1 Theme, 2 CIOs, 3 Questions: Geopolitics, AI, and the search for portfolio resilience

This content is for institutional investors and information purposes only. It does not contain investment, financial legal tax or any other advice, and should not be relied upon for this purpose. The materials are not tailored to your particular personal and/or financial position. If you require advice based on your specific circumstances, you should contact a professional advisor. Opinions expressed are those of the speakers as of the date of publication, are subject to change without notice and do not necessarily reflect Merce's opinions. Hello, we're here at the Global Investment Forum at Disney World in Orlando, recording a special edition of our 1-2-3 podcast, where we unpack one critical topic through three essential questions bringing together two CIOs to make sense of what matters most for investors. I'm Ann Marie Schultz, partner and US Investment's commercial leader at Mercer, and today I have the pleasure of hosting the special edition of our podcast. Against the backdrop of geopolitical tension, shifting rate expectations, evolving market leadership, and renewed focus on portfolio resilience. Investors are asking where risks are building, where opportunities are emerging, and how to think about positioning for the second half of the year. I am delighted to welcome Andrew McDougal, Mercer's US Chief Investment Officer, brand new, and Garvin McCarthy, Mercer's global alternatives, Chief Investment Officer. Andrew Garvin, thank you so much for both joining us today. To get us started, what are the most important shifts you're seeing in markets right now? Which ones do you think investors may be underestimating? Andrew, let's start with you. Great, well thank you. It's great to be here, particularly the US Investment Forum here in Orlando. I think the first thing we really have to take a step back on is geopolitical tension that you first referred to. It really is dominating a lot of client conversations, partially rightfully so, but when we think about what's being underestimated, and today, actually as we record, it was another key roller coaster in markets with the oil price bouncing again on the back of a potential setback in the peace agreement. One of the things that we often do is we take a step back and we say, what do we learn from history and what can this tell us about how to allocate today? One of the nuances about this development is the sheer magnitude. The street of Hormuz has never been closed like this for this amount of time. And whilst there was a period of softness and edging towards agreement in the last month and the oil prices came off, since we're back to way from that, you've seen the re-escalation. And the reason that's really important is because stockpiling is now heading towards lower levels in the US here, just printed today, the low stockpiles of oil since 2004. So, we're actually facing a relatively unprecedented exposure to the oil price because their soils being chipped are very little oiled in chipped, stockpiles are running low, and we're beginning to see that come through in future prices as well. So, that's the first major risk that I think is being underestimated. But one of the things that we have learned from history as well is we concept of peering through the fog. And what we know from most prior events like this is after the initial shock, actually markets are ultimately driven by fundamentals. And in a world where this is ultimately contained and there is demand destruction which will reduce the impact of the oil price. It's ultimately a step in the right direction overall. But it is set against perhaps one big positive in markets and there are risks with that as well. But maybe just to go briefly to the second key conversation which is dominating client conversations which is artificial intelligence. And the reason I link it so heavily to what's going to want to write noise because it really is in the one hand a stag-fishingery shock from the rising oil prices. But the offset to that is a record cap expending in AI. It's been pouring the economy and broader emerging economies as well for about the past year and it is showing new signs of letting up. And so one of the things we think about is investors is what's the Fed going to do and the Fed has a uniquely tricky time on their new leadership of navigating the decision of whether to look through this near-term jump in inflation and the potential for stag-fishingy shock with the recognition that AI is ultimately boosting growth and boosting productivity which is the last thing I'll pause and see what the government's use. But to briefly comment on Kevin Warsh, he is somebody that ultimately is focused on productivity. He is a bit of a dove. He's focused on the productivity which is good for the economy but he's also worried about the impact on the jobs markets. And that is another key risk which could be underestimated but it's actually too early to see what the impact is from a productivity and a liberal impact. Yeah, both fascinating. I think mega sort of themes that are dominating all aspects of investment markets public and private today. But do sort of double click on something connected to what Andrew talked about would actually be the importance of liquidity right now for investors. Both on the public and private side of their portfolios. We've seen a significant slowdown in distributions and private equity which has meant that many allocators to private assets have seen a challenge in terms of either they're now invested being higher or above sort of tolerance levels or indeed the reliance of cash flows to meet cash flow funding obligations not coming back as quickly as it has been required. This has been an issue investors are faced with and therefore the requirement to perhaps use secondary markets on both sides of the trade but as a means of generating liquidity is a set up which also creates opportunities for buyers to require assets that perhaps interesting valuations and is something that investors are really grappling with right now and IPO markets have been closed for quite a while for private market for private equity investments. And as we go forward we're seeing the early signs of perhaps that sort of starting to unlock which may give an exit valve to some of the liquidity pressures we're seeing around the market. So a really fascinating time and lots of key issues that are somewhat interconnected are at play in how investors need to factor in the liquidity as well as the macro risks they're faced with. You're both making me realize it's a very difficult time to be an investor right now because you have these competing interests and there's no clear line of sight what is going to prevail, whether it's going to be productivity gains or the promise of the May I versus perhaps the more certain threat of persistent inflation. And then you layer on private market behaving not the