LONG-TERM EQUITY INVESTMENT - Mercer...LONG TERM EQUITY INVESTING Page 5 of their investment strategies. We seek to understand how analysts and portfolio managers are aligned to client

LONG-TERM EQUITYINVESTMENTNovember 2013

In recent years there has been a rise in the number of industrycommentators advocating “long-term investing”. But what islong-term investing? Why is it gaining such support, and is thereevidence to support the opinions? And where does this leave theinvestor? This paper looks to address the questions around thisincreasingly popular topic from an equity perspective.Specifically, the paper outlines some of the benefits andconstraints of long-term investing, considers how managerincentives can affect investment outcomes, and assesseswhether a long-horizon approach to equity investing hasconferred any advantage to investors over the last decade.

BACKGROUNDA growing body of literature has delved into the breakdown of long-term relationshipsalong the investment chain towards what has become a short-term, transaction-orientedmarket. In 2012, the Kay Review1 summarised a number of problems associated withperceived excessive short-termism, primarily caused by a misalignment of incentiveswithin the industry and a culture based on transactions and trading. In 2013 Mercer helda series of consultations and interviews with a number of participants globally, includingasset managers, asset owners, and companies to look at various mechanisms tocultivate and promote long-term investment horizons.2 In addition, we recently publisheda paper that explores the implications of “behaving like an owner”.3

In this paper, we focus specifically on listed equity managers. The purpose of this studywas to determine what (if any) advantages asset managers with long-term investmenthorizons may have over approaches with a shorter-term focus. We highlight somearguments for, and constraints against, long-term investing and discuss the importanceof incentives on manager behaviour. Our study focuses on the Global Equity Core;Europe, Africa, and Far East (EAFE); and the US Large Cap Core equity universes asproxies for the broader market in analysing performance and style characteristics.

1 Kay J. UK Equity Markets and Long-Term Decision Making, July 2012.2 See www.mercer.com/loyaltyrewards.3 Ambachtsheer J, Fuller R, and Hindocha D. “Behaving Like an Owner: Plugging Investment ChainLeakages,” Rotman International Journal of Pension Management, Vol. 6, No. 2 (Fall 2013).

http://www.mercer.com/loyaltyrewards

LONG TERM EQUITY INVESTINGPage 3

DEFINITIONThe World Economic Forum defines long-term investing as “investing with the expectation ofholding an asset for an indefinite period of time by an investor with the capability to do so”.4 Inthe context of publicly listed equities, one could characterise long-term investing as buying thecompany as opposed to buying the share price. Arguably, the balance within the investmentmanagement universe has become tilted in favour of buying shares for short periods, reflectedby the fall in average holding periods over time. The charts below show that, for stocks listed onthe New York Stock Exchange, there has been a significant decline in the average holdingperiod from approximately seven years in the 1940s to seven months in 2007; a similar patternhas also occurred in the UK (for stocks on the London Stock Exchange) between the 1960s and2007.5

Source: The New York Stock Exchange Source: The London Stock Exchange

Further analysis by Thomson Reuters6 shows that the holding period of stocks in portfolios hasdeclined to less than one year. However, it should be noted that the level of turnover, as shownabove, has not changed significantly since the mid-1980s. Furthermore, these statistics reflectthe broad market behaviour rather than the behaviour of portfolios managed by, and for,institutional investors. These numbers have also been strongly influenced by the introduction ofhigh-frequency traders (that may represent anywhere from 30%–40% of trading volume inEurope, up to 70% of the volume in the US7).

ARGUMENTS IN FAVOUR OF LONG-TERMINVESTINGBenjamin Graham proposed a clear definition of investment that distinguished it from what hedeemed speculation. He differentiates between the two concepts on the basis of perspectiveand time horizon: an investor looks at a stock as part of a business and the stockholder as theowner of the business, while the speculator views him or herself as simply trading paper assetsin the share certificates.8 Although Graham allows room for both in the market place, heemphasises that, with the perspective of a part-owner of the business, the stock owner should

4 World Economic Forum. Future of Long-Term Investing, 2011.5 Haldane A. Patience and Finance, 2010.6 In an article in the Financial Times, Thomson Reuters noted that the average period that asset managers holdcompanies in a portfolio was estimated to be less than 10 months at the end of September 2011. (See: Sullivan R.“Kay Advocates More Long-term Investment,” Financial Times, available at http://www.ft.com/cms/s/0/79cfdd78-d0f2-11e1-8957-00144feabdc0.html#axzz2gAz7Yx5R, accessed November 21, 2013.)7 Haldane A, 2010.

