates can be reallocated in good time to take advantage of changing market opportunities. In the UK and the Netherlands, fiduciary management has been a feature of the pensions landscape for more than a decade, and outcomes have been demonstrably strong – particularly in volatile market conditions.


Myth 5: OCIO is a conflicted model

Critics argue that OCIOs are conflicted because they profit from their position as both advisor and investment implementer, but there is surely a distinction to be made between incentives and skewed incentives. A good service will always command a fee. In the OCIO model, schemes may pay a service fee and, perhaps, a performance fee too. OCIOs will only retain these mandates if they perform, so plans can be fairly confident that OCIOs will try their best to deliver the desired outcome for the plan and its members. If the perception of a conflict persists, this is not necessarily a reason to jettison a service that is potentially highly beneficial to the plan – this turns a win-win situation into a lose-lose one. Potential conflicts of interest exist in every walk of life and can often be managed with a little thought. In the case of the OCIO model, there are a number of intermediaries – professional services firms and individuals with the specialist skills to understand the products, the incentives and the potential conflicts – that can help with assessment and benchmarking.

Myth 6: OCIO leads to loss of control

A concern among some sponsors and trustees is that if you hand some of your decision-making to a specialist, you are no longer in control of your plan and of potential investment outcomes. However, delegating investment does not mean giving up. Trustees still control the objectives and the constraints within which the delegate operates, such as which asset classes are selected, potentially the hedge ratio, cost budgets and liquidity. If circumstances or needs change, trustees and plan sponsors still have the power to change the objectives and the constraints to which the delegate is working. In addition, the trustee or plan sponsor is fully responsible for the oversight of investment activities. Importantly, the time freed up allows focus on what really matters: funding, overall risk, stakeholder equity, conflict management and all the other activities that help keep members happy.


Don’t get ESG?By Jane Welsh

Asset owners and asset managers are being expected to raise their game on sustainable investing – but what does that mean in practice?


Are asset managers and asset owners switched on to sustainability? The benefits to the portfolio of incorporating environmental, social and governance (ESG) factors are not recognised by all. But we know for sure that many of the ultimate beneficiaries – pension fund members as well as charities and endowments – are very switched on to sustainability and have strong feelings about the subject.

There are many reasons why ESG is not mainstream, but the most significant seems to be one of understanding. In a poll at a Willis Towers Watson conference in February 2016, an audience of asset managers was asked what it would take for sustainable investment to be placed at the heart of portfolio construction. The number one response, by far, was ‘Greater clarity over what sustainable investment means’.

0% 2% 4% 6% 8% 10% 12% 14%

More production from asset managers

Trustee fiduciary duty in this area is clarified

Costs involved come down

Consultants encourage asset owners to do more

Beneficiaries gain a greater voice in investment strategy

Corporates take a bigger interest in this aspect of their pension funds

Greater clarity over what sustainable investment means

Asset owners’ time horizons lengthen8

12

1

0

0

0

2

7

Source: Bloomberg LP, Willis Towers Watson

Figure 1. 2015 returns across the major asset classes


No simple, catch-all definition

In fairness, the concept of sustainable investment is not clear-cut. This is an obstacle both to investor adoption and to asset managers’ ability to construct and articulate ESG strategies.

In broad terms, it starts with consideration of the financial impacts of ESG risks and opportunities. At a minimum, that means ensuring that asset managers consider ESG risks when selecting investments and building portfolios. It can also mean skewing the portfolio towards companies that rate highly on ESG criteria in the belief that these factors are not fully reflected in current prices. In addition, it can involve targeted thematic investments, for example investing in green energy on the basis that markets are not fully recognising the opportunity presented by the shift to a low-carbon economy. The definition for some investors can go beyond that to considering the broader societal impact of investment strategies – after all, there is little point in ensuring that pensioners have sufficient wealth in their latter years if the planet is no longer fit for human habitation. While this is not a widely held viewpoint today, an increasing number of ‘universal owners’ do appear to be taking this approach.

Whatever approach is taken, it needs to be underpinned by effective stewardship of the assets. Through effective voting policies and engagement, asset managers can influence companies to raise their game and manage their businesses more sustainably.

Impact on risk and return

Perhaps the most controversial aspect for investors is whether to accept that a focus on long-termism and sustainability entails preparedness to forego current gains for better future outcomes.

In another Willis Towers Watson survey, conducted in advance of the conference, we asked asset managers how they viewed the potential trade-off between financial returns and societal impact:

�� More than 30% said they take account of the societal impact of investment strategies and do not just focus on financial returns.

�� 11% of respondents are prepared to contemplate a limited degree of negative impact on returns to address broader societal goals.

Through effective voting policies and engagement, asset managers can influence companies to raise their game and manage their businesses more sustainably.

The issue of whether sustainability means sacrificing returns at all is divisive. Although early studies indicated that the inclusion of ESG factors created (slight) underperformance, a growing body of evidence suggests their incorporation can help the portfolio match or enhance returns from non-ESG portfolios, but it is not clear-cut and often implies that ‘G’ or governance is the key factor explaining superior results. Other studies have shown that company engagement can lead to superior risk-adjusted returns, which again suggests that good governance is an important factor.


Perhaps the most controversial aspect for investors is whether to accept that a focus on long-termism and sustainability entails preparedness to forego current gains for better future outcomes.


Integrating sustainability into the portfolio

So how can consideration of ESG be integrated into the portfolio? In our view, it is not just about simplistically screening out stocks, nor is it a tick-box approach to voting on company proxies. It is not about a single issue such as climate change; though climate change is clearly a very important issue and the world’s response to it will be significant for all investors, it is not the only risk to focus on when building a portfolio. We also think that the debate about ESG integration needs to be extended to asset classes beyond public equities. We are seeing an increasing number of green bond strategies emerging and recognise the work being done in the real estate industry to factor in increasing flood risks and greater demands for energy efficiency. But perhaps the thinking needs to be extended to more mainstream corporate bond portfolios and alternatives. Finally, we believe that the ESG perspective is not separate from the rest of the investment strategy – it must be integrated with other aspects of investment thinking.

Investors first need to determine their beliefs and this includes their beliefs about sustainable investment. Investment committees, trustee boards and even pension fund members should reflect on what their beliefs are and then develop policies that help ensure those beliefs are reflected in actions at the portfolio level. This could be a simple statement that the investor expects its asset managers to factor ESG risks into their investment decisions (ESG integration), or it could go further and actively target strategies that tilt towards companies with good ESG credentials or that give exposure to assets that will benefit from long-term trends in ESG factors.

Having set out their beliefs, investors will want to ensure that these are reflected in long-term strategy decisions. It is increasingly important to factor long-term themes or trends into risk and return assumptions for assets. We are doing more work on factoring in the impact of climate change and demographic changes into our secular outlook.

We have been factoring sustainable investment thinking into our private markets investment strategies for a number of years and began targeted monitoring of the active ownership credentials of asset managers about seven years ago. Going forward we will be doing this more systematically and focusing on the product level as well as the firm level in our analysis. In addition, the leading asset managers that are members of Willis Towers Watson’s Thinking Ahead Institute, which aims to change investment for the better, have determined that sustainable investment should be a key research priority for 2016.

