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SEPTEMBER 2016 THE WORLD HAS CHANGED. Active Management must change with it INSIGHTS.IDEAS.RESULTS.
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Page 1: Global Equities The World has changed Whitepaper_v4

SEPTEMBER 2016

THE WORLD HAS CHANGED. Active Management must change with it

INSIGHTS.IDEAS.RESULTS.

Page 2: Global Equities The World has changed Whitepaper_v4

2 AMP CAPITAL GLOBAL EQUITIES

Being a successful investor within Global Equities means you constantly have to think about secular change, or its more fashionable term - disruption. Had we written this article in 1970, we would have used typewriters, not computers, and it would have taken several weeks to ship printed issues of this article to readers around the world. But for the investment management industry as a whole, and active management in particular, approaches to research, portfolio construction, and risk management have barely changed in 40 years. We are now at that tipping point where “change happens slowly, and then all at once.”In three sections, we summarise our views on how the drivers of markets and our understanding of investment management have transformed, and we propose some ideas and solutions for both asset managers and asset owners to consider.

Page 3: Global Equities The World has changed Whitepaper_v4

AMP CAPITAL GLOBAL EQUITIES 3

In the US in 1975 85% of S&P500 value was in ‘tangible assets’ such as plant and equipment, machinery, vehicles, buildings and land. This was because the US was still going through the end of its industrialisation and hence if you knew where the US was in the manufacturing and industrial production cycle, then you would have a good chance of calling the stockmarket. During this time industrial juggernauts like General Electric and Dow Chemical were bellwethers of the index.

Fast forward to 2015 and 80% of the value in S&P500 is in ‘intangible assets’ such as patents, trademarks, copyrights, goodwill, brand, R&D, innovation. Today, it is asset light, knowledge based industries and consumer services companies that dominate the leaderboard such as Facebook, Amazon, Netflix, and Google.

100%

1975 1985 1995 2005 2015

80%

60%

20%

40%

0

Intangible Assets Tangible Assets

Components of S&P500 market value

The first key point to understand is that as economies mature and become more consumer focused you can no longer rely on top down macro insights to understand value creation.

We need to be building bottom up thematic insights from individual companies in order to be a successful investor in the digital age and in order to meet our risk and return objectives.

Consequently, investment research will need to focus not only on the company’s tangible assets, which are commonly understood, but also their intangible assets. Understanding a company’s intangible characteristics such as their competitive advantages, innovation capabilities, capital allocation, culture, and governance policies can lead to better informed investment decisions and avoid value destruction.

Unfortunately for asset managers, we believe the traditional tools used by fundamental analysts may no longer be sufficient to fully capture the impact of the increasing pace and variety of changes being faced by today’s companies e.g. excel based linear modelling, Porters 5 Forces, SWOT, Capital Asset Pricing Model. All of these tools were created in the 1960s and 1970s and assume the world is tangible and identifiable.

However, the rapid penetration of exponential technologies being adopted across many industries is making it increasingly difficult for companies to even define who their customers, competitors, suppliers, and substitute products are. The advent of computers, big data, and Artificial Intelligence has made the past infinitely easier to model, but makes the future increasingly uncertain.

So how can fundamental analysis be part of the solution to meet these challenges? Fundamental analysis should strive to better understand “sustainable value creation” at a broader level and take into consideration an uncertain future landscape. We should assess how well companies can either lead change, or respond to it, by assessing a company’s ability to innovate and allocate capital efficiently whilst assessing the likely impact of structural change and disruption.

Consideration of the investment implications of change requires us to focus on the likely losers as well as the likely winners, and therefore in a world of disruption, investment philosophies and processes should be equally applicable to generating alpha through short positions as they do through long positions.

To summarise this first section, we have identified that the drivers of company and hence stock market value have changed. This requires us to rewire our thinking about how we carry out fundamental investment research.