8 Graham, Benjamin with Zweig, Jason; Intelligent Investor, 4th edition, 2003; HarperCollins

http://www.ft.com/cms/s/0/79cfdd78-d0f2-11e1-8957-00144feabdc0.html#axzz2gAz7Yx5R


not be too concerned with erratic fluctuations in stock prices, since in the short term the stockmarket reflects sentiment but in the long term the true or intrinsic value of the business will bereflected in its stock price.

Investors acting as owners of the business with a long-term approach are then typically betterplaced to develop stronger relationships with companies, with ongoing dialogue that can fosterbetter long-term thinking on corporate strategy. This is a key benefit to long-term investing:being a long-term holder of stocks can enable investors to become more engaged with investeecompanies. Academic research by Elroy Dimson showed that companies with more engagedshareholders, and more emphasis on the long-term business strategy rather than short-termexpectations, have been able to create stakeholder value — and specifically, “after successfulengagements, companies experience improvements in operating performance, profitability,efficiency, and governance.”9 Empirical research done by Lucien Bebchuk on the effects ofshareholder engagement also suggests positive impacts on company performance in both theshort and long term.10

Another benefit that accrues to investors employing a long-term invest approach is lowertransaction costs. Higher turnover within a portfolio will incur a higher level of transaction costs,which can create a drag on returns. A manager with a higher level of turnover therefore has toaim at a higher hurdle to add value on a net-of-costs basis than do his lower-turnover peers.

CONSTRAINTS TO LONG-TERM INVESTINGIncreasing short-term pressures from all participants along the investment chain have resulted ina disproportionate focus on short-term performance (and short-term thinking) rather than long-term value creation. This can be observed at the fund manager level, where it may beuncomfortable for the manager to be seen as “doing nothing” by clients, even if this is ultimatelythe correct course of action. In addition, an increasing emphasis from clients on more frequentreporting has created a focus on shorter-term performance. Anecdotal evidence from Mercer’sconsultations with global market participants suggests that managers entrusted to invest onbehalf of clients with a long time horizon may still be constrained from taking a long-term viewon the basis of how performance is evaluated and rewarded. A further look at the incentivestructure of investment managers has highlighted that, as one might expect, those with short-term performance pressures tended to focus more on short-term investments, with a greateremphasis on short-term behaviour at the expense of long-term corporate governanceresponsibilities.11

THE ROLE OF FIRM STRUCTURE ANDINCENTIVESAt Mercer we recognise that there is no perfect firm structure or remuneration package thatdirectly results in investment strategies with long-term investment horizons. Within our four-factor analysis (see Appendix 1), for all styles of investing and investment horizons, thebusiness management score emphasises our core belief that well-managed investment firms,with appropriate incentive structures, are more likely to enhance the long-term competitiveness

9 Dimson E, Karakas O, and Li X. “Active Ownership,” 2013, available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2154724, accessed 21 November 2013.10 Bebchuk L. “The Case for Increasing Shareholder Power,” Harvard Law Review, 2004.11 Legg M. Long-term Investing in a Short-term World, Legg Mason Capital Management, 2006.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2154724


of their investment strategies. We seek to understand how analysts and portfolio managers arealigned to client interests and whether these teams are aligned to perform over a sensible timeperiod given their investment process. Our business management analysis tends to reflect anypotential concerns we may have regarding the size of the organisation, the incentive structuresin place, and the impact this could have on managing asset growth as well as ensuring theteam’s efficiency. For example, where we see managers with long-term investment horizons, butshort-term incentive structures, we will note these inconsistencies.

From a theoretical standpoint, it may appear easier for owner-managed firms to provideindividuals with incentives and a more favourable environment to foster long-term thinking.Spreading business ownership across employees tends to create an alignment of interestbetween the portfolio manager and analysts with that of the firm and ultimately clients, and maycreate a more stable investment team. Clear leadership can play a strong role in setting theinvestment philosophy and fostering a culture that keeps the firm on course over market cycles.In addition, the environment may be less subject to the pressures of larger firms where theremay be a number of constraints, such as limited independence, interference from the parent,and other bureaucratic pressures. Publicly listed asset managers could be pressured further todeliver results that may lead to taking short-term-oriented actions.

According to the Investment Management Association (IMA), there has been a trend towardsboutique asset managers characterised by independent ownership, a greater degree ofspecialisation, and self-definition.12 However, this does not necessarily foster long-term thinking,as we have seen a number of hedge funds with high-turnover strategies, for example, whichoperate in small boutique structures with independent ownership and specialisation.Furthermore, the downside of owner-managed firms can be an over-reliance on a single productor asset class, and hence some pressure on resources if the style/strategy is out of favour for asustained period of time. Additionally, factors such as intergenerational transfer and successionplanning can also present challenges. However, we have seen owner-managed firms typicallyalign the portfolio manager with client interests and develop deeper and longer-lasting clientrelationships as a result.