Investors first need to determine their beliefs and this includes their beliefs about sustainable investment.


Time to rise to the challenge

Asset managers are realising that the tide is turning. Our view is that, in the future, sustainable practices are going to be a prerequisite for being hired to manage investment mandates. Asset owners will want to understand the risks they are running with respect to these long-term themes, both at a portfolio level and at an overall strategy level. And this understanding of risks will not be confined to equity portfolios.

In addition, asset owners will look to collaborate with other entities to ensure that they use their collective voice to effect positive change, and they will want to be transparent in doing so.

The whole of the investment industry needs to rise to this challenge. More and more, clients are demanding it – they are under pressure from their members, their sponsors, from regulators and from industry entities, as well as from the increasing body of evidence showing that ESG risks are rising and need to be understood and managed better.


Thematic investing in an era of uncertaintyBy Michael Garcia

The job of the asset owner has become progressively more difficult over time as uncertainty has increased in the investment world. We should continue to develop, implement and refine strategies to operate within this changing environment.


Times of uncertainty

Certainty is a scarce luxury, yet it is one that we constantly seek.

We comb through data, build models, establish hypotheses and generate theories in an attempt to transform the unknown into the known. We like predictability: it is part of the human condition and we build our institutions (political, legal and even corporate) to provide us with it.

However, uncertainty is the fluid nature of reality. If you accept that the world (geology, climate, societies, economies, markets and so on) is complex and continually adapting, then uncertainty just ‘is’. More than ever, we are seeing how this uncertainty is increasingly taxing on our clients who, as investors, are compelled to adapt to a new and ever-changing investment landscape.

Yet instead of fearing uncertainty, we believe uncertainty should be embraced.

The role of thematic investing

At its core, thematic investing is a forward-looking investment process that focuses on long-term patterns. It is about explicitly forming a view of the future, developing deep, sophisticated beliefs and positioning to benefit from long-term transformations and trends.

While thematic investing is not the only strategy that can successfully operate within an uncertain world, we do believe it serves as one means of enhancing an asset owner’s ability to identify opportunities and assess risks within an uncertain environment.

From our perspective, any level of investment analysis rarely possesses definitive evidence about every aspect of influence on a market and/or asset – almost all analysis entails uncertainty of some kind. However, one element that we often speak about is the long-horizon aspect related to the changing nature of uncertainty (assigning probabilities to outcomes and ultimately to the pricing of assets). While in reality precise probabilities around future events (forecasting) are usually not possible to construct, probabilities can be used as an illustrative device for thinking about uncertainty and how that uncertainty will evolve.

Probabilities can be used as an illustrative device for thinking about uncertainty and how that uncertainty will evolve.


Thematic investing is not purposed to eliminate uncertainty, but rather the goal is to assess it. Its analytic foundations are grounded in identifying the major secular forces influencing the market environment, assessing a range of plausible futures and outcomes, and determining the probabilities related to future payoff scenarios.

We would contend that a large component of uncertainty is directly linked to difference in beliefs; those beliefs materially affect the structural pricing of assets. Whilst traditional analysis often focuses on either near-term likelihoods or consequences, thematic investing requires the judging of both, over multiple horizons.

In a sense, thematic investing is a process that attempts to ‘future-proof’ a portfolio.

While the trend is fundamentally long-term in nature, it is not necessary to confine implementation of the theme to only long-term-oriented strategies and/or investment teams.

Implementing a thematic programme

Although the definition of a ‘theme’ will always be subject to interpretation, we believe that a theme is a long-term trend that affects the price stability of a group of assets. Thematic investing is a dynamic process that is capable of employing a multitude of investment styles, asset classes and strategies purposed to exploit long-term trends.

While the trend is fundamentally long-term in nature, it is not necessary to confine implementation of the theme to only long-term-oriented strategies and/or investment teams. By taking a systemic view of the theme and gaining clarity on interrelations and interdependencies (analysing first, second and third order impacts over 5, 10 and 20-year horizons), an organisation is better suited to exploit the full spectrum of thematic opportunities across durations. This view differs significantly from the approach of many investors, who view thematic investing as an equity-centric, buy-and-hold strategy focused on identifying the next ‘big thing’ or breakthrough idea.

As an example of thematic investing, a widely accepted demographic trend is ageing – people are living for longer than they used to. However, the gulf between what investors speak about and what investors invest in remains enormous.


However, while focusing upon long-term trends intuitively makes sense for a long-horizon investor, we find that only a select number of asset owners are truly acting upon it due to a number of constraints. Organisational settings and governance are overwhelmingly influential in determining the attractiveness and ultimate success of a thematic investing programme.

Broadly speaking, successful and sustainable implementation of thematic investing requires a long-term-oriented and supportive organisational culture and executive leadership team, who are less concerned with immediate payoffs/outcomes and/or relative performance (based upon an index or multiple comparators).

So, is thematic investing solely reserved for the very largest asset owners? Can traditional asset owners take advantage of thematic investing? We believe they can.

While thematic investing may appear best suited to internal programmes with thematic thinking integrated into an organisation’s culture, internal programmes are not the only way to leverage the merits of thematic investing. Broadly, thematic investing at an institutional level can also be implemented effectively through embedded partnering (where an asset owner works closely with an asset manager or intermediary to access select products and/or services) and external management (where the asset owner appoints an external partner/manager to execute its thematic investing strategy or a portion thereof).

If we think about many Asian countries, the proportion of ageing individuals in the population is growing significantly. This has a wide-ranging influence across the healthcare, financial services and consumer sectors. Within this context, an investor could explore a broad spectrum of opportunities spanning:

1. Public equities – Chinese and/or multinational pharmaceuticals, insurance, technology, medical devices and distributors

2. Real estate – elderly care facilities and senior residential housing

3. Private equity – hospitals, clinics, doctors/nurse staffing and insurance

4. Private credit – pharmaceutical corporate debt, pharmaceutical financing and medical device restructurings

5. Venture capital – biotechnology (diagnosis, molecules, therapy, treatments and delivery), telemedicine and remote monitoring

6. Infrastructure – distribution centres, logistics and transportation

Organisational settings and governance are overwhelmingly influential in determining the attractiveness and ultimate success of a thematic investing programme.


Those investors that are able to take a long-term view, whilst avoiding mission impairment in the short term, have a competitive edge over others.


Helping our clients to think and act thematically

It remains to be seen how the era of uncertainty will evolve and impose challenges and pressures upon asset owners. What does seem clear though is that the market appears to be under-incentivised to focus on the long term (instead choosing to focus on short-term price changes) and that asset owners that are willing to take a longer-term view could be well-positioned to be compensated.

While it is difficult to be overly prescriptive regarding a single investment process that is best suited to operate within this transforming environment, thematic investing offers significant merits that investors should consider as they look for strategic direction.