We need to be building bottom up thematic insights from individual companies in order to be a successful investor in the digital age and in order to meet our risk and return objectives

The drivers of market value have changed

Page 4: Global Equities The World has changed Whitepaper_v4

4 AMP CAPITAL GLOBAL EQUITIES

2000 2002 2004 2006 2008 2010 2012 2014 2016

Active TotalPassive

500

2500

0USD

bn

-500

2000

1500

1000

-1500

-1000

-2000

2000 2002 2004 2006 2008 2010 2012 2014 2016

25

40

20%

15

35

30

5

10

0

Cumulative flows into global equity funds

Source: EPFR Global, ICI, and Bernstein analysis.

Passive share of total equity fund AUM

Source: EPFR Global, ICI, and Bernstein analysis.

Before the widespread use of computers (and fax machines), the ‘edge’ in fundamental equity research was seen to be in information gathering. Consequently, managers employed armies of analysts to ‘hunt’ for information.

Now, information is everywhere, owing to the use of computers, the internet, big data, and artificial intelligence in addition to fair disclosure of information regulations. In the short-term, market efficiency is about news, changing risk aversion, liquidity and transaction costs. Machines now do this much better than humans can and their collective intelligence is multiplying at a rapid rate. That has resulted in a substantial decrease in alpha generating opportunities for fundamental investors in the short term.

However, most active managers remain focused on outperforming market capitalisation weighted benchmarks over a 12 month time horizon. Further, encouraged by consultant frameworks they often employ largely systematic if not mechanistic processes, which effectively expose the portfolio to a discrete set of factors, such as value, growth, or size. This is despite the fact that one word style descriptors are often unhelpful given that ‘Style’ and portfolio characteristics are not the same.

But given the pressure to fit processes into ever smaller style boxes, it should therefore be no surprise that enhanced passive and smart beta strategies have emerged. These strategies aim to replicate these factors and hence a considerable portion of an active manager’s process for a very low fee.

Global investors have, in aggregate, bought $2 trillion of passive equity funds and ETFs over the last 10 years and at the same time have sold $1.5 trillion of active positions. As such, the proportion of equities run passively has risen from 15% to 35% over the last decade.

In a research report, Sanford Bernstein quip that “smart beta is growing not because it is an intellectual breakthrough, but because like Uber, it is cheap and disruptive.” To explain why, let’s assume an investor believes in quality and seeks exposure to it. The investor can either find an active manager focused on quality companies or can simply buy a smart beta product such as iShares MSCI World Quality Factor ETF. At first glance the answer seems obvious, the investor should choose the smart beta ETF at a cost of just 10 basis points rather than the active manager at a cost of 100 basis points.

However, quality isn’t just one factor, it is two: (1) the spot (today) level of returns and (2) the evolution (future) of returns. Smart beta can help us with the first part, but fundamental analysis is required for the second part, and this is where the majority of alpha is to be found. Over a 5 year holding period >2/3 of stock performance is due to value creation with <1/3 due to changes in multiple. Over 10 years, multiples may move 50% but earnings could grow 10x, highlighting the non-mean reversionary importance of quality growth.

The simple message here is that active managers need to focus on the long term and on genuinely non replicable stock research, the kind of insight which cannot be picked up by a machine.

Our understanding of investment management has changed

Page 5: Global Equities The World has changed Whitepaper_v4

AMP CAPITAL GLOBAL EQUITIES 5

Proposals for considerationThe end of the active-passive distinction is ultimately, we think, a good thing. Investors now have a much improved understanding of alpha vs beta and their interaction with costs & fees.

We have moved out of the univariate benchmark paradigm of the last 30 years to a multivariate benchmark world, where the smart betas have become benchmarks.

This realisation requires fundamental active managers to demonstrate true skill at stock selection, portfolio construction, and risk management. Active fees need to be supported by meaningful alpha potential. The key to defending active fee levels will be to demonstrate idiosyncratic returns.

For fundamentally driven portfolios it means an explicit focus on identifying companies that create value over the longer term. In doing so, active engagement with companies will become increasingly important for understanding intangible drivers of companies – in other words, those unable to be picked up well by passive / quantitative approaches. Further, by actively engaging with companies we are in a better position to assess whether risks are being managed appropriately and we can encourage boards to shift their remuneration focus away from short term share price gains to broader metrics that are focused on long term value creation.

The new world requires highly active, benchmark unaware, conviction weighted, long term orientated portfolios focused on the understanding of competitive advantages, structural change, and secular trends.