Incentive structures can play a crucial role in setting the long-term agenda; however, researchshows that managers that are incentivised on short-term metrics will tend to make decisions thatdeliver short-term performance.13 Typically we have seen incentive structures with componentsincluding base salary, in some cases an equity stake, and performance-related bonuses setover a one- and three-year period (and for some managers over a 5-year period as well). Howmuch emphasis is placed on the one, three, and five-year period will typically vary by firm, butwe have seen a greater emphasis on five-year performance for managers with long-terminvestment horizons. Qualitative evaluation also tends to be emphasised as many managersstress the importance of team culture to ensure employee retention over the long term.

DATA ANALYSISWe undertook data analysis to determine whether investment strategies with long-terminvestment horizons had a performance advantage over those with shorter-term investmenthorizons. For this analysis, we screened Mercer’s Global Investment Management Database(GIMD™) to focus on the Global Equity Core, US Large Cap Core Equity, and EAFE Equity

12 IMA Asset Management Survey, 2011 and 2012.13 Eccles R, Ioannou I, and Serafeim G. The Impact of Corporate Sustainability on Organizational Processes andPerformance, July 2013, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1964011, accessed 21November, 2013.

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1964011


universes for strategies that had returns and expected turnover data available for the trailing 10-year period, ending 31 December 2012.

This reduced our opportunity set from approximately 1,800 strategies to close to 500 across thethree universes. For the purpose of this study, we used expected turnover data14 provided byasset managers as a proxy for the holding period and have defined long-term as strategies withturnover of less than 40% per annum.15 We define medium-term strategies as those withturnover between 40%–100% per annum, and short-term strategies as those having turnovergreater than 100% per annum.

As highlighted in the table below, the majority (90%) of the 500 strategies across these regionsexpect their turnover to be less than 100% per annum. Managers in our study that employ ahigh-turnover (>100% per annum) investment approach represent approximately 10% of thetotal opportunity set. It is interesting that, regardless of geographic region, the percentage ofmanagers represented by each turnover approach — low, medium, and high — was fairlyconsistent across the three universes.

Global US EAFE

TurnoverNumber ofManagers

Percentage ofOpportunity

SetNumber ofManagers


SetNumber ofManagers


SetLow (<40% p.a.) 69 45% 59 35% 73 42%

Mediium (40–100%p.a.) 71 46% 86 51% 88 51%

High (>100% p.a.) 14 9% 22 13% 12 7%

TOTAL 154 100% 167 100% 173 100%

PERFORMANCEThe chart below summarises the results of our analysis. We acknowledge that our study islimited to one 10-year period — due to the difficulties in gathering a more exhaustive data set.The results of our analysis show that over the 10 years to 31 December 2012, there is no strongrelationship between expected turnover levels and relative performance. Between January 2003and December 2012, the Global and EAFE results provide some support for the hypothesis thatlong-horizon strategies (that is, managers that employ a low-turnover investment approach) mayprovide superior long-term performance, but the US results do not support this conclusion (seeAppendix 2a, Panel 1 for more detail). We note that across the three approaches, the magnitudeof the differences in relative performance does not appear to be significant.

14 This data was taken from Mercer’s GIMD, which defines expected annual turnover as the lesser of purchases andsales divided by the average market value, excluding cash rollovers. It should be noted that this data is based onmanager estimates rather than actual portfolio turnover. In a previous study, Investment Horizons: Do Managers DoWhat They Say? (2010), we highlighted the risk that managers may tend to display a greater degree of portfolioturnover than their estimate. Our analysis also excludes an analysis of the difference between name turnover (howlong a single asset is held) and “dollar” turnover (a measure of portfolio activity), which also warrants attention.15 Using 40% as a frame of reference for low-turnover strategies was a subjective decision for consistency reasons.We also looked at more objectively dividing the universes equally into one third each to determine low-, medium-, andhigh-turnover strategies. The outcome in performance and style characteristics was little changed; therefore ourconclusions remain the same.

LONG TERM EQUITY INVPage

While our study suggests that the relationship between expected turnover levels and relativeperformance is weak, we believe it is also important that onestyles that characterisobjective, we looked at the performance of style characteristics using data from StyleResearch.outperformed the market while growth factors lagged, and momentum factors were generallyneutral (see Appendix 2b).

This conclusion, although instructive, could be too simplistic and might not fully explain whathappened. A turbulent macroeconomic environment has affected equity markets in a variety ofways over the past 10 years. For example, from 2003 to 2007 highgenerated a higher level of excess return versus their comparable lowInvestors and plan sponsors would have been generally better off seeking out managers thathad high portfolio turnover, as highlighted in the chart below (see Appendix 2a: Panel 2).exception was the EAFE universe, where investment strategidid relatively better. Based on Style Research, during this same time period, value andmomentum style factors outperformed the market, while quality factors underperformed (seeAppendix 2b). While speculating, one potentiaexpanding and access to credit was more accommodative. This may have favoured managersthat actively reallocated capital to new investment ideas.