With this in mind, Willis Towers Watson has worked to develop a broad range of thematic advisory and investment management expertise to help our clients navigate the era of uncertainty. Each offering is highly focused, attuned to serve the specific needs of our clients and rooted in a common belief: those investors that are able to take a long-term view, whilst avoiding mission impairment in the short term, have a competitive edge over others.

Thematic offerings include:

�� Thematic programme development

�� Thematic advisory (theme development and idea sourcing)

�� Delegated investment services

�� Fund solutions (multi-theme, multi-manager portfolios)

�� Organisational change (investment process and organisational design)

�� Risk assessment

�� Strategic asset allocation

�� Investment manager selection

We understand that creating a process that can play an active role in navigating an uncertain environment is neither quick nor easy—but it is possible and effective. The biggest obstacles to creating a robust thematic investing programme are not technical. The challenge lies in shifting focus from short-term execution to long-term strategic thinking.

We believe that with the right organisational mindset and governance, thematic investing can help provide leadership in an era of uncertainty.

Since 2004, passive assets managed by the largest managers have grown by

almost

13% annually

for the top 500 managers as a whole

compared to around

5% annually


Investment by numbers

According to Willis Towers Watson’s 2016 Global Pension Assets Study, Global institutional pension fund assets in 19 major markets weighed in at $35.4 trillion at year end 2015. The asset values crabbed sideways in 2015 being up during the early part of the year and down a little by the end of the year. Global pension fund assets have now grown at 5% on average per annum (in USD) since 2005, when they were just in excess of US$21 trillion.

The study highlights six areas of significant change: the move in pension design towards DC, the demands on investment talent, the internal focus to the pension funds’ value chain, governance improvements, increased risk management focus, and the increased consideration of sustainability and ESG. The study also shows that defined contribution (DC) assets

Figures are based on results from: The World’s 500 Largest Asset Managers, The World’s 300 Largest Pension Funds, Global Pensions Asset Study 2014 and Alternative Assets 2014.

grew rapidly for the ten-year period to 2015. As a result, DC pension assets now represent over 48% of global pension assets.

The study confirms a number of trends in pension fund investment strategy. Allocations to alternative assets – especially real estate and to a lesser extent hedge funds, private equity and commodities – in the larger markets have grown from 5% to 24% since 1995. The study also confirms the increased globalisation in equities. During the past ten years US pension plans have maintained the highest bias to domestic equities (63% in 2015). Canadian and Swiss funds remain the markets with the lowest allocation to domestic equities (25% and 35% respectively in 2015) while UK exposure to domestic equities has more than halved, to 35%, since 1998.

Assets managed by the world’s largest 500 fund managers grew by over

2%

Assets managed by the world’s largest 500 fund managers reached a record

US$ 78.1 trillion


Total assets of the world’s largest 300 pension funds reached a new high of over

Global institutional pension fund assets in the 19 major markets reached

US$35.4 trillion

Total global alternative assets under management hit

US$6.3 trillion

US$ 15

trillion

Pension fund assets

US$1.1 trillion

Endowments and foundationsUS$84 billion

Insurance companies

US$296 billion

Banks

US$128 billion

Fund of funds

US$116 billion

Sovereign wealth funds

US$192 billion

Wealth managers

US$652 billion

33%

8%5%

2%3%

19%

4%

Allocations to alternative assets, especially real estate and to a lesser extent hedge funds, private equity and commodities, for the main pensions markets grew to 24% from 5% in 1995

24%5%

23%

22%

10%

6%

4% 3%

33%

33% Real estate (over US$1.1 trillion) 23% Hedge funds (US$791 billion) 22% Private equity funds (US$767 billion) 10% Private equity fund of funds (US$342 billion) 6% Funds of hedge funds (US$219 billion) 4% Infrastructure (US$149 billion) 3% Illiquid credit (US$98 billion)

Over US$1 trillion

23%

22%

10%

6%

4% 3%

33%

33% Real estate (over US$1.1 trillion) 23% Hedge funds (US$791 billion) 22% Private equity funds (US$767 billion) 10% Private equity fund of funds (US$342 billion) 6% Funds of hedge funds (US$219 billion) 4% Infrastructure (US$149 billion) 3% Illiquid credit (US$98 billion)

Over US$1 trillion

Top 100 alternative investment managers by share of assets. Real estate managers hold around one-third of all alternative assets.

Note: Proportions may not sum up to 100% due to rounding.

One-third of all alternative assets belong to pension funds

Top 100 alternative managers’ assets by investor type


Global warming – what does Paris mean for institutional investors?By Nico Aspinall


Nico chairs the Resource and Environment Board of the Institute and Faculty of Actuaries, the actuarial professional body in the UK. This Board has the mandate of making resource and environmental issues mainstream in the actuarial profession and providing actuarial support for work in new fields relating to climate change, transition and adaptation.

The agreement in Paris in December last year made history: 194 nations came together to make a series of agreements around the science and need for action on climate change. These are worth paraphrasing and reiterating here:

�� There is a consensus that carbon dioxide emitted by most forms of economic activity creates climate change – a warming of the planet.

�� Without action, there is a significant risk that the effects of climate change will be severely damaging and potentially even terminal for the human species.

�� Even with action, some warming of the planet is inevitable, but there is reasonable consensus that a target of warming by 2°C would limit the very worst effects of climate change and should maintain a biosphere in which humans might live.

�� Action on carbon dioxide emissions should be to reduce net emissions over time to zero.

Nico Aspinall explores the implications of the Paris climate agreement for institutional investors and how the investment industry might need to evolve to deal with these issues.


While many have resisted these points and would present the science behind them as being debatable, Paris is seen as marking the end of this debate at an international level.

Nevertheless, scratching beneath the surface of the agreement we find vagueness. Is the intended target of maximum warming from pre-industrial levels 1.5°C or 2°C? What policies will be involved in implementing and potentially enforcing the dramatic reduction in carbon dioxide emissions needed? Ahead of the Paris conference, each country submitted Intended Nationally Determined Contributions (INDCs – non-binding commitments to reduce emissions) which, even if achieved, appear unlikely to be sufficient to meet a 2°C goal and, indeed, are not binding. While the rostrum rhetoric has been that mankind has come together to achieve something unique in Paris, the devil still lurks in the absence of realism and detail.

Most obviously absent from the Paris agreement is detail around the role of the private sector in reducing emissions. In the Western world, the majority of carbon dioxide emissions are created in the private sector. Without successful engagement between policymakers and the corporate world, the prospects of limiting warming to 2°C appear slim. There remain material risks around the desire and ability of governments to enforce realistic reduction obligations on their private sectors, given that these can be presented as reducing their competitiveness.


What policies should be expected?

