R E S E A R C HPE R S PE C T I V E SVOLUME 6; NO. 2

H E A LT H W E A LT H C A R E E R

C O N T E N T

03 F O R E W O R D

04 I N F L A T I O N — Y E S T E R D A Y ’ S P R O B L E M ?

08 E M E R G I N G M A R K E T D E B T ( E M D )

13 A L T E R N A T I V E R I S K P R E M I A ( A R P )

19 I N V E S T I N G I N A T I M E O F C L I M A T E C H A N G E : E Y E S O N 2 0 2 0 A N D B E Y O N D

22 A R T I F I C I A L I N T E L L I G E N C E

26 C R Y P T O C U R R E N C I E S : F O O L’ S G O L D O R T H E F U T U R E ?

32 P O S T C A R D F R O M A L E X I S C H E A N G

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Robert Howie is a principal in the Hedge Fund Boutique of Mercer’s Wealth business. He leads manager research and the generation of intellectual capital for alternative assets in Europe, focusing on hedge funds, insurance-linked securities, multi-asset and other liquid alternative strategies. Additionally, he advises institutional investors on the use of alternative assets, including manager selections and portfolio construction. He may be reached at robert.howie@mercer.com.

Matt Reckamp is a principal based in St. Louis. He conducts research on private equity funds and fund of funds as a member of the Mercer Private Markets group. Previously, he researched US equity strategies for Mercer’s Equity Boutique. Matt remains involved with client work, with particular emphasis on foundation and endowment clients. He may be reached at matt.reckamp@mercer.com.

Welcome back to Research Perspectives! This edition features three nuanced investment topics with real portfolio management implications. For example, we begin with an article that considers the shifting inflationary (and disinflationary) forces and whether the potential for inflation is still relevant for today’s investors. The next piece is a bullet-point primer providing an inclusive, but streamlined, summary of emerging market debt as a viable investment option. We follow that with a discussion on a specific segment of the hedge fund universe known as alternative risk premia funds. These funds seek to systematically capture return sources and are beginning to be used as a complement to liquid alternative allocations.

This edition also features a few articles on very topical subjects with potentially significant broad-based implications. We start with an announcement of our upcoming comprehensive report, The Sequel, a follow-up to our 2015 paper, Investing in a Time of Climate Change. On a related note, this edition of Research Perspectives also includes a postcard from Alexis Cheang, featuring her thoughts on Mercer’s responsible investment efforts. We then briefly address some applications and implications of the emergence of artificial intelligence. The final piece tackles the emergent topic of cryptocurrencies, considering both the causes for enthusiasm as well as pending challenges.

We hope you enjoy!

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I N F L AT I O N — Y E S T E R D A Y ’ S P R O B L E M ?

Boom boxes, Polaroids, floppy disks and phone books — these are mostly alien to younger generations today, consigned to the past thanks to the wisdom and technology of our age. With only one of the last 35 calendar years exhibiting inflation above 5% in the US, is high inflation just another quaint phenomenon to be added to the history books? Or is it a dormant risk lying in wait?

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1 For an interesting, although somewhat technical, discussion of some of the limitations of our understanding of inflation, please see a presentation by Claudio Boria, Head of the Monetary and Economic Department at the Bank for International Settlements, titled, “How Much Do We Really Know About Inflation,” presented at the 87th Annual General Meeting of the BIS in June 2017, available at https://www.bis.org/speeches/sp170625a.htm.

For some observers, the runaway levels of inflation observed in the 1970s and 1980s are unequivocally a problem of the past. A combination of central bank independence, structural reductions in the strength of organized labor, decreasing reliance on fossil fuels and improvements in technology that lower consumer prices has made inflation more easily controlled by policymakers, and high levels of inflation are unlikely.

However, others argue that inflation is almost inevitable as unemployment reaches secular lows in the US and the UK, a reversal in demographic trends will see rising dependency ratios in the decades ahead, and central bank policy remains extremely stimulative in a historical context.

The reality is that we cannot know for sure. Inflation is a complex phenomenon driven by many interacting forces within an economy, and although some of these relationships are relatively well understood, others are not.1 Consequently, we are cautious about making bold predictions around the likely level or direction of inflation over time.