16

strategies used to assess performance based on expected turnover. The Global, EAFEResearch are based on individuals stocks within the Global, EAFEexcess return over the market,performance of the

LONG TERM EQUITY INVPage 7



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LONG TERM EQUITY INV7




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LONG TERM EQUITY INVESTING

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This conclusion, although instructive, could be too simplistic and might not fully explain whathappened. A turbulent macroeconomic environment has affected equity markets in a variety ofways over the past 10 years. For example, from 2003 to 2007 highgenerated a higher level of excess return versus their comparable lowInvestors and plan sponsors would have been generally better off seeking out managers thathad high portfolio turnover, as highlighted in the chart below (see Appendix 2a: Panel 2).exception was the EAFE universe, where investment strategidid relatively better. Based on Style Research, during this same time period, value andmomentum style factors outperformed the market, while quality factors underperformed (seeAppendix 2b). While speculating, one potential explanation might be that global economies wereexpanding and access to credit was more accommodative. This may have favoured managersthat actively reallocated capital to new investment ideas.




Returns 1 Jan 200




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LONG TERM EQUITY INVPage

Contrarily, in the fivdebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this pemanagers that employed a lowmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfo

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LONG TERM EQUITY INVPage 8


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LONG TERM EQUITY INV8


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LONG TERM EQUITY INVESTING

year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this pemanagers that employed a lowmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfo

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year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this pemanagers that employed a lowmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfo

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Returns 1 Jan 20

year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this pemanagers that employed a low-turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfo

Returns 1 Jan 20

Low


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Returns 1 Jan 20

year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this pe

turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfo

Returns 1 Jan 20

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Returns 1 Jan 20

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High


High


Returns 1 Jan 20


turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to addalpha by continually turning over their portfolio.

Returns 1 Jan 20

EAFE


Medium

EAFE


Returns 1 Jan 20


turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum alagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to add

lio.

Returns 1 Jan 2008

Med

ium

EAFE


Medium

EAFE


Returns 1 Jan 2003



08 –

Med

ium

EAFE

Medium

EAFE

3 –



– 31 Dec 2


Medium


– 31 Dec 2



31 Dec 2

Low


Low


31 Dec 2



31 Dec 2

Low


Low


31 Dec 2



31 Dec 2012



31 Dec 2007



012

High


High


007



012

High


High





Medium



turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this sameperiod, value and quality style factors outperformed, while momentum and growth style factorslagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to add

Med

ium

US


Medium

US



turnover investment approach tended to outperform those withmedium and high expected turnover strategies (see Appendix 2a, Panel 3). During this same

nd growth style factorslagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to add

Med

ium

US


Medium

US






Medium





Low

Low

year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate frombeing willing to accept risk to shunning it. The chart below shows that during this period,



Low

Low

year period ending December 2012, the global financial crisis, eurozonedebt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate from

riod,turnover investment approach tended to outperform those with

medium and high expected turnover strategies (see Appendix 2a, Panel 3). During this samend growth style factors

lagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to add


riod,turnover investment approach tended to outperform those with

medium and high expected turnover strategies (see Appendix 2a, Panel 3). During this samend growth style factors

lagged (see Appendix 2b). Again, one might speculate that investors were better off remainingwith managers that had conviction in their investment decisions and were not seeking to add

0.0%1.0%2.0%3.0%4.0%5.0%6.0%

-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%




0.0%1.0%2.0%3.0%4.0%5.0%6.0%

-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%



nd growth style factorslagged (see Appendix 2b). Again, one might speculate that investors were better off remaining

-2.0%-1.5%-1.0%-0.5%0.0%0.5%1.0%1.5%2.0%2.5%3.0%

debt panic, and the United States debt ceiling debacle of 2011 caused markets to oscillate from


Overall, one needs to understand the varying market styles that characterised the underlyingperiod before reaching a full conclusion. It is important to highlight that the style of investing canhave as much of an impact as the time horizon of the strategy and that different approaches withdifferent horizons can add value.

PORTFOLIO STYLE AND CHARACTERISTICSLong-term investing can apply to any style, such as growth, quality, or value. Our analysis of theglobal equity manager universe17 for the period ending 31 December 2012 showed somecommon style characteristics for short-horizon strategies, but less so for long-horizon strategies.Specifically, the average low-turnover managers displayed some positive value tilts, but nosignificant positive quality factors. The average high-turnover manager appeared to displaygreater tilts towards growth and momentum biases, with tilts away from quality and value. Werecognise this is a snapshot in time, and therefore cannot determine whether thesecharacteristics would be persistent. We are not surprised, however, with these style tilts asmomentum-biased strategies are frequently high-turnover and tend to be short-durationstrategies (if captured purely quantitatively).