So, what should the private sector expect to see from governments around the world as they seek to close the gap between their policies and the rhetoric? The first major area of policy is to limit carbon dioxide emissions and provoke the needed transition to a low-carbon economy. The most likely policy routes chosen by governments are cap and trade emissions permit systems. Cap and trade has been tried and failed in the past (notably in Europe) so some reform of the implementation is likely, but it is seen as presenting the simplest route to reduce emissions. To work effectively, these systems require greater transparency of the emissions created by each participant in every supply chain, and so the short-term action is likely to be to produce a common disclosure regime of carbon dioxide emissions across the global economy. It is vital that this is holistic so that all stages of the global supply chain can be captured and limit the temptation for corporations to cheat the system, for instance by moving production to low-transparency regimes. A G20 task force has been launched, headed by the Governor of the Bank of England, with just this intent. It will report back at the end of 2016.

The second major area of policy will be to reduce the exposure in each economy to the effects of climate change itself, both on the basis of financial costs and quality of living. Extensive research is being undertaken to try to understand the likely impacts of climate change and this divides into the two broad areas:

�� Mitigation – reducing the impact

�� Adaptation – accommodating the change

Climate change is an extensive topic so the research is incredibly varied, covering the effects of sea level rise on infrastructure, how rainfall and drought patterns change, food security, disease patterns and healthcare systems, among many others. The policy choices between mitigation

and adaptation will vary depending on the region under consideration, the degree of severity of climate change that has been taken into account, and the relative roles of the public and private sectors. Undoubtedly more will be done by governments in this area in future years, though in the short term this may not be far-reaching.

Do institutional investors need to act?

Institutional investors do not need to believe in climate change as an inevitability to act. They need to note that governments have committed to acting on climate change and that scientists are flagging significant uncertainty in what climate change will mean. Taken together, this means that their investments may be exposed to a risk that needs to be managed and potentially profited from.

Recently, a number of climate change commentators have been talking about stranded assets (meaning the ownership of capital that cannot be recovered due to changing market tastes or government action). Historic examples include buggy whip, steam engine and whalebone corset manufacturers. The recent discussion has highlighted holdings of fossil fuel-producing companies, with the narrative that they are inevitably overvalued if governments impose restrictions that make their reserves unburnable.

Determining whether an asset is valued fairly or not is a subjective process, particularly when it comes to pricing in changes to government policy. However, it does appear that as a result of Paris some action will be taken to restrict emissions of carbon dioxide, even if the pathway of that action is unclear. Holdings of fossil fuel companies will at some stage represent the economy of the past, so the need to review them is clear.

More widely though, we believe that climate change should be increasingly seen by long-term shareholders as both a risk and an opportunity in the assessment of the ownership and value of a company. Forward-thinking companies will seek to manage their exposure to climate change, mitigating its effects and adapting to the new world. This improves their resilience to climate impacts, reduces the likelihood that they become a stranded asset and potentially opens up new commercial opportunities.

The world needs institutional capital to protect itself from the adverse effects of carbon on our atmosphere and oceans. Paris will be seen as a watershed moment in the case to invest in the economy of the 21st century in full view of the transformational changes ahead.

Holdings of fossil fuel companies will at some stage represent the economy of the past, so the need to review them is clear.

Institutional investors do not need to believe in climate change as an inevitability to act. They need to note that governments have committed to acting.


You may have noticed a new term lately: big data. Like many buzzwords, it conveys a useful concept that has no clear definition, as it has been socialised too quickly. But make no mistake: big data is not just for use in other industries – we are starting to use its technologies to improve our research on asset managers.

Using ‘big data’ techniques to improve manager research – just a buzzword or buzzworthy?By Robin Penfold


In this article, we will explain what we are doing by answering three questions:

�� What are machine learning techniques?

�� How can we use them in manager research?

�� How will this shape the future of our manager research?

Asset owners have different needs from manager research, which requires us to meet multiple goals. Having reflected upon these goals, we thought about the best ways to exceed them. One way was to use the ‘machine learning’ techniques from big data.

What are machine learning techniques?

These techniques let computers improve their performance on a specific task, just by undertaking it more often. The tasks (and the underlying techniques) vary enormously, but include:

�� Predicting house prices (like Zillow and Zoopla)

�� Recommending other products for you to buy, given your previous purchases (like Amazon and Netflix)

�� Driving a car (like Google and Tesla).

Diagnosing breast cancer is another example. In this case, scientists have created an automated pathologist that uses advanced image processing to find to more than 6,000 quantitative aspects of breast cancer tissue that could predict prognosis1. Using many samples, machine learning calculations then found a subset of these features that were associated with samples from patients who had died sooner.

The good news, though, is that the features that were the best predictors of patient survival were not from the cancer itself but were from the adjacent tissue. So, rather than looking at just the cancer, as was the prevailing norm, the software found new factors to consider when understanding the biological aspects of cancer tissue. At the very least, scientists hope to improve cancer diagnosis, leading to faster treatment for those who need it most.

Machine learning techniques let computers improve their performance on a specific task, just by undertaking it more often.


How can we use machine learning techniques in manager research?

When you think about researching asset managers, you might not think of cancer diagnosis. But consider the parallels. The automated pathologist assesses the image features of the cancer and its surrounding tissue to see if the patient in question requires treatment. Manager researchers gather a mass of data about an asset manager before using their experience to judge whether it merits inclusion in your portfolio. Both approaches use features to assess a task. Both do a better job with more experience. And both do so by following a particular process.

For that reason, we will use the analogy of an automated pathologist to describe a machine learning approach that we are developing for manager research. Called ProductPrioritiser, this approach combines our formal (FREX) rating of an investment product with an array of data that we store about it.

And, just as an automated cancer pathologist uses features – like the structure of a cell’s nucleus or the presence of mitosis tissue – so does ProductPrioritiser. Its features, though, focus on what might drive the future returns of an investment product.

To illustrate these possible features, we have produced Figure 1. For the purposes of this paper, we based it upon a random subset of the long-only equity products that we follow.

Let us consider what this chart means, starting at the top-left plot. Each dot represents a different product. We then compare our formal rating of that product against the experience of its lead investor.

What do we find? Well, no top-rated product has a lead investor with under 18 years of investment experience (in other words there are no dots with an x-axis of under 18 years and a y-axis of 1). Furthermore, the typical relationship – as shown by the best-fit line – is upward sloping from left to right (except for the two graphs in the third column). This tendency makes sense, as we would generally expect better investment decisions from more experienced lead investors.

Taken together, these plots show that we prefer long-only equity products with:

�� Higher tracking errors2

�� Lower portfolio turnover

�� Lower fees and costs for the portfolio

�� Greater importance of the product to the asset manager.

ProductPrioritiser’s features focus on what might drive an investment product’s future returns.

We have shown six of the features that could be used to see if an investment product will tend to have high future return expectations. Unlike the automated pathologist, we do not have thousands of image-related features to build our model’s experience. However, we have assigned a formal research rating to a large number of investment products, each of which has hundreds of associated features in our proprietary database. Armed with this data, we are working to build a robust and predictive ProductPrioritiser model that will develop an experience of what our manager research analysts typically prefer when assigning a product with our highest formal rating. We can then use this model to project a preliminary rating for a previously unrated product, using data that we can find relatively quickly and cheaply. With less effort, the thinking goes, we could learn a lot of information about the product’s rating, just by leveraging what we already know about similar products.