We do believe, however, that the balance of inflationary and disinflationary forces is shifting in a manner that suggest an increasing number of plausible scenarios in which inflation could move meaningfully higher than current levels in developed economies.

P E A K G L O B A L I Z A T I O NInflation and wages — and by extension, the labor market — are intertwined, and for the last few decades, the increasing globalization of the labor market has acted as a disinflationary force, as it has opened up cheaper labor markets in emerging economies. This has reduced the bargaining power of workers in developed economies and exerted downward pressure on both wages and prices globally.

However, the influence of this relationship may be waning as previous sources of cheap labor in Asia, Latin America and Eastern Europe see their wages and living standards increase and the options for low-cost labor outsourcing reduce. Although there may be scope for further trade liberalization to drive production costs down globally, there is perhaps a greater chance of moves in the opposite direction (“deglobalization”) given the current tensions surrounding global trading relationships.

F E W E R W O R K E R S A N D M O R E R E T I R E E SAnother inflation driver, with a long-term trend that may be changing direction, is global demographics — in particular, the proportion of the total population that is working versus the proportion not working (that is, the dependency ratio).

There is a lively debate around how changes in the dependency ratio may influence interest rates and inflation, but a compelling argument centers on the supply and demand for goods and services. In simple terms, the argument is that children and retirees contribute only to the demand for goods (via consumption), whereas the working age population contributes to both the demand and the supply of goods (via consumption and production of goods). The dependent population (children and retirees) therefore provide an inflationary impulse to the economy, whereas the working age population tends to be a disinflationary force (since its production tends to exceed its consumption).

United Nations population projections suggest that we are at, or close to, a turning point in the global dependency ratio. This could mean that a longstanding disinflationary force may turn into an inflationary one over time.

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C Y C L I C A L P R E S S U R E SIn addition to the structural drivers, a further inflationary impulse arises from cyclical pressures in the current economic environment. Although cyclical drivers such as low levels of unemployment and strong global growth can, to some extent, be offset by tightening monetary policy, cyclical forces are arguably more inflationary today than at any time since the global financial crisis. This is particularly true in the US, where fiscal stimulus is being applied at a time when the economy is already facing late-cycle inflationary pressures.

Running counter to the above, it is worth noting that technology is likely to remain a powerful disinflationary force for decades to come, with the prospect of rapid increases in automation placing downward pressure on wages and production costs. However, it is extremely difficult to assess the likely pace of technological development and its impact on inflation over time.

Given the challenges of determining the drivers of the inflationary process and the complex interaction of the forces, we would caution against emphasizing a firm prediction on the likely level or direction of inflation over time. However, our discussion highlights that the balance of inflationary and disinflationary forces in the global economy may be changing, and we would argue that inflation risks are currently skewed toward the upside from a cyclical standpoint. Investors should therefore avoid biasing portfolios in a way that assumes a continuation of past trends and seek to ensure that portfolios are likely to be robust in inflationary scenarios.

Building on a clear assessment of an investor’s inflation needs (driven by the investor’s objectives and liabilities), we encourage inflation-sensitive investors to review the balance of risks within their portfolios and, in particular, the extent of their exposure to higher inflation scenarios.

Inflation-sensitive investors holding portfolios dominated by broad market equity and fixed interest bonds could consider diversifying both their growth and their defensive portfolios. Within growth portfolios, real assets — both listed and unlisted — may provide some degree of inflation sensitivity. Within defensive portfolios, inflation swaps, inflation-linked bonds, shorter-duration bonds and floating-rate assets are likely to prove more robust under higher inflation scenarios than traditional fixed interest government and corporate bonds.

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Inflation risks are currently skewed toward the upside from a cyclical standpoint. Investors should avoid biasing portfolios based on past trends and ensure that portfolios are robust in inflationary scenarios.

Phil Edwards is the Global Director of Strategic Research within Mercer’s Wealth business, with responsibility for developing intellectual capital on portfolio construction, asset-class views and key investment themes. Phil sits on the Global Strategic Research Committee, which has responsibility for driving Mercer’s research agenda and bringing new ideas to Mercer’s client base. He may be reached at phil.edwards@mercer.com.