It bears discussing some of the differences among growth, quality, and value styles. Growthmanagers will tend to concentrate on identifying companies that are going to generate highercash flows faster, or for longer (or both) than market expectations, and buy shares in thesecompanies, waiting for the growth and returns to materialise. These growth stocks can beexposed to short-term sentiment and managers may require higher turnover as they add or trimpositions to add value. There is no clearly agreed definition of what constitutes a “quality” biasedstrategy. However, investors that claim to invest in quality companies will often focus onidentifying companies with sustainable characteristics, which can equate to dominant marketpositions, high barriers to entry, strong balance sheets, and strong management. Such investorswill buy these companies at share prices that are not too high so as to erode the opportunities ofattractive long-term returns, and are more likely to exhibit lower turnover. These companies maynot be growing particularly quickly, but their enduring franchises enable the compounding ofreturns over long periods. Value investors tend to look for “cheap” stocks, and rely on the marketrecognising the underlying worth of the business, and often this may take some time, requiringpatience, discipline, and a long-term outlook. However, they may only hold stocks for a shortperiod, depending on when the market recognises the underlying value. Therefore, a valueinvestor is not always a long-term investor by definition.

From our experience, while fund managers may claim that they have a longer-term mindset than“the market” as a whole, these managers will typically tend to assess shares on a combinationof growth, quality, and value factors. In practice, the short-term effects of valuation changes,arising from market volatility, may be more a powerful influence on investment decisions thanthe longer-term changes in the value of the business driven by growth factors. In our view,genuinely long-term investors are more likely to be focused on growth and/or quality (wherestability is helpful to both) while value managers may perhaps be more precisely regarded as“patient” rather than genuinely long-term investors.

ENVIRONMENTAL, SOCIAL, AND CORPORATEGOVERNANCE (ESG) AND ACTIVE OWNERSHIP

17 We focused on the global equity universe only due to data completeness.


Active ownership is an area in which we see significant potential for enhancement for long-terminvestors. Asset managers with long-term investment horizons have highlighted to us theimportance of meeting with companies prior to making investment decisions as a key part oftheir decision-making process. From a monitoring perspective, some of these managers will alsotake a proactive role in maintaining a dialogue with companies, with the intention ranging fromgaining a deeper understanding of the firm’s strategy to driving changes in company behaviour,without necessarily becoming activist investors.18 However, many managers will be relativelyremoved from the voting and engagement process and instead rely on external researchproviders for guidance. Other managers will typically not engage with companies at all as theysee little value in this. These characteristics are reflected in our environmental, social, andcorporate governance (ESG) ratings, which assess the extent to which we feel managersintegrate ESG factors in their decision-making framework and take an active ownership rolethrough voting and engagement (see Appendix 3 for ESG ratings guidance).

Within this study, we focused on the Global Equity Core universe to look for trends in ESGratings, and found that, as would be expected, low- turnover managers exhibit better ESG andactive ownership characteristics than high-turnover managers (see chart below). More generally,the majority of the equity strategies we have rated in GIMD tend to exhibit some of thesecharacteristics indicated by managers achieving an ESG 3 rating or higher.19 An ESG 3 ratingtypically implies that managers, 1) have a thoughtful voting/engagement process in place, 2)arebroadly thinking about ESG integration , and/or 3) are placing greater emphasis on governanceissues (and less so on environmental and social). Although this distribution of ratings isreflective of the broad universe, we believe that managers with a long-term investment horizoncould be well placed to undertake a greater degree of higher-quality engagement withcompanies and integration of ESG issues where relevant.20

ESG Ratings by Turnover – Global Equity Universe

18 This paper excludes activist strategies primarily due to lack of data availability; however, some may argue that thisgroup of investors can be successful in creating long-term shareholder value.19 Based on data from May 2013, approximately 9% of all rated equity strategies were rated ESG 1 or 2 (highestratings); 46% were rated ESG 3 and 41% were rated ESG 4 (lowest ratings). See “Guide to Mercer Ratings.”20 The soon to be published paper, Building a Long-Term Shareholder Base: Assessing the Potential for Loyalty-Driven Securities, makes the suggestion for investors to move beyond the (important and legitimate) ex-post-orientedpractice of voting at AGMs (approving reports, remuneration) towards appropriate “higher quality” ex-anteengagement (not engagement for the sake of engagement, but engagement that ensures a constructive shareholdervoice).