1

0

1

0

0.40.0 0.6 0.8 1.0 0.0 0.25 0.50 0.75 1.0 0.5 1.0

2.00.0 3.0 4.0 5.0 2.5 5.0 7.5 10.0 0.5 1.0 1.5

Share of firmʼs assets in product

Experience of lead investor Tracking errors Portfolio turnover

Active share Firmʼs expected share of alpha

Figure 1. Comparing our FREX ratings against six key product features

The ones and zeroes on the vertical axis denote the investment product’s formal rating – ‘top-rated’ and ‘not top-rated’ respectively.


When it comes to manager research, we think that machine learning techniques justify their current buzz.


How can machine learning shape the future of manager research?

In addition to the uses above, we want ProductPrioritiser to improve how we:

�� Project provisional ratings for products that we have already rated formally — Doing so will sensibly challenge our existing formal ratings and so improve them.

�� Improve the clarity and consistency of our documentation about a product — Let us assume that three senior analysts have just left XYZ Partners, one of your asset managers. Today, typical reporting would tell you that the average tenure of the product’s analysts has fallen from, say, twelve years to five years. By using ProductPrioritiser, though, we aim to show you how our preliminary view has changed, given these departures.

Big data techniques in manager research: Just a buzzword or are they buzzworthy?

When it comes to manager research, we think that machine learning techniques justify their current buzz. That is why we are committing sizeable resources to apply these techniques, which should help us to meet our manager research goals more effectively.

1. For a good overview of this study, see https://med.stanford.edu/news/all-news/2011/11/stanford-team-trains-computer-to-evaluate-breast-cancer.html

2. This finding likely reflects our previous thinking in this area – specifically, the paper by Robin Penfold and Craig Baker in 2012, entitled ‘Concentrated equity products: Why we generally prefer them to diversified products’.


Sovereign wealth funds – Perspective from AsiaBy Peter Ryan-Kane

Sovereign wealth funds (SWFs) have grown in prominence in Asia, but they face slower growth and consolidation, questions over their identity and purpose, and fundamental process issues.


In their pure form, SWFs are investment funds owned and controlled by a sovereign state acting to preserve or enhance residual financial assets. They are an irrevocable store of the wealth of a nation, not deferred savings schemes.

The wealth of a nation comprises many aspects: its people, capital, physical endowments, heritage and accumulated financial assets. Net wealth should subtract all obligations, domestic and foreign, current and future.

Many funds are not true SWFs – for instance, Australia’s Future Fund was set up to meet future benefits to civil servants, so it exists for a specific group of individuals rather than the state itself. Its assets are not the unencumbered property of the State.

By contrast, China’s, Korea’s and Singapore’s Investment Corporations are pools of sovereign assets that the State has an unambiguous claim and title to: True SWFs.

In some cases net national wealth is held at the central bank, and there is a discussion to be had as to whether that wealth could be held, managed and set a different mission, separate from the central banking mission.

These distinctions are likely to become more pertinent as an era of rapid growth draws to a close, putting additional pressure on State resources and calling for greater introspection and analysis of each fund’s mission, management and purpose.

We expect much greater focus on income and capital growth needs and a more honest discussion of intergenerational considerations (which will vary widely). In future, it will be the spending rules that will embody the financial and risk frameworks for these funds, much more so than is the case today.


Timing is critical. Some countries in the region have missed the opportunity to establish or expand an SWF and should proactively look for the next opportunity.


Source: World Bank

Figure 1. Fuel as a percentage of total exports

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20

40

60

80

100

SWF countries – non-Asia

SWF countries – non-Asia Non-SWF countries

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Imperial progress

It was the Asian financial crisis of the 1990s that sowed the seeds of collective state investment in the region through national pension and provident systems. Economies were exposed for being too dependent on short-term foreign borrowing and struggled to meet those debts as their currencies crashed. Although not SWFs themselves, these systems captured income that would otherwise have been spent and deferred it on behalf of the population.

Many asset managers established beachheads in Asia in the early 2000s, particularly in Hong Kong and Singapore, to capture the asset flow from provident funds and national savings systems and subsequently SWFs, and this has now spread to local management and product development in many Asian countries.

Fatal delays

Timing is critical. Some countries in the region have missed the opportunity to establish or expand a SWF and should proactively look for the next opportunity. We would argue that Australia is a prime example of a country that missed an opportunity to create a SWF that would have preserved the assets of the nation as it sold its mineral resources to China over an extended period, and, indeed, perhaps the wealth illusion of the Future Fund inhibited that capture.

Broadly, the circumstances that give rise to the ability of a nation to set up a SWF are where national income runs above national production or output for a period, resulting in a build-up of foreign reserves, which can be either recycled into the economy – often leading to real asset inflation and money illusion (sometimes called Dutch disease) – or preserved.

Excess income arises from the sale of exogenous natural resources, competitive advantages from lower labour costs or foreign aid, all of which are temporary. There is a legitimate discussion to be had around the extent of intergenerational ownership of the income, which will vary case to case.

Interestingly, having energy as a major part of your exports is not a prerequisite for having a SWF, as the chart below shows. Clearly, almost without exception, major energy exporters do have SWFs, but for many countries – particularly in Asia – SWFs have been set up where energy is not a major export, if at all. This reflects a sensible realisation that the factors creating net sovereign wealth are temporary, and should be taken advantage of when they occur.

We see opportunities for Cambodia, Indonesia, the Philippines, Thailand and others.


Looking ahead

Through a combination of narrowing competitiveness, slower global trade and fiscal pressures, we expect a period of consolidation, introspection and maturing of SWFs – and a welcome opportunity for improvements in the sometimes dysfunctional way in which these funds are managed.

We expect to see greater divergence in strategy and approach, most likely hastened by outcomes from the next cyclical slowdown, that will reveal structural exposures to illiquidity, credit, complexity and other factors that may not be fit for purpose but have been pursued in the search for yield.

It is plausible that as funds pursue more complex structures or assets, they may seek to outsource these, but perhaps to some kind of intermediary agency rather than entirely to the private sector. In an environment of modest returns, facilitative, less exploitative, trustworthy and transparent structures will be ever more important. This might assist with governance, accountability and stakeholder buy-in.

Certainly, in today’s world of modest return, a more sophisticated and clear-sighted conversation about the management, purpose, strategy and the very identity of many SWFs needs to begin soon.

It is plausible that, as funds pursue more complex structures or assets they may seek to outsource these, but perhaps to some kind of intermediary agency rather than entirely to the private sector.


Something that might help

Most of the funds in the region have been managed ‘bottom up’, driven by a need to deploy capital and diversify. Often there is not a ready reconciliation between the investment assets and the purpose and risk tolerance of the fund (typically only discovered in times of stress).

An exercise that starts with the current portfolio and investment process and works back up to higher-level goals is something we have found to be very effective in helping funds bridge these gaps. The exercise is an inclusive one, gathering a wide range of inputs from various parts of the investment process and articulating and reconciling those against the fund’s purpose. Funds we have done this with develop a clearer strategy and capacity roadmap, sense of purpose and focused list of action items.