Ian Murray is a research associate within Mercer’s Global Strategic Research Team, with responsibility for supporting the development of intellectual capital on portfolio construction, asset-class views and key investment themes. He may be reached at ian.c.murray@mercer.com.

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E M E R G I N G M A R K E T D E B T ( E M D)

W H AT I T I SDebt issued by countries, or by corporates based in countries, defined as “emerging” based on certain widely accepted criteria, such as GDP per capita being below a certain ceiling level

S O V E R E I G N L O C A L C U R R E N C Y D E B T• Issued in a country’s own (local) currency

• Less-direct link between local-currency bonds and developed-country bond markets

• Inherently involves substantial FX volatility exposure to the currencies of the EMD issuer countries

• Main index is JP Morgan Government Bond Index – Emerging Markets (JPM GBI-EM)

• Main indices contain <20 countries, but, in aggregate, these countries tend to have slightly higher credit rating than those in hard-currency indices

S O V E R E I G N H A R D C U R R E N C Y D E B T• Issued in “hard” currencies (predominately US dollars,

but also euros or sterling)

• Broadest EMD category, with >80 EM countries issuing hard currency debt

• Main index is JP Morgan Emerging Market Bond Index set (JPM EMBI)

• Has indirect exposure to country’s local currency since the country’s ability to repay debt may be affected by the level of its exchange rate

• Tends to link to US Treasury market and US economy because yield of hard-currency bonds offers an “EMD/credit” yield premium above prevailing treasury

T Y P E S O F E M D

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C O R P O R A T E D E B T • Usually issued in US dollars

• Also issued in local currency, but most global investors tend to focus on hard currency

• Main index is JP Morgan Corporate Emerging Market Bond Index (JPM CEMBI)

• Breadth of issuance extends across 40–50 countries

• Linkage between EMD (hard currency) Corporates and US Treasury market and US economy

• Hard-currency EM corporate mandate offers clear yield pick-up in comparison to US treasuries and arguably has less “EM country risk” than sovereign EMD portfolio

• Portion of EM corporates market is included in broad global high-yield indices, so some degree of overlap possible between EMD and high-yield mandates

O T H E R F O R M S O F E M D• Frontier EMD markets

• Local currency corporate bond

• Many EMD managers may invest in bonds in these categories as part of wider EMD portfolios, but stand-alone mandates in these areas are relatively few at this point

E M D P E R F O R M A N C E I N R E C E N T Y E A R S

EMD markets linked with US bond market via prevalence of

issuance in US dollars

Returns roller-coaster-like, with steady performance post-Global Financial Crisis followed by sharp

sell-offs in May 2013 due to US easing expectations and in 2015 due to global

risk and commodity price declines (especially oil)

Performance sensitive to macro economic events, US dollar and US

interest rates, commodity prices and liquidity conditions

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W H AT H A V E O U R C L I E N T S B E E N D O I N G ?

E M D A N D A C T I V E M A N A G E M E N T

I N V E S T O R S W I T H S T R A T E G I C P R E F E R E N C E F O R L O C A L C U R R E N C Y

• Long-term strategic allocations to local-currency EMD as a component of a growth portfolio

– Higher credit quality of the issuer base underpinning local currency

– Higher level of available yields

– Additional alpha lever for investment managers

– Additive to market returns when EM currency appreciates

A C T I V E M A N A G E M E N T

• Allows investors to obtain exposure to the beta of an asset class in an effective manner

• Is required to counterbalance the flaws of benchmark investing evident in EMD

• Controls some of the tail-risk characteristics of the asset class

• Manager alpha potential through:

– Information-flow asymmetries

– Differing levels of market access

– Varying levels of market liquidity

– High degree of idiosyncratic credit risk across the issuer universe

I N V E S T O R S W I T H L E S S T O L E R A N C E F O R V O L A T I L I T Y

• Implementation of a total-return approach

– Still exposed to general beta of the asset class

– Incorporation of some downside protection

– Ability to invest across the broad spectrum of EMD assets

P A S S I V E R E P L I C A T I O N

• Harder to replicate EMD markets due to higher and more complex tax levels and higher levels of market turnover

• Tends to be more expensive than in other markets

• Often has higher tracking error characteristics than developed markets

Generally, various EMD categories can serve the needs of different investors. Several multi-asset credit managers use EMD in their portfolios, across the hard, local and corporate spectrum.