0%10%20%30%40%50%60%70%80%90%

ESG 1: ESG 2: ESG 3: ESG 4:

Low Mid Highn = 95, strategies with a 10-year track record


As noted earlier, external research and the experience of a number of investment managershave shown that active dialogue and quality interactions with companies can be value-creatingfor the company and can lead to better corporate performance over longer periods. There isgrowing conviction among investors that taking a more holistic approach to investment decision-making, including ESG analysis and active ownership, can be financially material and enhanceshareholder value over the long term. We are seeing an increasing number of mainstreamglobal equity managers developing ESG policies and incorporating these factors as an integralpart of their investment decision-making and portfolio-management processes. This is reflectedby the growth in the number of signatories to the United Nations Principles for ResponsibleInvestment (see graph below).21 However, we recognise that engagement can only besuccessful if managers hold shares over a long enough time frame to enable the development ofa relationship with the companies; this would likely not be the most efficient use of time formanagers that have a short-term investment horizon.

Signatories of the UN Principles for Responsible Investment and AUM

Source: United Nations Principles for Responsible Investment

We note that this paper focuses mainly on asset managers and does not necessarily addressother market-wide benefits that can be achieved from investors becoming more long-termoriented. In a separate paper22, we explore the implications and benefits of other participantsalong the investment chain, such as asset owners and corporations behaving like owners byaddressing downstream leakages (such as active management fees, manager transition costs,and excessive trading) as well as upstream leakages (such as unwarranted M&A activity andmisaligned incentive structures at the corporation or enterprise level).

CONCLUSIONSWhere does this discussion take us? There are some clear advantages to investing with alonger-term outlook and lower-turnover approach. This does not negate the merits of someinvestment approaches with shorter-term horizons, although strategies with a longer-term

21 The graph shows all signatories to the United Nations Principles for Responsible Investment (UNPRI), with assetmanagers currently representing 62% of the total as at April 2013. Note that Mercer’s ESG ratings are not dependenton asset managers becoming signatories to the UNPRI; however, an increasing number of asset managers are beingdriven by this initiative to develop their ESG policies.22 Ambachtsheer Fuller, and Hindocha, 2013.

0

5

10

15

20

25

30

35

0

200

400

600

800

1000

1200

1400

Apr-06 Apr-07 Apr-08 Apr-09 Apr-10 Apr-11 Apr-12 Apr-13

Number of signatories Assets under management (US$ trillion)


investment horizon benefit from lower direct costs (for example, leakages) and a clear point ofdifferentiation (many institutional managers claim their investment advantage is the ability tolook through the “market noise” to take advantage of the short-term focus of the market). Afurther differentiator for long-term investors can be company engagement — specifically, assetmanagers with a focus on the long-term growth and value creation of a company couldpotentially benefit from becoming more active (but not necessarily activist) investors andworking with companies to create long-term value.

It is also clear that most institutional managers claim to have a relatively long-term outlook, incontrast to the broader market. Our data analysis shows that the majority of managers claim tohave expected turnover of less than 100% per annum, and between 35%–45% of managers inthe analysis believe they have turnover of less than 40% per annum. The results of our analysisshow that while low-turnover strategies in the Global Core and EAFE universes exhibited betterperformance over the 10-year period to December 2012, this was not the case for US LargeCap Core strategies. Furthermore, one needs to understand the varying market styles thatcharacterised the underlying period before reaching a full conclusion.

It is important to recognise the role that investment horizons and style biases will play inaffecting investment outcomes, and to assess performance against those expectations.Investors with a long-term investment horizon can cover a range of investment styles, andMercer’s manager research process focuses on what to expect from a given strategy andwhether this behaviour is in line with expectations of the manager. This incorporates the impactof “costs” on higher-turnover strategies and the potential for longer-term managers to capturethe advantages discussed above. Equally important for an investor with a long-term outlook isensuring the manager’s incentive structure is properly aligned with their objectives, and thatmanagers are free to operate outside the shorter-term pressures inherent within manyinvestment firms.

Some key questions that clients should consider addressing with their managers are:

- Does your manager’s investment philosophy and process call for adopting a longerholding period? How does portfolio turnover reflect this?

- If turnover is high, is this due to name turnover (i.e. entering or exiting positions) orreweighting of existing positions?

- Does the manager measure the long-term underlying corporate performance of stocksheld beyond the market value of the portfolio? Are there alternative measures toevaluate asset managers against their objectives (beyond quarterly performance) tomove away from a short-term focus?

- Is there room for higher levels of engagement and active ownership such that managerscould better use their influence for positive corporate change?

In closing, the systemic benefits of a long-term investing approach assume that longer-termholding periods by investors will allow company executives to focus more on long-term valuecreation and less on managing short-term financial results. This is creating interest in low-turnover managers from some of our clients. Mercer has more than 100 highly rated low-turnover strategies within the Global Equity, EAFE, and the US Large Cap Core universes, andwould be pleased to discuss the role that long-term mandates could play in client portfolios.