1. Secular Outlook 2015The objective of our Secular Outlook (now known as the Five-year capital market outlook) publications is to assess the prospects for asset returns and risks over the next five years. Whilst we have our own views on these, which we set out towards the end of the report, we recognise that the historically unusual starting point we find ourselves in means a) history is a less reliable guide than usual, and b) one’s beliefs and mental model of the world become even more important.

2. Ignoring the herdMany UK institutional investors benchmark their UK property portfolio against a form of the Investment Property Databank (IPD) Index. This Index is dominated by three main property sectors – retail, office and industrial. We believe that investors could be more wide-ranging in their consideration of property sectors and less driven by the Index and peers in order to achieve a better portfolio and to take advantage of key thematic trends. In particular, data from the US highlights that alternative property sectors have outperformed traditional property sectors by more than 2% per annum over the long term.

3. Conflicts of interest and agency issuesAs soon as any agent is employed, there is the potential for conflicts. Conflicts of interest arise where an agent benefits at the expense of a client – this would ultimately be a breach of fiduciary duty. However, a recommendation that results in an additional fee to that agent does not automatically introduce a conflict if that action is also in the interests of the end beneficiaries.

4. Redefining DC pension scheme defaultsAchieving mission clarity is an important first step in managing the risks in a DC pension scheme. Defining the DC mission has always been complex, requiring the need to combine the range of potentially incompatible objectives of different stakeholders. At retirement, each benefit type (lump sum, annuity or drawdown) will be chosen by significant proportions of the membership in any scheme, so in future we expect DC schemes will offer managed investment options tailored to meet the needs of these different groups of members.

The best of Willis Towers Watson Highlights of 2015

Global Investment Committee

Secular Outlook 2015

1

Ignoring the herd Efficient sector allocations

within UK property

2

Confl icts of interest and agency issues

Perspectives

3

Redesigning DC defaults The mission is redefined

4


5. The future investment landscapeThis handy compendium covers: Challenges facing the world’s biggest funds – Is in-house management the future for large asset owners? – Ubiquitous and adaptive investing: The aspiration of a truly global fund – The in-house investment team: Right people, roles and rewards – The investment model for asset owners: Is there a best-practice version?

6. A new perspective on equity portfolio constructionThe world of ‘alternative investments’ has enjoyed a meteoric rise as institutional investors sought to diversify their assets in a low-return environment. As some of these investment strategies have become more established, and complexity has risen in many traditional strategies, it is reasonable to ask ‘Just how alternative are alternative investments?’. We believe the conventional asset class boxes used by much of the industry are becoming less relevant and can actually lead to suboptimal implementation of investment strategies. While investors have typically divided their asset portfolios into ‘equity’, ‘fixed income’ and ‘alternatives’, we argue that focusing instead on the underlying beliefs and drivers of return is a better way to approach portfolio construction. We will explore this idea with the example of a typical equity portfolio.

7. De-risking in the current environmentInvestors should be preparing for a turn in the economic cycle and thinking about how they can reduce risk, particularly given the strong recent performance and increasingly stretched valuations within equities. This paper sets out the economic scenario we believe is creating the need to take action now and provides case studies of how clients have addressed this. Over the years, we have talked about a number of ‘levers’ that can be used to reduce risk effectively. But what are they, are they right for you and how confident can we be that they will be effective in the next crisis?

8. VistaA newsletter providing investment-related updates for Asia Pacific, such as evolutionary changes in investment, investment events and consultant opinions.

The future investment landscape Big questions for big asset owners

November 2014 towerswatson.com

These articles were first published on top1000funds.com

5

A new perspective on equity

portfolio construction

Issue at hand

The world of ‘alternative investments’ has enjoyed a meteoric rise as institutional investors sought to diversify their assets in a low-return environment. As some of these investment strategies have become more established, and complexity has risen in many traditional strategies, it is reasonable to ask “just how alternative are alternative investments?”. We believe the conventional asset class boxes used by much of the industry are becoming less relevant and can actually lead to sub-optimal implementation of investment strategies. While investors have typically divided their asset portfolios into ‘equity’, ‘fi xed income’ and ‘alternatives’, we argue that focusing instead on the underlying beliefs and drivers of return is a better way to approach portfolio construction. We will explore this idea with the example of a typical equity portfolio.

A ‘risk premium’ framework

In the simplest terms, investors expect to earn a return above a risk free rate for taking on risk. We refer to this as a ‘risk premium’. For example the equity risk premium (ERP) or credit risk premium compensates investors for bearing different forms of uncertainty around future cash-fl ows. There is an illiquidity premium compensating investors for locking up their capital for longer periods of time. Also important is what we call a ‘skill’ premium. This is the concept that some return (positive or negative) can be driven by active manager skill. This skill should be evident above any systematic style or factor premiums that can be relatively easily captured at low cost, such as a value premium or a trend following premium. These latter factors are often referenced as smart betas.

“...just how alternative are

alternative investments?”

6

Over the years, we have talked about a number of ‘levers’ that can be used to reduce risk effectively. But what are they, are they right for you and how confident can we be that they will be effective in the next crisis?

What de-risking levers are available?Most pension funds’ asset risk is dominated by equities. There are five key levers to de-risk given this context:

• Diversification out of equities and into other asset classes and/or greater diversification within equities. This also gives us greater access to ‘alpha’ or manager skill and potentially the illiquidity premium

• Increasing liability hedging (interest rate, inflation, currency and longevity)

• Investment in global aggregate bonds • Overlaying the portfolio with equity or bond options • ‘Extreme risk hedges’, for example physical allocations to gold, safe haven currencies, long-dated US treasuries.

Large reductions in risk may require the use of most of these levers, but for smaller levels of risk reduction, an investor can pick and choose from the menu. For example, to reduce risk by (say) 10% an investor could either switch into cash, do more liability hedging, diversify or use options.

In addition, there are a number of structural risk management levers that can be employed:

• Better implementation, for example the use of smart beta, a more focused use of active management, illiquid assets and dynamic management

• Liability management, for example DB to DC transfers and DB annuity purchases. By shrinking the size of the pension scheme, the size of the risk is similarly reduced.

Investors should be preparing for a turn in the economic cycle and thinking about how they can reduce risk, particularly given the strong recent performance and increasingly stretched valuations within equities. This paper sets out the economic scenario we believe is creating the need to take action now and provides case studies of how clients have addressed this.

De-risking in the current environment

7

towerswatson.com

Changes Are Taking Place This edition of Vista provides you with updates on evolutionary changes in Towers Watson’s investment mission, process and internal structures. We outline why we need to change and how we go about creating the change.

These changes should enable us to remain relevant in the investment industry, continuing our mission of Changing Investment for the Better through being more dynamic in helping our clients capture the very best opportunities from all asset classes and geographies.

We have looked at how we organise ourselves to deliver this mission. A large part of our resources are devoted to research, ideas generation and portfolio construction. The following areas are covered in the first article of this edition.

