July 2020

Inside view: Balancing risks for better returns

GymnastGood governance adds value to investment programmes. This is especially true during market corrections and crises, says Janet Li, wealth business leader for Asia at Mercer. The Covid-19 pandemic is one of the most transformational events affecting the global economy in the working lifetimes of most current investment professionals and asset owner fiduciaries. The direct capital market effects of the pandemic include liquidity challenges, a sustained spike in actual and implied volatility, valuation adjustments across asset classes and significant changes to forward-looking return expectations. The pandemic has driven long-term nominal and real interest rates lower. It has contributed to a sharp decline in oil prices, with the risk of supply exceeding not just demand but also physical storage capacity. At the same time, the pandemic has directly affected the fiscal solvency of governments, the financial stability, and in some cases, the solvency of individual corporations and entire industries, and the balance sheets of insurance companies. All of these entities – governments, corporations and insurers – are also often the funding entities for long-term, diversified investment programmes. Challenges to their financial standing have therefore altered the liquidity budgets, risk tolerance and investment time horizons of many of the world’s largest asset owners. On the social front, the pandemic has impacted beneficiaries of these programmes – separate from its impact on the investment returns of these programmes – either directly through sickness or indirectly through employment status, near- and long-term individual earnings expectations, and long-term tax payment expectations. As of today, many fundamental questions about the virus itself, the course of the pandemic and its economic, societal and capital market consequences remain unanswered. Global systemic risks
We believe the framework recently developed through a collaborative study between the World Economic Forum (WEF) and Mercer for evaluating and incorporating global systemic risks into investment programmes provides useful insight for asset owners on addressing the risks and opportunities created by the pandemic. Drawing on the ‘World Economic Forum Global Risks Report 2020’, the new Mercer/WEF study, ‘Navigating a Pandemic-Driven Market Crisis’, highlights the most significant risks faced by economies today. Six key global systemic risks were identified as the initial focus and also as most relevant to long- term investors. These six risks have varying importance to different asset owners based upon each fund’s objectives, policy mandates, capital adequacy and governing structures:
  • Climate change
  • Water security
  • Geopolitics
  • Technological evolution
  • Demographic shifts
  • Low and negative real long-term interest rates
The framework created during this investigation into investment and governance practices regarding global systemic risks can be applied to the Covid-19 pandemic. There are two objectives:
  • Evaluate the usefulness of governance strategies developed to address more gradual but equally destabilising systemic trends in addressing the Covid-19 pandemic-driven market crisis.
  • Consider practical investment actions by long-term investors that support economic recovery and seek to generate attractive risk-adjusted returns. We reference such investments as “transformational”.
Infographic Time for agile governance
Triggered by the Covid-19 pandemic, many large diversified asset owners in Asia are re-evaluating their governance policies. Leading asset owners are finding ways to pursue compelling risk-adjusted investment returns while also taking investment actions to help mitigate and address the impact of the pandemic. While the awareness of governance has continued to be on the rise for institutional investors in Asia, there is still very mixed progress against the global systemic trends, which also aligns with the observation from global investors in the collaborative study. The growth opportunities in Asia look to present more rewarding outcomes for institutional investors who are willing to take proactive steps on transformational investment. It is all but certain that this will ultimately differentiate them from others via better outcomes in the future. Although many questions remain regarding the impact of the pandemic, we believe two things are clear:
  • The same disciplined, agile governance and implementation arrangements that sophisticated asset owners have developed and adopted following past crises are working well during the current crisis.
  • The framework transformational investors are adopting to deal with other global risks can be used to develop an investment policy that addresses the risk of future pandemics.
Good governance, when applied to the recent Covid-19 market experience, illustrates how investment practices can potentially benefit the economy and broader society throughout market volatility and economic uncertainty. This highlights investors’ ability to influence positive outcomes and mitigate systemic risks, which is fortunate, as the world continues to face some of its biggest economic, social and health challenges. © 2020 funds global asia

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