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Fiduciary investors will continue to push into alternative asset classes and private market opportunities as expectations for future returns in bond and equity markets remain low, Rich Nuzum, president of Mercer’s Investments & Retirement business observes.

In pursuing alternative and private market opportunities in asset classes including infrastructure, private equity and debt, venture capital, hedge fund as well as more esoteric and opportunistic strategies and themes, funds will encounter more complexity and greater governance challenges than many are currently be equipped for, says Nuzum, who is on Mercer’s executive leadership team and who spoke on the eve of the consulting and investment firm’s global investment forum from his base in New York in early March.

Further, private markets and alternative asset classes might be the best way to allocate to important long term investment themes that will be pervasive in coming decades such as climate change and global demographic shifts, he says.

“Some fiduciaries feel pretty good with equities at all-time highs, interest rates have dropped for 30 years. But when you look forward it’s not likely they’ll get the equity market returns and certainly not the bond market returns during we have had during their working lifetime,” Nuzum says during a conversation on Investment Magazine’s Market Narratives podcast series.

Historically, private equity, debt, real estate, infrastructure and alternative strategies have performed well but have struggled to keep up with equity markets as interest rates have come down.

“On a forward-looking basis those asset classes look attractive, particularly with a long term focus,” Nuzum says.

“But in those asset classes you can’t invest on a passive index fund basis so [the funds] are also trying to capture as much of the skill premium as they can,” he comments.

Nuzum describes passive equity funds as an example of real democratisation of financial markets in action in light of the exposure unsophisticated investors can get to markets made efficient through the actions of a diverse and deep investor pool for a low single digit basis point cost. But he adds that sovereign and large pension and superannuation funds, in contrast, have some progress to make to allocate effectively in light of future financial market conditions.

Reframing risk

Nuzum describes the governance challenges as “huge” for funds moving into alternative asset classes because of the complexity and also because of the gap between the best and worst performing general partners and investment managers.

“Just one of the governance challenges is what we refer to as single line item risk, that is as an asset owner if you are going to move into alternatives or hedge funds, you’re inevitably going to make an investment that’s going to go to zero. That happens in those spaces,” he says.

It can be difficult for funds to adapt their governance approach to stay the course with these strategies if an investment blows up or doesn’t pan out and public markets are much more forgiving in contrast to private market and more esoteric areas where fiduciaries are heading, Nuzum describes.

“Stock managers don’t typically take a beating [when one company blows up]… but with private equity and hedge funds for instance our stake holders tend to be less familiar with those and when an investment goes to zero there can be a lot of after the fact second guessing,” he says.

“When you go into these asset classes you need the governance and sophistication so that when a single investment doesn’t do well the governance bodies can look at the overall performance in context, look at the diversification and stay for the long term,” he says.

Private markets and alternatives are also likely to be the most effective avenue for fiduciary investors to participate in the biggest trends to dominate financial markets this and in decades to come, Nuzum says. He describes fiduciary investors’ approach to climate as mitigating future risks as much as earning returns in the near term.

“If you are investing in clean tech and the price comes down then we all win, we don’t need government intervention because the hand of the free market is doing its thing.

“That’s why sovereign wealth fund clients are slightly overweighting their investments to renewable energy, it’s not because they’re expecting the policy to quickly change, they are trying to over come that shock factor when it does,” he says.

Climate change is the number one ranked investment trend among asset owners with multi-decade time horizons, Nuzum says, citing Mercer research. Climate change sits along-side the impact of low long term real interest rates, technological evolution and disruption, geopolitics, demographic shifts and water security as the most important investment trends for fiduciaries.

Smith is head of content and managing editor of Professional Planner and Investment Magazine.
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