Five-step investment process: We havespent some time ensuring that we canexplain all of our thinking in a simpleframework.

Portfolio construction: We have evolved thestructure of our resources to better reflecthow we think about portfolio construction.

Manager research evolution: We haveevolved the manager research teamstructure to fit more neatly with the portfolioconstruction step of the investment process.

Towers Watson has been offering delegated solutions including fund solutions to clients in EMEA and the United States. In the Viewpoints section, we talk about Towers Watson Investment Management, which is the UK-based portfolio management group behind our fund solutions — an extension of our existing delivery model.

Other regular sections highlight what has been going on with our investment advisory teams and clients across the Asia-Pacific region.

Enjoy this Vista!

Naomi Denning Managing Director Investment Services, Asia Pacific

“Life does not get better by chance. It gets better by change.”

Jim Rohn

Vista Volume 07 | Investment Services | August 2015

In this issue

2 Evolutionary Changes in Investment

8 Viewpoints: The Driving Force behind Towers Watson’s Fund Solutions

10 Mandate Chat: What Are Funds Doing?

11 Spotlight: What Are We Doing?

12 Consultants Talk: Where We Spoke

14 Towers Watson Papers

8


Australia

Following a period of significant legislative change, the Australian superannuation industry enjoyed a relatively quiet year on the regulatory front in 2015. This enabled funds to sharpen their focus on product design, with particular emphasis on protecting against investment, inflation and longevity risk in retirement.

Australian superannuation funds typically set their investment return objectives as consumer price inflation (CPI) plus a margin. In the current low-return environment, the likelihood of achieving these inflation-relative objectives over the next 5-10 years has reduced materially, in some cases to below 50%. As a result, in 2015 many funds reviewed both their investment strategies and their objectives and a significant number have chosen to reduce their long-term return objectives.

Looking ahead, as the fiscal positions of Australia’s Commonwealth and State governments continue to deteriorate following the collapse in global commodity prices, the tax concessions afforded to superannuation are likely to be placed under intense scrutiny, with much speculation that tax rates on superannuation contributions (and possibly also on earnings) will be increased this year. While these changes may well play a short-term role in plugging gaps in the government’s finances, they will do little to encourage confidence in the superannuation system or to help Australians save for a more comfortable retirement.

Canada

Canadian pension plans and employers, due to unfavourable economic conditions and the low interest rate/low asset return environment, have been trying to find new ways to improve their governance structures and risk management processes and, at the same time, rationalise associated costs. From that perspective we have seen a substantial increase in the interest in outsourced CIO (OCIO) solutions, also known as Delegated Investment Services (DIS). This trend in the Canadian market is expected to gain additional traction as pension committees realise their fiduciary duty is better exercised by focusing on objective setting, long-term strategic decisions and mission monitoring activities.

The Province of Québec enacting Bill 57 effected key changes to actuarial valuation rules, shifting away from solvency to going-concern valuation. While long-term implications of the Quebecker pension system are not clear at this point, regarding the affordability and sustainability dilemma, in light of the new legislation pension plans need to revisit their asset allocations and long-term investment strategies.

Another push from regulators came from Ontario, where environmental, social and governance (ESG) factors need to be addressed in pension plans’ statements of investment policies and procedures (SIPPs). Even though the adoption of specific policies and principles regarding ESG factors in the investment process is not mandatory at this point, it is in line with our long-term view of sustainable investment and stewardship.

Global news


China

2015 saw significant price actions and high-profile but extreme government interventions. China’s onshore equity market recorded about 10% return in the year with considerable volatility. Major local equity indices rose more than 50% to reach the peak in early June, and then plunged sharply by around 30% by the year end. These volatilities, along with the pressure on the RMB exchange rate, drove investors to explore global diversification. We have observed increasing awareness of offshore allocation.

In an attempt to curb dramatic capital outflows experienced in the year, the State Administration of Foreign Exchange (SAFE) took time to approve a new offshore investment quota for institutional investors. How soon SAFE will restore the speed of approval is yet to be seen.

Market volatilities in 2015 also led to wide discussion around combining the bank, insurance and capital market regulators into a unified regulatory body. A high-level co-ordinative agency has already been set up in the State Council.

The China Insurance Regulatory Commission (CIRC) rolled out the China Risk Oriented Solvency System (C-ROSS – the Chinese version of Solvency II) for the local insurance industry. The framework adopts a standard formula approach and combines US RBC and European Solvency II concepts. The regulation has had a profound impact on insurance investments. For example, illiquid alternatives such as private equity, infrastructure and property investments require much lower capital compared to listed equities. As a result, insurance companies are looking to expand these allocations, both domestically and globally, to a sizeable percentage compared to foreign peers.

Germany

Following a broad decline in yields in 2014, German 10-year bund yields continued to be highly volatile throughout 2015. However, at the end of the year, the 10-year bund yield was broadly unchanged compared to the previous year, at levels of around 0.60%. Fairly low spread levels for high quality corporate bonds and a moderate spread widening in 2015 resulted in disappointing returns for EUR Corporate Bonds. Most major benchmark indices closed at year end in slightly negative territory. Equities, however, were broadly positive, as European investors strongly benefited from the weakening euro. Unhedged investments in global equities yielded approximately 10% return in EUR terms, whilst USD investors were facing slightly negative returns for the broader global equities market. In a portfolio with a typical allocation of 20% in global equities and 80% in European bonds, overall returns were usually positive, but still close to zero.

On the regulatory front, revisions to the insurance company and pension fund investment ordinances came into effect in March 2015. These set out the investment restrictions applied to pension funds (falling under the EU IORP Directive) and smaller insurance companies. With effect from January 2016, larger insurance companies were required to comply with the Solvency II regime, with their investments regulated instead via solvency capital requirements. In March 2016 the UCITS V Directive was adopted in Germany via a change in German investment law. The new regulation also sets out new provisions for alternative investment funds regarding loan investments.


Hong Kong

Similar to the Shanghai-Hong Kong Stock Connect (SHKSC) scheme, which was launched on 17 November 2014 to allow direct cross-border trading of designated stocks, another cross-border co-operation initiative called the mainland-Hong Kong Mutual Recognition of Funds (MRF) was launched on 1 July 2015. With an initial investment quota of RMB300 billion for in and out fund flows each way, the MRF initiative allows eligible funds domiciled in mainland China and Hong Kong to be sold directly to investors in both markets under the mutual recognition rules.

Prior to this initiative, international investors can only gain access to the mainland China’s onshore market through the Qualified Foreign Institutional Investor (QFII) or Renminbi Qualified Foreign Institutional Investor (RQFII) quotas. On the other hand, mainland Chinese managers and investors can only invest in offshore markets through the Qualified Domestic Institutional Investor (QDII) programme. The mutual recognition of funds arrangement has therefore opened the gate of a new channel to access investments in mainland China. Similarly, foreign asset management groups will be able to utilise Hong Kong as the preferred platform for domiciling their funds in order to cater the demand from mainland investors.