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Many EM economies are also exposed to demographic tailwinds driven by younger populations, which are expected to contribute positively to labor force and economic growth.

From a debt perspective, a number of key emerging economies also enjoy lower levels of government debt and stronger fiscal positions than their developed-market counterparts.

EMD exposure provides investors with access to a large and diversifying set of assets and return drivers with different characteristics to developed-world assets.

EM growth dynamics present the possibility for significant productivity gains due to improvements in infrastructure, equipment and labor force up-skilling.

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Noel is a senior consultant with Mercer’s Wealth business in Dublin, working in Mercer’s Bond Boutique, where he is the lead researcher for EMD and MAC strategies. Noel sits on Mercer’s Global Asset Allocation Group and is a member of the International Ratings Review Committee. Prior to joining Mercer in 2000, Noel worked for seven years as a fixed-income and currency asset manager with a Dublin-based fund manager. He is a Fellow of the Institute of Actuaries and holds a first-class honors degree in economics and mathematics from Trinity College Dublin. He may be reached at noel.collins@mercer.com.

EMD strategies can play a valuable role in investors’ growth portfolios going forward. Such exposure could be across the EMD spectrum or could focus more on EMD local currency, where yields are higher with a slightly higher issuer credit quality on average.

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A LT E R N AT I V E R I S K P R E M I A ( A R P)

W H A T A R E A LT E R N A T I V E R I S K P R E M I A S T R A T E G I E S ?Many moons ago, before passive investing was widespread, the nascent world of investment management could commonly attribute all investment returns to the skill of the investment manager. Finding profitable investments and avoiding loss-making investments, in any form, was considered the mark of a good fund manager, and determining how much of this was down to skill was a difficult task.

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Over time, investment theory evolved and investors began to differentiate between the return associated with broad market exposure (“beta”) and the return attributable to manager skill (“alpha”). However, this distinction was mostly limited to traditional asset classes, in which passive investment options were emerging as a benchmark and an investible alternative. Meanwhile, the world of hedge funds and alternative investing continued to be a difficult area for investors to access in a low-cost, systematic way.

In the last decade, this has begun to change, as the academic literature has expanded to identify many potential investment approaches that can be used to systematically access return sources historically thought of as alpha or manager skill.1 ARP funds attempt to capture a range of these return sources in a systematic fashion to create a profile of returns capable of performing a role that is similar to other strategies used within the core of a diversified liquid alternatives portfolio. Typically, such strategies are available at a lower cost to the end investor when compared to traditional hedge funds. While systematic (or “rules-based”) approaches are sometimes thought of as quasi-passive (especially when they are packaged in index format), ARP strategies are very clearly active and require a large number of subjective choices in terms of design and implementation.

These investment approaches, in general, aren’t new. Most of them have been around for many years and have formed a valuable part of the return-generating arsenal for many hedge fund managers.

1 A study by Harvey, Liu and Ziu (2016) counted as many as 316 unique factors, identified in articles and working papers mostly published in top journals, despite some considerable selectivity. They do also conclude that this is likely a significant overestimate of the profitable risk factors that actually exist and is due to data-mining, but this demonstrates just how broad the literature on this topic is. (https://academic.oup.com/rfs/article/29/1/5/1843824)

E V O LV I N G I N T E R P R E TAT I O N O F R E T U R ND R I V E R S O V E R T I M E

S K I L L ( A L P H A )

A LT E R N AT I V E R I S K P R E M I A

T R A D I T I O N A L R I S KP R E M I A ( B E TA S )

E V O L V I N G I N T E R P R E T A T I O N O F R E T U R N D R I V E R S O V E R T I M E

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E Q U I T Y F I X E D I N C O M E C U R R E N C Y C O M M O D I T Y

