Endurance and Resilience – putting portfolios to the test

The investment landscape is constantly shifting and evolving. This presents investors with new considerations, opportunities and risks. Whether it is navigating the impact of climate change, meeting net-zero carbon emissions targets or even how consumer behaviour will change in a post Covid-19 world, investors should consider how to incorporate these into their portfolio design process.
 

Uncertainty needs to be considered, estimated and quantified.  Bridging the gap between economic events and implementing investment strategies requires not just quantitative modelling skills but also a deep qualitative understanding of global issues.  Mercer’s bedrock is our decades of experience in managing capital for institutional investors around the world.  This Intellectual Capital establishes the principles used to build portfolios, Portfolio Management separately constructs and manages portfolios while my team, Portfolio Intelligence (PI) crunches the numbers and looks for empirical verification. The independence of PI enables the freedom to challenge whether we are on the right track, avoid group-think and help deliver outcomes for clients.
 

The last decade has seen an exponential increase in the volume of data available to investors.  We believe the next will be defined by the algorithms used to aggregate, refine and interpret it. Empirical models and risk engines are the cornerstone of efficient portfolio design. These tools are incredibly powerful, and, at Mercer, we use these extensively. We stress-test our portfolios with more than a hundred ‘historical’ and ‘hypothetical’ model scenarios based on high-quality historical data.  On top of employing standardised models, where appropriate, we also construct our own suite of bespoke scenarios.

While we are, of course, interested in the numbers, we also understand there is more to analysis than raw data and reports. The real value flows from the experienced understanding and interpretation of the output of our quantitative tools. Based on our experience and knowledge of a portfolio’s construction we know what to expect and when we should see it – where there is a misalignment with our expectations, we investigate.
 

Take for example a client’s growth portfolio. We can analyse how the portfolio responds to a range of hypothetical or historic situations. From there, we can disaggregate this portfolio – delving into how various asset classes, sectors and regions behave. We take a cascade approach; analysing the portfolio at various levels ranging from the top level down to the individual sub-investment manager. This gives us a clear picture of the impact of our portfolio construction decisions at different levels. So, if we observed a result we did not expect it, why not? Is there a change in sub-investment manager behaviour? Is the portfolio still robustly constructed? We feed these insights back into our portfolio management process furnishing our team with truly deep understanding that informs the portfolios we analyse.

Crystal balls don’t exist and no single scenario we run portfolios through will ever fully come to pass.  But each test tells us a little more about each portfolio – adding colour and texture to our understanding and reaffirming our conviction.  Where we want to explore further, we build our own model scenarios – this is as much art as science. We lean on Mercer’s experience to suggest directionality and magnitude of market shocks and use powerful computational engines to help ensure the ripple effects of these  shocks are felt throughout the model.
 

Among the challenges for portfolio managers this year is controlling for the increasingly volatile path of inflation. Inflation has exceeded central bank targets during the early stages of the recovery, especially in advanced economies with successful vaccination programmes, but many suspect the pressures will be transitory. There are many possible scenarios from this point in time. A resurgent coronavirus could hold back the economy, leading to deflation. Or the government could overstimulate the economy as it recovers, leading to sustained inflation. We could even return to 1970s-style stagflation, with an unbalanced economic recovery leading to simultaneous inflation and unemployment. 

Here we have chosen to ‘go deeper’ and develop a bespoke set of scenarios and while there are myriad customisable factors in each scenario – from equity and bond markets to interest and exchange rate movements – each iteration deepens our insight. There are as many factors as there are dials on a music producer’s mixing desk – so we must adjust our ‘dials’ much the same fashion – with every twist and turn we gain a deeper understanding of the relationship between each factor, enriching our insights when we review the portfolio as it passes through the scenario.
 

We believe that risk engines and other sophisticated tools, powered by vast amounts of data, will play a central role in portfolio management over the coming decade. However, we are certain that it will be the investment managers that harness these tools most effectively that will provide the success for clients. Here at Mercer, we pride ourselves in building robust portfolios for our clients.  To do that we need to consider as many eventualities as we can - protecting portfolios from losses and leaving open the potential for gains, whatever scenario comes to pass.