These portfolios should be constructed within a risk focused framework to maximize stock specific risk. Some of the best suited strategies to achieve this are concentrated long only portfolios, and fundamental market neutral strategies focused purely on selecting stocks to deliver consistent, incremental returns with low volatility across an investment cycle and with low correlation to equity and bond markets.

The ability to isolate alpha in this way and package it up with the other components of returns creates many opportunities for asset managers and asset owners to construct tailored solutions around an increasingly customised set of investment goals. It means investors can reduce payment in some commoditised areas, such as market and factor exposure, and allow for spending money where it is most valuable, such as the efficient capture of cross-asset risk premia and also on rewarding real, true stock picking.

There are four themes which we expect will become highly important to meeting risk and return objectives in the new world:

1) Long short opportunities to increase in a world of rising disruption, dispersion, and divergence

2) Concentrated portfolios to counteract rising correlations

3) Capital Structure & Corporate Governance dynamics

4) Long Term mindsets and long term mandates

These portfolios should be constructed within a risk focused framework to maximize stock specific risk

Page 6: Global Equities The World has changed Whitepaper_v4

6 AMP CAPITAL GLOBAL EQUITIES

We believe that the change in the value drivers of markets combined with the need for active managers to generate idiosyncratic returns will increasingly require listed investment strategies to consider accessing the full breadth of investment opportunities through long short investing.

In addition a low growth, low inflation, low return world means that the overall pie is growing quite slowly. However, structural shifts and secular change, predominantly through the disruptive forces of technology, mean the shifts within the slices of the pie are happening at an unprecedented pace.

Consumer spending might grow at 2-3% in this new world, but Amazon Retail is growing at 30% per annum and its Prime customers have the same consumer spending power as the whole of Germany. Whilst not all market share donators are standalone shorts, those which have high operational and/or financial leverage, poor capital allocation and governance policies, are at extreme risk.

Thus the next decade should really be the environment for fundamental long short investing to thrive.

There are a number of drivers for this:

The disrupters can be unlisted. Most disruption is being created by capital light businesses. By definition capital light businesses, typically in the technology, consumer, and healthcare sectors, require less capital. So there is less of an urgency to list on the stock exchange and for the founders to increase disclosure of their operations, dilute their equity, or give up voting rights. This means they are more secretive, more flexible, and more determined. This development has coincided with the growth in the private capital markets including venture capital and private equity.

For example, Uber and AirBnB have been incredibly disruptive to the global travel market but are still unlisted. In the food retail sector, Aldi and Lidl are low cost business models which have impacted the traditional supermarket giants all over the world from Tesco in UK to Woolworths in Australia. Both Aldi and Lidl are unlisted. The collective growth of smaller niche and bespoke brands, aided by the Internet and social media, are taking market share from the major brands. Organic, farm to table food, craft beers, and identity fashion are good examples.

Listed disrupters may not always be ‘investable’. Disruption from below typically occurs when a new technology is applied to rapidly reduce the cost of a good or service. If the good or service is commoditised then the benefits are passed straight through to the consumer rather than being held by the producer. For example, we believe that whilst renewables are great for the world, we are generally cautious on investing in listed companies given persistent cost (and price) deflation and low returns. However, we believe renewables as share of global energy mix is set to rise considerably over next 30 years and as such it adds to our negative investment thesis on fossil fuels.

Glamour stocks may have glamorous valuations. Some investment themes can be highly emotional and as such the popularisation of the theme and the poster child company can see valuations rise wildly. For example, whilst we are big believers in the structural transition away from traditional broadcasting and advertising models towards online and over the top media, we find it hard to reliably assess value in ‘hot stocks’ like Netflix but in turn it is much more efficient to be short traditional media companies.

We believe that the change in the value drivers of markets combined with the need for active managers to generate idiosyncratic returns will increasingly require listed investment strategies to consider accessing the full breadth of investment opportunities through long short investing

Long short opportunities to increase in a world of rising disruption, dispersion, and divergence

The average age of technology companies going public in 2014 is now 11 years. This has steadily risen from just 4 years in 1990s.