way they want to. It's a very tough wall right now for our investor clients. And we urge all of us to navigate that complexity and give clients that perspective to thrive. And one of the things that we think about equities has one of the big areas of the third aspect really of key areas of focus for clients right now. And on the one hand valuations look quite expensive by most traditional measures and backward looking measures. But when you look forward, the forward price earnings and the peg ratios of many of these companies are actually at historical norms and not broad based but in certain markets. And so the reason that's important when we talk about this idea of balancing and navigating the uncertainty actually all the time it's about keeping your call knowing the benefits of a longer term perspective and not being phased by short term blips. And the reason offered there is an important aspect for being opportunistic and what you do. But what you don't want to do is turn your entire asset pool into giant macro hedge funds. And we'll maybe return to that. Fair enough. Yeah, Garvin, let's talk a little bit about how these market dynamics are showing up in alternative portfolio especially when you think about what's happening. Certainly we have the private debt markets giving us a bit of a hard time of late. Private equity markets all eyes as you talked about earlier about the potential IPO environment and then energy, the reliance of AI technology on energy. Take us through what this means for private markets portfolio right now. Yeah, incredibly interesting time as I think we've alluded to. I think there's a couple of couple of key things to focus on. I think if we look back over the last five to ten years, so private market asset classes, alternative asset classes, have had a relatively strong performance period driven largely in part by lower interest rate environments. The cheap capital has fueled long-term growth. And that's been abundantly evident through the long-term private asset returns. So people have had generally a very good experience of wanting to beat these asset classes. As we face some of the more structural sort of headwinds, meeting some tailwinds of opportunity like AI, I think what we're expecting to see as we go forward is more dispersion of outcomes from investors across all of these asset classes. Be a private equity, be a private credit real assets hedge funds. So I think whereas over the last decade manager selection portfolio construction almost hasn't mattered as much, it's been more about having access to the asset class, not necessarily access to the manager or the assets that were driving performance because the lower environment cheap liquidity, was a rising tide that lifted all bolts. We think going forward, that is not the environment we're faced with. We have elevated interest rates at least compared to historic levels. We have capital that's more discerning, that is looking more selectively at opportunities. As I mentioned earlier, liquidity options on both sides of the table for people to trade risk or buy risk. And that is creating a dispersion of outcomes that we expect will reward the best managers in the market and perhaps create some disappointing or pedestrian outcomes for the media and/or below media managers in a way that in recent times hasn't mattered so much. So, managing manager selection, portfolio construction are really going to drive sort of the experience of investors in these markets over the next decade. And that's going to be a crucial sort of, I think, aspect for investors to grapp with about it. It's not just owning the asset class. It's how they access that asset class, which GPs they're in, which assets they're in. Because one of the other things you alluded to, memory was the concentration of thematics that are driving outcomes, digital AI. And that's crossing over. So, in a portfolio context, one of the dominant teams for private equity investments relates to digital and how that's dominating. But that's also coming up from infrastructure portfolios, from real estate portfolios. And the credit has been heavily funding lots of the software and developments of the private capital and private companies in those segments. So, I think the perspective to look through to what you own, the underlying driver of that, and to aggregate that risk at a portfolio level, is going to matter more across the total portfolio and across asset classes than it's ever done in the past. So, asset class labels may matter a little less going forward. And manager selection is going to be more important. So, I think it's a very interesting time for our world to invest in. And once you're bringing that back to one overarching observation around, we told what the 3D's of diversification is. We diversify across asset classes and risk factors. We diversify within the opportunity sets. And then, crucially, we diversify across the managers. And I think if I think about some of the conversations that Clans are coming to ask for help with us now, versus three or four years ago, they're perhaps recognizing that they couldn't achieve some of their goals with just a small number of managers, two or three. And what we've observed from history is, whilst there is some perceived safety in just going for two or three brand names, in practice, you're left with sometimes a core outcome or indeed a disappointing outcome. And so, that last lever of manager diversification is really critical at times when markets are under more stress, which they are today. - So, if we think ahead now to the second half of the year, we won't have a resolution coming into the end of June, sounds like on the crisis ahead. - And a very robust IPO calendar being discussed. - Potentially. - Disgust, right? So, a lot of uncertainty on one side, a lot of volatility on the other. What can investors be doing over the next three, four, five months, especially when we're supposed to be taking a long-term perspective, right, with respect to how we are looking at portfolios? What should they be thinking about? And where would you guide them to lean in where they can on either seeking opportunity or managing risk? - Well, maybe we'll start with some of the easier decisions, right, which is when you think about some of the liquid markets, that element of structural diversification, markets have become more concentrated. But if you, an easy way to broaden that out is obviously to allocate to international. So, as a US investment base here, international equities are cheaper. They don't have the same structural dynamics or strengths, but they don't have the same evaluation concerns either. So, structural diversification international and emerging markets, which I know has not been a choice flavor here in the US for many years and there are many skeptics, but it's a small way to strengthen the overall diversification, although I would caveat that even EM has some concentrations in itself. And then that