Carry

Investor overpay for expected capital growth

versus stable dividend income

Investor over-extrapolate extreme steepening or

flattening of curves

The excess return from borrowing in a low interest

rate currency and lending in a high interest currency

The convenience yield represents compensation in excess of storage costs

required by holders of physical commodities

Momentum Cross-sectional and based on recent relative performance. Driven by slow information dissemination (Initial under-reaction) and positive feedback trading (subsequent herding/over-reaction)

Value Investor overpay for growth stocks

Investor overpay for protection against inflation

and default

In equilibrium, currencies ultimately revert to levels consistent with absolute/

relative PPP

Prices have often reverted to long-term averages; value

strategies can buy and sell based on veviations from

the mean

Quality/Defensive Investor overpay for low quality/high beta stocks

Investor overpay for for low quality/ high beta bonds

N/A N/A

Trend Similar to momentum, but directional and based on recent adsolute performance.

Volatility Investors overpay for option protection (so that implied volatility tends to be higher than realized volatility)

Arbitrage

Merger Arb: “Deal risk” or the risk that the deal will fall apart, is the risk that be arbitrageur is willing to bear

Convertible Arbitrage: Seeks to capture any deviation in value between a convertible bond and the value of the underlying

bond and equity call option

N/ADemand is seasonal for some

commodities, which can be exploited

W H A T A R E T H E S E P R E M I U M S ?There is no strong consensus on which premiums are the most appropriate building blocks for an ARP fund, or how best to access any given risk premium. However, the table below covers some of the more established risk premiums.

A number of these factors can be harvested in long-only as well as long-short format (for example, value and momentum are widely exploited by equity managers), but the factor exposure will be much more diluted when accessed in a long-only strategy (simply expressed as a “tilt” within a beta-dominated exposure).

ARP strategies extend the application of widely understood factors, such as those listed, to a wider range of asset classes. They also provide access to less widely used factors, such as trend, volatility and arbitrage, as well as offer a more targeted (often long-short) exposure to the factors than can be captured otherwise, while minimizing their exposure to traditional betas.

The table below outlines the primary return premiums used within ARP strategies as well as a simplified explanation for the existence of each premium.

H O W D O E S I T W O R K I N P R A C T I C E ?Given the relatively intuitive theory behind many of these premiums, it is tempting to assume that capturing them is also straightforward. However, the approaches taken to capturing and combining these factors can vary widely, and the choice of approach can often be the difference between a profitable strategy and a loss-making one.

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“In theory, there is no difference between theory and practice. In practice, there is.”

– Yogi Berra, Major League Baseball Player

For example, let’s consider the value premium and some of the decisions facing a manager. First, a manager has to determine which asset class (or asset classes) offers the best opportunity for exploiting the value premium. Next, the manager has to pick an index or universe of securities, as well as decide which (and there are many) value metrics to use. Should the absolute score or a rank be used? Should calculations be weighted to take greater account of more recent data? How frequently should the strategy be rebalanced, and how should trading costs be controlled? In addition, investors should be aware that many factors exhibit a degree of “factor decay” over time as their existence is increasingly recognized and exploited by practitioners.2

Therefore, despite the approach being systematic in nature, design and implementation decisions can have a dramatic impact on the outcome. The chart below illustrates the extremely wide variation in returns achieved by ARP strategies (largely targeting similar return premiums) over the last eight years.

The returns associated with each premium within each asset class can be highly variable, resulting in relatively unattractive risk-adjusted returns on a stand-alone basis. However, correlations across different premiums in the same asset class and across asset classes for the same premium are typically very low (as can be seen in the chart below), which makes the overall risk/return characteristics associated with ARP strategies much more favorable. Consequently, where managers have appropriate asset class and factor expertise, we favor a multi-asset, multifactor approach for ARP strategies, allowing for the broadest possible opportunity set, and the maximum level of diversification.

2 Work by McLean and Pontiff in 2014 (“Does Academic Research Destroy Stock Return Predictability?”) found that a given factor’s return declined by c.56% following publication of academic research identifying the factor. After allowing for the effect of statistical bias (for example, that the factor returns could be due simply to data mining), they estimated the “publication effect” to be a c.31% reduction in return.

Returns shown have been normalized for a constant level of 7% volatility. Actual returns within the universe may differ.