Number of companies valued at more than $1 billion1

Public funding Private funding

Number of companies valued at more than $10 billion1

2005 2010 2015

100

400

300

200

02005 2010 2015

100

0

Tech companies are increasingly gaining significant scale and market share without going public

Page 7: Global Equities The World has changed Whitepaper_v4

AMP CAPITAL GLOBAL EQUITIES 7

Environmental, Social, and Governance. The challenges of disruption combined with management teams which have a poor track record of capital allocation and poor governance policies can generate large idiosyncratic and uncorrelated alpha. There have been many company examples in recent years across multiple industries including Tyco, Toshiba, Deutsche Bank, Volkswagen, Valeant, Yahoo!, Hertz.

In simple terms, if as a fundamental investor you can correctly identify structural change but you cannot access the disrupter on the long side because it is unlisted, you can at least short the incumbent.

In technical terms, disruption creates dispersion and divergence. Dispersion and divergence is a persistent phenomenon across regions, countries and sectors around the globe and can be readily captured by a fundamental equity process. One highly intuitive, but typically unconsidered, aspect of dispersion and divergence is that it is, by definition, always a positive number, unlike market beta, which can be decidedly negative.

Consequently, Long Only investors may find that the value they create through stock picking is, on occasion, overwhelmed by market turbulence. Conversely, Long Short investors only need relative conviction to prove justified in order to generate incremental gains (assuming effective management of market-related risks).

It is our belief that the structural shifts underway have placed pressure on sales growth for incumbents and increased the risk of adverse operating and financial leverage for lower quality companies. This is supported by evidence which shows that the pool of stocks that destroy value (proxy for structural shorts) is growing. Now 35%, from 25% 5 years ago, and highest in Asia.

45

35

40

30

20

10

25

5

15

0

Firm

s w

ith

RO

IC<W

AC

C(%

)

’11 ’12 ’13

Global

’14 ’15

25.8

28.7

33.8

27.8

34.4

’11 ’12 ’13

North America

’14 ’15

14.5

20.7

25.6 23.0

30.0

’11 ’12 ’13

W. Europe

’14 ’15

24.2 26.0

34.4

29.0

35.1

’11 ’12 ’13

Asia

’14 ’15

35.8 36.2

39.4

30.7

36.1

Page 8: Global Equities The World has changed Whitepaper_v4

8 AMP CAPITAL GLOBAL EQUITIES

There is growing concern that an increase in passive penetration increases correlation within stock markets. Whilst the evidence remains mixed on a simple relationship between the proportion of passive assets and average stock correlations, Sanford Bernstein believer there is strong evidence which suggests that when correlation spikes occur they do appear to be amplified by more passive management.

Further, they appear to demonstrate that some concentrated funds exhibit an advantage when correlation spikes higher. As correlation increases, especially on the scale that we have seen in recent years, ceteris paribus, it becomes harder for active managers to outperform as, even if their views are correct, they can’t differentiate themselves from the market. The one exception to this is the group of highly concentrated managers who are

not diversified. If they have a concentrated position in a very small number of names, then they can produce a return that is meaningfully different from the market.

Of course, they have to get their views right, and periods of increasing correlation often go hand-in-hand with “bad” developments in markets, but at least they have the potential to do well. The empirical evidence bears this out, showing there is a tendency for the more concentrated funds to outperform in periods of increasing stock correlation. Moreover, this is outperformance that they generally don’t give back as correlation falls.

In addition, concentration can provide higher returns for a limited increase in risk – why own your 50th best idea if you don’t have to?

% Reduction in possible average volatility with number of stocks held

Source: Fisher & Lorie - All NYSE Stocks traded 1926 - 1965

600

Ind

ex

Ind

ex

400

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0

110

100

95

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Europe fundamental fund AUM: <40 stocks vs. >40 stocks

Mar

-05

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-05

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-06

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-07

Mar

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-08

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-11

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-11

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-12

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-12

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-13

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-13

Mar

-14

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-15

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-14

Sep

-15

Shift towards true active (alpha) strategies, while the traditional core flounders

100

90

1 2 8 16 32 128 Entire Market

80

70

60

50

20

10

40

30

0

CONCENTRATED PORTFOLIOS COUNTERACT RISING CORRELATIONS

Page 9: Global Equities The World has changed Whitepaper_v4

AMP CAPITAL GLOBAL EQUITIES 9

The figure below shows that the two best-performing tracking error categories within fundamental management were 5-8% and greater than 8%, while the worst was the group with tracking error less than 2%. This difference still survives net of fees, with the 5-8% tracking error category delivering the highest return and the less than 2% category having the lowest return.