final lever, which is probably more of an active risk budget element, which is allocations to smaller cap companies further dilute some of that concentration in the mega cap. So, that's maybe more on the, on the equity side. The other thing I were actually encouraging clients to think a lot about is what is the diversification that they value the most? And do they have the right balance of diversification? So, Garval may be pick up on the growth factor diversification, particularly within privates, but we always think about balancing business cycle resilience and regime resilience. Some clients care about them differently, and our jobs to make sure they get the right type of resilience that's right for their objectives. So, a quick example would be actually for some clients who do have that ability to take some capacity for higher complexity. We are seeing some lighten up on duration and includes modest allocations to hedge funds as a diversifying alpha source. But for more complex clients, they're going one step further and they're saying, "Do you know what? I want to keep my duration." It's at reasonably attractive levels, but I'm going to use a bit of an enhanced toolkit, maybe a bit of leverage to free up some cash, to invest in hedge funds. So again, it's not broad-based use, but it's very selective use to increase the alpha opportunities that's under overall portfolio resilience. Yeah, and I fully agree, of course. I think the one layer before maybe getting into some of the specifics and alternatives, I think, as Andrew alluded to, that total portfolio approach and frameworks really important right now. Because we talked about a common set of risk factors that are affecting lots of asset classes at the same time. We've talked about the emergence of these mega themes that are digital infrastructure AI that are driving portfolio companies, public and private at the same time across your portfolio. So understanding where what risk you own, how that's sized in your portfolio, your tolerance for the outcomes that can sometimes be binary in terms of how these cycles emerge is going to be very important for investors to understand the risk that they own. So I think not just relying on a traditional SAA lens to understand risk by asset classes, but to peel back the onion to look at portfolio companies and aggregate and look at common factor risk in a way that puts the data from your public, your alternative and your private portfolios together is a really important tool that we're using across our client portfolios right now to understand holistic risk at a total portfolio level. And that's been something that hasn't always been possible because of data constraints, liquidity constraints, but now what frameworks, what the emergence actually of AI tools to be able to technology to do this in a more rigorous way, it's enabling us to be better to all the portfolio investors. That's a really important point. And that integration is at the heart of the total portfolio approach. And there's two other key pillars, which are at the tails of that, which are also equally important. And the reason in the US we're seeing a greater desire for asset owners to explore this is because they really are seeing the market environment, is causing them to question whether very stable frameworks, like traditional strategic asset allocation, which is built more for a stable world, which is really the best way to approach capital management today. And so those two other pillars that alignment, firstly, is really about asset owners having a stronger connectivity of their true mission and embedding that in the culture of their organizations. So give you a quick example. The alignment really comes through, particularly for larger organizations, where the specialist, in let's say private credit, really doesn't have much of awareness of the overall mission of the total portfolio objectives. They're all to be paid today, often, what they do in their area. And the alignment is saying, let's get a better balance between recognizing specialty for asset class and the collaboration it's needed in today's environment to go over and point about the conversion of asset classes and some risk factors to be able to look through that. The third element is really around adaptability. And sometimes say this is the more sexy bit of the total portfolio approach, because who doesn't want to be more adaptive for an evolving market condition. But back to that point about we still believe in a strong risk factor diversification and a road map, we do not think clients should throw out the road map for their overall total portfolio guide. And some folks call it there for unconstrained and go anywhere you want for the whole asset pool. We think that's a very fast way to lose money over time. So keep the structure, but make the structure better by embedding the adaptability and the collaboration. And the key part of that is the competition for capital, but it's particularly important today across private markets to think about that competition for capital and how that's competing across the total portfolio. - Yeah, and just the last point, the tools are now available to execute that competition for capital through co-investments, through GP-led continuation vehicles, through secondary market activities, give you a much richer tool kit to be able to shape your portfolio in a really adaptive way to Andrew's point. So that's really important for investors to think about. It's not just the standard set and forget, pick a GP, allocate capital to their fund. It's actually managing your exposure in an active way by using the tools available to you in terms of the types of deals you look at, the types of mechanisms you'll be able to realize your liquidity through and to evolve to look at different structures. And we've seen semi-liquid and interval funds and those have been very topical for some good reason. - Yes. - Some headline risk as well, but I think the toolkit is broader. And I think that's an important consideration for investors. And I think it's a second half of the year, I think manager selection will matter more than ever. So it's something that we do need think about in terms of how you're gaining that exposure, I'm sure which instruments you're-- - You're both reminding me of what I'd call a very simple advice that we tend to give to our clients, which is know the two or three business metrics that really matter to you for when and how is your portfolio going to behave on a day that those go really poorly? - Yep. - Make sure that you know what you all and use all of the tools in the toolkit that you can because I think the market environment is telling us that we need to. - So thank you Andrew and Garvin and to all of our listeners. We want to encourage you to like and subscribe to our podcast and importantly reach out to your local more certain consultants if you have any questions or want to learn more. Thank you. (upbeat music)