The global financial crisis (GFC) continues to reverberate throughout investment markets, introducing a number of 'new realities' important to institutional investors as they consider their strategies for 2011.
The events of 2008, including the full onset of the sub-prime crisis, the bankruptcy of Lehman Brothers, the takeover of Merrill Lynch and financial stocks losing more than 50 per cent of their value, had huge consequences for financial markets and the global economy.
For investors, the 'normal' rules failed to apply, exacerbated by the fact policy-maker actions rather than fundamentals were driving prices in financial markets.
Even now, economic and financial confidence is only slowly returning to most western countries. The crisis wreaked havoc on a number of nations' balance sheets, disrupted the credit allocation process in western economies and added to the potential for global tensions.
The new challenges underscore the need to focus on critical issues, consider the downside of any strategy and set investment priorities that can respond robustly in a changing and uncertain investment environment.
Global issues: the new realities facing investors
There is still a great deal of uncertainty in the post-GFC world. This presents both risks and opportunities arising from an unpredictable 'new reality'.
The status of sovereign debt as a safe-haven investment has been put into question. In a world where the cost of borrowing for Microsoft is cheaper than the cost of borrowing for many sovereign developed countries, the whole approach to bond investing may need to be revisited.
Major developing economies, such as China and India, are growing in economic strength and have expanded capital market access, thus creating a two-speed world economy. In particular, the inexorable rise of China, paymaster to the United States consumer and seeming new friend to Africa, and emerging Asia and Europe, raises fundamental questions about changing world hegemony and economic might.
Consistent with a two-speed world economy, the inflation outlook is very different for developed and emerging markets. Continuing high levels of excess capacity are keeping wage and price pressures in the US at bay, and weak growth and fiscal austerity in Europe suggest very little risk of domestically-generated inflation.
By contrast, inflation has picked up sharply in countries such as China, Russia, Brazil, South Korea and Indonesia. It is even higher in India, despite having come off its recent peak.
Reform of the US and European financial systems to avoid a repeat of the US and European bailouts of 2008 is barely off the drawing board.
To achieve true diversification, arguably investors must broaden their horizons, a lesson learned in the global economic downturn when major equity and credit markets around the world moved in lockstep.
These 'new realities' mean investors will need to strive to create true diversification and will also be challenged to design forward-looking portfolios, rather than being biased towards past successes. Flexibility will be crucial.
Managing the new realities
Investors need to start focusing more attention on the longer-term fallout and implications from the GFC, and consider how to reflect this in their portfolios. This means ensuring portfolios retain the flexibility to respond to market developments and avoid the adverse effects of locking into a strategy that cannot accommodate changing conditions.
This is about being more global, having inherent hedges to control volatility, implementing dynamic asset allocation and allowing more manager discretion around benchmarks. A way to do this is to look for deeper, more specialised insights into specific asset classes, and we believe alternatives will play a greater role in portfolio construction in this sense.
Mercer's boutique research structure, launched two years ago, is meeting this need with more sophisticated, in-depth research to identify investment talent in these sectors, to monitor performance and put in place proper risk mitigation policies and procedures.
These specialised capabilities include alternatives, equities, bonds and real estate. In fact, in response to the opportunities and needs in this space, Mercer has increased its research spend by 35 per cent in the past two years.
The varying fortunes of the world's economic players, with their substantial differences in debt positions and economic outlooks, look likely to continue to create uncertainty and volatile markets in 2011.
The post-retirement challenge
Australia, like most developed economies, is starting to feel the impact of the demographic tide of baby boomers entering retirement. Three million Australian baby boomers are expected to retire in the next 20 years.
Australians aged 60 and older will increase as a percentage of the total population from 18.3 per cent in 2007 to 28.5 per cent by 2040, according to the Centre for Strategic and International Studies' Global Aging Preparedness Index.
This will put greater pressure and scrutiny on the superannuation and funds management industry to better manage risk and produce superior returns.
In the context of superannuation, investment returns have already been under the spotlight since the GFC and this will be exacerbated by the changing demographic profile and looming longevity risk.
With investment returns earned in the post-employment period accounting for about two-thirds of superannuation benefits, smarter and flexible investment portfolio design is going to be paramount, and goes hand in hand with the questions around post-retirement product design.
At Mercer, we are advising clients to look beyond the accumulation phase. By providing tools and advice to enable them to build and offer a whole-of-life superannuation solution, super funds can help their members maximise capital at the point of retirement to optimise income in the drawdown phase while better managing risk, which in turn can improve member engagement and retention of funds under management.
Mercer believes the new realities of the investment environment will create many opportunities, but they also call for fresh thinking, the ability to make quick decisions and resilience in the face of a distinct lack of certainty.