IMPORTANT NOTICES

References to Mercer shall be construed to include Mercer LLC and/or its associatedcompanies.

© 2013 Mercer LLC. All rights reserved.

This contains confidential and proprietary information of Mercer and is intended for the exclusiveuse of the parties to whom it was provided by Mercer. Its content may not be modified, sold orotherwise provided, in whole or in part, to any other person or entity, without Mercer’s priorwritten permission.

The findings, ratings and/or opinions expressed herein are the intellectual property of Mercerand are subject to change without notice. They are not intended to convey any guarantees as tothe future performance of the investment products, asset classes or capital markets discussed.Past performance does not guarantee future results. Mercer’s ratings do not constituteindividualised investment advice.

Information contained herein has been obtained from a range of third party sources. While theinformation is believed to be reliable, Mercer has not sought to verify it independently. As such,Mercer makes no representations or warranties as to the accuracy of the information presentedand takes no responsibility or liability (including for indirect, consequential or incidentaldamages), for any error, omission or inaccuracy in the data supplied by any third party.

This does not contain regulated investment advice in respect of actions you should take. Noinvestment decision should be made based on this information without obtaining prior specific,professional advice relating to your own circumstances.

This does not constitute an offer or a solicitation of an offer to buy or sell securities, commoditiesand/or any other financial instruments or products or constitute a solicitation on behalf of any ofthe investment managers, their affiliates, products or strategies that Mercer may evaluate orrecommend.

For the most recent approved ratings of an investment strategy, and a fuller explanation of theirmeanings, contact your Mercer representative.

For Mercer’s conflict of interest disclosures, contact your Mercer representative or seewww.mercer.com/conflictsofinterest.

Mercer’s universes are intended to provide collective samples of strategies that best allow forrobust peer group comparisons over a chosen timeframe. Mercer does not assert that the peergroups are wholly representative of and applicable to all strategies available to investors.

This document has been prepared by Mercer Investments (Australia) Limited ABN 66 008 612397 (MIAL), Australian Financial Services Licence #244385. ‘MERCER’ is a registeredtrademark of Mercer (Australia) Pty Ltd ABN 32 005 315 917.

http://www.mercer.com/conflictsofinterest


APPENDIX 1: MERCER’S FOUR-FACTOR ANALYSIS

As part of Mercer’s overall rating analysis for a strategy, Mercer’s investment researchers reviewthe strategy on the basis of four specific factors — idea generation, portfolio construction,implementation, and business management — each of which is assigned one of four scores:negative (-), neutral (=), positive (+), or very positive (++).

Mercer believes the first three factors are the main components of every investment processand managers that do these activities well should have above average prospects ofoutperformance. Mercer also believes that to remain competitive over longer periods, managersmust be able to maintain and enhance their capabilities in these three areas. To do this,managers need to have significantly strong business management, which is the fourth factorMercer assesses.

Factor Core belief

Idea generation The key attribute that a manager needs to possess to have potential tooutperform over the long term is the ability to generate value-addinginvestment ideas.

Portfolio construction The quality of a manager’s portfolio construction process will determine howeffectively its value-adding investment ideas are converted into consistentoutperformance.

Implementation For a manager to outperform, the value added through its investment ideasand portfolio construction process must outweigh the drag on its performancedue to transaction costs.

Business management Well-managed investment firms are more likely to maintain and enhance thecompetitiveness of their investment strategies over time than poorly managedfirms.


APPENDIX 2: DATA ANALYSIS

a. Risk/Returns Data by Turnover Approach

Panel 1: 1 January 2003 to 31 December 2012

Source: Global Investment Manager Database



Period AbsoluteReturn (%)

ExcessReturn (%)

StandardDeviation (%)

Tracking Error(%)

InformationRatio

High 9.7 1.6 18.1 7.5 0.2

Medium 9.4 1.3 17.3 4.6 0.2

Low 10.2 2.1 17.6 5.6 0.3

High 8.4 0.9 17.1 3.8 0.1

Medium 7.9 0.4 17.3 3.3 0.1

Low 7.9 0.4 16.8 3.9 0.1

High 9.4 0.7 19.2 4.0 0.2

Medium 9.9 1.2 18.8 4.1 0.3

Low 10.5 1.8 18.3 4.6 0.4

Global Equity Core

US Large Cap Core

EAFE


ExcessReturn (%)


Tracking Error(%)

InformationRatio

High 22.9 5.4 12.3 6.5 0.8

Medium 20.6 3.1 10.7 4.0 0.6

Low 21.2 3.7 10.7 4.7 0.7

High 14.7 1.3 9.9 2.9 0.3

Medium 14.5 1.1 10.0 2.7 0.3

Low 13.6 0.2 10.1 3.3 0.1

High 23.2 1.1 11.7 3.5 0.2

Medium 24.0 1.9 11.6 3.4 0.5

Low 23.1 1.0 11.0 3.7 0.2

Global Equity Core

US Large Cap Core

EAFE




b. Excess Returns by Style Factor (%)

Source: Style ResearchNote: Based on Style Research data, the excess return measures the performance of the top 50% of stocks within amarket less the whole of the market.