130

140

150

110

120

Ind

ex

100

90

2005 2006 2007 2008 2009 2010 2011 2012 20152013 2014

0.2 to 2(11) 5 to 8(51)2 to 5(146) >8(11)

120

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Ind

ex

100

95

105

85

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2 to 5(41) 5 to 8(23)

2005 2006 2007 2008 2009 2010 2011 2012 20152013 2014

Gross relative performance of fundamental funds by tracking error categories

Source: eVestment and Bernstein analysis

Net of fee relative performance of fundamental funds by tracking error categories

Source: eVestment and Bernstein analysis

The opportunity to deliver better performance potential for similar risk, particularly within a highly correlated market regime, have seen concentrated buck the trend in active AUM flows. The share of fundamental AUM accounted for by funds with fewer than 40 stock holdings has doubled over the last five years. We expect this to continue.

The share of fundamental AUM accounted for by funds with fewer than 40 stock holdings has doubled over the last five years. We expect this to continue

Page 10: Global Equities The World has changed Whitepaper_v4

10 AMP CAPITAL GLOBAL EQUITIES

CAPITAL STRUCTURE & CORPORATE GOVERNANCE DYNAMICSOver time, the impact of capital allocation and capital intensity on portfolios can be dramatic. A Credit Suisse report from 2015 showed that capex-lite companies have outperformed capex-heavy companies in Australia by 830 basis points per annum since 1989. There are similar studies on the US market going back to the 1930s comparing the capex-heavy steel industry to the capex-lite beverage industry. This difference in performance, spread out over 80 years, is enormous – an investment of $1,000 in the beverage sector has grown to $26m whilst a $1,000 investment in the steel industry has turned into $57,000.

Less capex = more shareholder returns Return of Buying Bottom Third of Capex/Sales Companies and Selling Top Third*

800

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400

600

200

100

300

0

Capex-lite companies outperform capex-heavy

Capex-heavy companies outperform capex-lite

89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 0807 09 10 11 1412 13

* ASX 200 ex-Fins, current constituents. Source: Holt, Datastream, Credit Suisse estimates

It is not that capital intensity is bad per se, but most managers are not effective at doing it. We have analysed why the vast majority of management teams tend to allocate capital poorly. One of the reasons for this is that they are not incentivised to do it. In Australia, TSR and EPS growth dominate. TSR is mentioned in 80% of incentive plans versus 50% in US and EPS growth in 40% of incentive plans versus 25% for US. Return on capital and cashflow are one of the lowest at 20% and 5% respectively, despite the fact that return on capital-based incentive plans tend to correlate with strong outcomes.

Frequency of 2015 long-term incentive plan metrics, for ASX 100 & S&P 500 companies100%

TSR EPS Returns CashFlow

Revenue OperatingIncome

80%

60%

20%

40%

0

Australia USA

Return on capital-based incentive plans tend to correlate with strong outcomes35%

Returnon capital

Operatingincome

TSR Revenue EPS Cash flow

Sector average TSR25%

30%

20%

10%

5%

15%

0

Going deeper, an area of research we are currently engaged with is the interaction between industry disruption and management incentives. When faced with industry challenge, are CEOs incentivised to do the right thing and focus on value creation or are they more concerned with short term EPS or empire building? Many CEOs try to defend disruption by making a bold acquisition for ‘strategic’ reasons which can compromise the balance sheet and future return p[potential.

Page 11: Global Equities The World has changed Whitepaper_v4

AMP CAPITAL GLOBAL EQUITIES 11

The market’s disproportionate focus on short-term factors leads to the market mis-pricing and undervaluing companies that can generate secular growth and returns, and in turn, creates alpha generating investment opportunities. The reason why long term investment opportunities exist is rooted within behavioural psychology and cognitive science which tells us that humans exhibit a general tendency to underestimate long-term impacts and overestimate short-term impacts on asset prices and economies.