Italy

2015 saw a generally very good performance of the Italian pension scheme portfolios, down to the traditional high exposure of the pension schemes in Italian government bonds. The implementation of the European Central Bank programme of bond purchases has clearly benefited investors in government bonds, with the spread creating a substantial positive impact on current bond holdings.

As a general trend, we have also seen a slight move towards illiquid assets. In June 2015 the Italian government issued a new law to incentivise pension scheme investments in infrastructure assets, based on a tax credit on the returns of this type of investment. Also, research showed that illiquid assets are now better matching the risk profile of a long-term investor, so these assets have become more popular among Italian Pension Schemes. Among illiquid assets, we have seen more interest in ‘internationalisation’ of the real estate portion of the portfolios: the traditional strongly overweight allocation to Italian RE has started to change to create more diversification (typically we have noticed more interest in commercial and logistics rather than residential).

Global news


Middle East

The dramatic fall in oil prices caused a profound change in Middle East economics. Significant reserves were built up in the good times, and in the short term, these enable the Gulf states to survive the current very low oil prices for some years. To some extent this is seen as a deliberate move to aim to force out the higher-cost producers, particularly US shale and Russia. Iran coming back on stream has complicated matters; that said, the Middle East has always been full of complexities.

The greater concern for the region is the longer-term outlook for oil prices. The Gulf economies are currently far too reliant on oil revenues. This is particularly true of Saudi Arabia, where oil accounts for 80% of budget revenues and nearly 50% of GDP. Despite the low cost of production, the economy’s present configuration apparently requires an oil price of around $85 to break even. Saudi Arabia has recognised that this is not tenable, and is beginning to embark on reform. Whilst it seems momentous from their perspective, it really only represents minor steps towards a more balanced economy.

More broadly, there is the intention to become a more investor-friendly environment with special zones such as the Dubai International Financial Centre (DIFC – an ‘offshore’ location that is on firm ground in the UAE) that aim to cut red tape and operate regulation that is more aligned with Western best practice. This has led to a revamp in insurance regulation – with local insurers now facing risk-based capital requirements akin to, although different from, the European Solvency II requirements. The investment insurance team have been highly successful in providing support to both local and global insurers operating in the region.

Japan

The change in attitudes of the Japanese general public towards investing is being tested regarding whether it can maintain momentum for pursuing riskier assets such as equities and investment trusts, breaking the tradition of preserving assets predominantly in bank deposits.

In addition to the favourable global financial markets in recent years, there have been various tailwinds in Japan to support the households to expand investing in riskier assets under Abenomics, including the introduction of the Nippon Individual Savings Account, which grants households access to tax-exempt investing. In response to the change in the governmental policy as well as the attitudes of retail investors, it is also a favourable sign of change in the investment industry that asset managers have started competing with better terms in fees for their investment trust products.

It is currently a matter of concern, with the heightened instability of the financial market, whether the investment appetite of Japanese households with financial assets of 1,700 trillion yen will continue to bloom.


Netherlands

2016 will prove to be an exciting year for Dutch pension funds as three major forces collide: market volatility at extremely low interest rates, a continued search for yield, and regulatory opportunities for a new pension vehicle. With over €1,200 billion invested, the Dutch pension fund industry is logically sensitive to market volatility as explained by Willis Towers Watson’s ‘six for sixteen’, the six macro trends for 2016, including low rates expected in the Euro-zone (as opposed to the US), the fragility risks in China and the US and the emerging markets, the low commodity prices and geopolitical risks.

These aspects have had an effect on plummeting solvency ratios at the start of 2016, and the Dutch regulatory framework offers few opportunities for risk-taking when under pressure. But as usual, Dutch pension funds are not inactive. In the search for yield the Dutch investors try to harvest the remaining illiquidity premium: an increased interest in ‘alternative credit’ such as mortgages and illiquid loans, which both still offer attractive spreads relative to the more liquid assets. And in the regulatory space a new pension vehicle (the APF, a ‘general pension fund’) offers Dutch pension funds a way to share and save costs, while maintaining their own identity within a wider framework.

United Kingdom

Whilst returns on the majority of asset classes were generally positive over 2015, there are still clearly concerns over the fragility of capital markets and this has manifested itself during the early stages of 2016. With an outlook of limited upside returns but significant downside risks, there has been an increasing focus on developing robust strategies with a strong risk management focus based around pension schemes’ funding positions. Trustees are facing an increasing number of implementation considerations and the move to delegating more of these implementation considerations continues. Trustees are using delegation to different extents, but the common aim is to free up more time to focus on the key issues that drive funding and investment strategy.

DC pension scheme trustees have been grappling with the significant changes in legislation over the past two years. These have involved changing the default and lifestyle strategies offered to members to cater for increased flexibility, with the majority of our clients having now agreed and implemented strategies to deal with this.

The imposition of a charge cap on default strategies has added another consideration and there has been a lot of focus on negotiating lower fees or tweaking investment strategies to ensure schemes are compliant. DC trustees are increasingly monitoring actual member actions to ensure the strategies developed are appropriate.

Global news


United States

As the US continues through the political process as we approach the November 2016 presidential election, the political uncertainty is matched by uncertainty in the global economy and the markets as the US prepares itself for the post-Obama era.

On the policy front, the Federal Reserve and the US Treasury market appear to be at odds for their anticipated path for both inflation and economic growth, with the Fed’s expectations for both exceeding those of market participants in the aggregate on both metrics. In the face of Fed tightening of the policy rate, long-term yields (perversely) have fallen rather than risen with the widely followed 10-year Treasury yield declining from its year-end 2015 levels of 2.2% to below 1.7% as of early February 2016. Continued USD strength relative to just about all other global currencies continues to be a driver of markets as well as monetary tightening in the US (through more expensive exports and cheaper imports).

After registering a small positive return of 1.5% in 2015, the widely followed S&P 500 Index for US equities fell sharply in January, reflecting renewed concerns about the outlook for global growth in an environment when many US companies have been operating at peak profit margins.

In this context, our five-year outlook calls for a continuation of the ‘muddle through’ that we have seen in the economy and markets for the better part of the last 18 months, but the balance of risks is to the downside in our view. While the US is better positioned than many large economies, we do not believe that its economy and markets will be immune from an environment of low global growth with market returns that are, in the main, muted and volatile.

Copyright © 2016 Towers Watson. All rights reserved.WTW-EU-16-PUB-2547

willistowerswatson.com

About Willis Towers WatsonWillis Towers Watson (NASDAQ: WLTW) is a leading global advisory, broking and solutions company that helps clients around the world turn risk into a path for growth. With roots dating to 1828, Willis Towers Watson has 39,000 employees in more than 120 countries. We design and deliver solutions that manage risk, optimise benefits, cultivate talent, and expand the power of capital to protect and strengthen institutions and individuals. Our unique perspective allows us to see the critical intersections between talent, assets and ideas — the dynamic formula that drives business performance. Together, we unlock potential. Learn more at willistowerswatson.com.

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