ExcessReturn (%)


Tracking Error(%)

InformationRatio

High -2.1 -1.5 21.9 8.2 -0.2

Medium -0.7 -0.1 21.7 5.0 0.0

Low 0.2 0.8 22.3 6.3 0.1

High 2.4 0.5 22.0 4.4 0.1

Medium 1.7 -0.2 22.4 3.8 0.0

Low 2.6 0.7 21.5 4.3 0.1

High -2.8 0.4 24.2 4.3 0.2

Medium -2.6 0.6 23.7 4.6 0.2

Low -0.8 2.4 23.2 5.2 0.5

US Large Cap Core

EAFE

Global Equity Core

Value Growth Momentum Quality

Global 1.9 -0.6 -0.1 1.1

US 1.2 -0.3 0.1 0.7

EAFE 1.4 -0.6 0.2 1.2

Global 2.1 -0.3 1.7 -1.2

US 1.3 -0.1 1.7 -2.4

EAFE 2.1 -0.2 1.6 -1.4

Global 1.7 -0.7 -1.5 2.9

US 1.2 -0.4 -1.3 3.6

EAFE 0.8 -1.0 -0.9 3.2

1 January 2003 – 31 December 2007




APPENDIX 3: GUIDE TO MERCER’S ENVIRONMENTAL, SOCIAL, ANDCORPORATE GOVERNANCE RATINGS

ESG Ratings

Mercer assigns ratings to strategies that represent Mercer’s view on the extent to which ESGand active ownership practices (voting and engagement) are integrated into the manager’sinvestment process and decision-making across asset classes. ESG factors are incorporatedinto the investment process on the basis that these issues can impact revenue, operating costs,competitive advantage, and the cost of capital. During discussions with managers about ESGintegration, Mercer assesses the use of ESG information to generate outperformance. Fourfactors are assessed to derive an overall ESG rating: idea generation, portfolio construction,implementation, and firm-wide commitment.

ESG ratings are differentiated between those assigned by Mercer’s investment researchers andthose assigned by Mercer’s Responsible Investment (RI) team. Ratings assigned by the RI teamwill include (RI) after the rating, indicating that a separate ESG research note has been writtenand that ESG factor scores are available in GIMD.

ESG Rating Scale

ESG1 /ESG1 (RI)

The highest ESG rating is assigned to strategies that Mercer believes to be leaders inintegrating ESG and active ownership into their core processes, and that provide clearevidence that ESG overall, or a particular ESG theme, is core to idea generation andportfolio construction.

ESG2 /ESG2 (RI)

The second-highest rating is assigned to strategies that, in Mercer’s view, include ESGfactors and active ownership as part of decision-making, with a strong level ofcommitment made at the firm-wide level and some indication that data and research arebeing taken into account by the managers in their valuations and investment processes.

ESG3 /ESG3 (RI)

The penultimate rating is assigned to strategies for which, in Mercer’s view, the managerhas made some progress with respect to ESG integration and/or active ownership, but forwhich there is little evidence that ESG factors are taken into consideration in valuationsand investment processes. Strategies with an ESG 3 rating will tend to place moreemphasis on governance factors and/or the voting process.

ESG4 /ESG4 (RI)

The lowest ESG rating is assigned to strategies for which, in Mercer’s view, little hasbeen done to integrate ESG and active ownership into their core processes.

For further information, please contactyour local Mercer office or visit our website at:http://www.mercer.com

Argentina

Australia

Austria

Belgium

Brazil

Canada

Chile

China

Colombia

Czech Republic

Denmark

Finland

France

Germany

Hong Kong

India

Indonesia

Ireland

Italy

Japan

Malaysia

Mexico

Netherlands

New Zealand

Norway

Peru

Philippines

Poland

Portugal

Saudi Arabia

Singapore

South Korea

Spain

Sweden

Switzerland

Taiwan

Thailand

Turkey

United Arab Emirates

United Kingdom

United States

Venezuela

http://www.mercer.com/

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LONG-TERM EQUITY INVESTMENT - Mercer...LONG TERM EQUITY INVESTING Page 5 of their investment strategies. We seek to understand how analysts and portfolio managers are aligned to client