In the long-term market efficiency is about valuation, growth and cost of capital. The longer your time horizon, the more important the difference in the rate of return on capital the company generates and can reinvest at becomes relative to the difference in the multiple you buy or sell at. Over a 5 year holding period >2/3 of stock performance is due to value creation with <1/3 due to changes in multiple.

Over 10 years, multiples may move 50% but earnings could grow 10x, highlighting the non-mean reversionary importance of quality growth. Generally, superior return premiums do fade over time but in some rare cases they can be sustained for 20 or 30 years. For fundamental investors, this results in a significant shift from information advantage to understanding advantage. We can measure the persistence of return premiums by analysing a firm’s competitive advantages.

Longer term market performance driven by value creation

100%

1 month 3 month 1 year 2 years 3 years 5 years

70%

50%

20%

90%

80%

60%

40%

10%

30%

0

Multiple change

Prop

orti

on o

f EV

ch

ange

, by

fact

or

Cashflow growth

6%

94%

17%

83%

41%

59%

52%

48%

59%

41%

68%

32%

Illustrative performance – importance of ROIC over multiple

Company A (Low ROIC)

Company B (Low ROIC)

Book value at year 0 100 100

Valuation at year 0 1.5x 2.5x

Market value year 0 150 250

Multiple expansion/(contraction) 33% (20%)

Return on invested capital 10% 20%

Market value year 10 519 1,238

Annualised return 13% 17%

Reward per risk Low High

As Towers Watson note in a recent paper, Long-term investing requires the asset owner and asset manager to have, and stick to, a long-term mindset in the face of tough times. While intentions are often genuinely to be long-term, the resilience of this position is invariably challenged over the investment period.

For the asset owner and asset manager it is important to have investment beliefs regarding why a long-term investing policy is being pursued. These beliefs should be formed through collaborative discussion and hence commonly shared. Then, ingrained in stone, they should represent the DNA which sets the starting point for investment decision-making and processes.

Being long term means missing out on short-term opportunities along the way without someone pointing the finger. During many three-year periods the long-term portfolio manager will be in the bottom half of the pack.

For example, despite the track record for long-term value of a quality focused growth strategy, there are times when the market rotates into unloved stocks, commonly termed “junk rallies”.

A typical example is when bull markets mature and in the very early recovery stages when there is a tendency for investors / speculators to rotate into capital intensive cyclicals that carry high operating and financial leverage, companies which typically have a very poor track record of long term value creation, or concept companies with no earnings. Example periods occurred during 1998-99 and 2007-08

Although many investors try to mix styles (in an attempt to maximize returns), we do not believe that the injection of ‘trash’ into quality portfolios or neutralizing sector bets to hedge beta in the short term would improve our ability to meet our long-term objectives. Periods of underperformance tend to be relatively short lived, as high quality firms tend to maintain attractive operating returns while poor quality firms generally remain disappointments.

However maintaining this view can lead to reputation risks, career risks, regret and pressures both externally and internally to repeatedly justify poorly performing investments as peers produce superior results and, in the case of a DB pension fund for example, funding deficits worsen. Long-term investment in public markets is not the norm and requires resource, skill, internal support (for example appropriate compensation mechanisms) and a contrarian attitude to execute well.

The reason why long term investment opportunities exist is rooted within behavioural psychology and cognitive science

LONG TERM MINDSETS AND LONG TERM MANDATES

Page 12: Global Equities The World has changed Whitepaper_v4

Important note: This document is provided for Australian residents and residents of countries where it would not be prohibited or against local laws to provide the information in this document (“Permitted Jurisdictions”). This document is not provided to any person who is a resident of any other country. The information in this document is only available to persons accessing the document from within Australia or another Permitted Jurisdiction. While every care has been taken in the preparation of this document, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) makes no representation or warranty as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This document has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This document is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital. © Copyright 2016 AMP Capital Investors Limited. All rights reserved.

CONTACT DETAILS For more information on how AMP Capital can help grow your portfolio, visit our website, www.ampcapital.com


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