31 December 2017 (number of strategies in sample shown in brackets)

35%

30%

25%

20%

15%

10%

5%

0%

-5%

-10%

-15%

5% - 25%

2010 (6) 2011 (8) 2012 (10) 2013 (14) 2014 (17) 2015 (19) 2016 (25) 2017 (22)

25% - 50% 50% - 75% 75% - 95% MEAN

C A L E N D A R Y E A R R E T U R N S F O R A LT E R N A T I V E R I S K P R E M I A U N I V E R S E

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U S I N G A R P W I T H I N A B R O A D E R I N V E S T M E N T S T R A T E G YWe believe ARP strategies can play a valuable role within an investor’s portfolio as a complement to existing liquid alternatives allocations, such as traditional hedge funds and multi-asset exposures. An allocation to ARP can increase the flexibility within a wider liquid alternatives allocation, as it should increase the liquidity and lower the overall cost for a portfolio of hedge fund strategies. We expect ARP strategies typically to be used as a diversifying component within the “core” segment of a hedge fund portfolio.

When selecting and combining ARP strategies for use in a liquid alternative portfolio, we encourage a balance of breadth and expertise, blending two or more managers where possible. Depending on an investor’s objectives, constraints and beliefs, we believe that a sensible allocation to ARP strategies would most likely be in the region of 20%–40% of their total liquid alternatives allocation. This recognizes the fact that many hedge fund return drivers (and sources of manager skill) will not be captured within ARP strategies.

C O M M O D I T I E S V A L U E M O M E N T U M C A R R YL O W

C O R R E L A T I O N S A C R O S S F A C T O R S

W I T H I N A N A S S E T C L A S S . . .

Value

Momentum -0.5

Carry -0.5 0.6

V A L U E E Q U I T Y F I X E D I N C O M E C O M M O D I T Y F X

. . . A N D A C R O S S A S S E T C L A S S E S

F O R A S I N G L E F A C T O R

Equity

Rates 0.1

Commodity 0.1 0.1

FX 0.1 0.0 0.1

Note. The correlations shown are estimates made by Mercer using s sample of simulated single factor returns from investment managers.

C O R R E L A T I O N A C R O S S F A C T O R S A N D A S S E T C L A S S E S

A P P L I C A T I O N S W I T H I N A B R O A D E R S T R A T E G Y

A L L O C A T I O N

Real assets

Public equity

Private equityDefensive fixed income

Growth fixed income

Liquid alternatives

Focused single strategies: alpha generation

30%–70%

Multi-strategy and/or ARP

20%–60%

Hedging strategies

0%–30%

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We believe that investors looking to develop their liquid alternatives allocation should actively consider the role that ARP strategies might play as a complement to traditional hedge fund exposures.

Kishen Ganatra is a senior associate within Manager Research’s Hedge Fund Boutique. Kishen carries out research on hedge fund and multi-asset strategies, being the lead researcher for core and idiosyncratic multi-asset strategies, and chairs the Multi-Asset Ratings Review Committee. He may be reached at kishen.ganatra@mercer.com.

Ian Murray is a research associate within Mercer’s Global Strategic Research Team, with responsibility for supporting the development of intellectual capital on portfolio construction, asset-class views and key investment themes. He may be reached at ian.c.murray@mercer.com.

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I N V E S T I N G I N A T I M E O F C L I M AT E C H A N G EE Y E S O N 2 0 2 0 A N D B E Y O N D

Three years ago, we were busy preparing to launch our 2015 report, Investing in a Time of Climate Change. Looking back to that time there was a lot of hope for what the upcoming Paris climate meeting might hold, but also fear that time was running out for policymakers to act.

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We now know that the outcome of the 2015 meeting was The Paris Agreement on climate change, currently supported by 197 nations globally — a significant milestone. However, it’s important that we continue to look forward to the next key milestones for investors.

For this reason, we are preparing for the launch of the sequel to our initial report. With this 2018 report, we will take a look back at what’s happened (a lot!) since we published our 2015 study and what’s changed, before once again considering potential future pathways.

We know 2020 is a critical year: In order to be on track to meet the commitments of The Paris Agreement to keep warming to well below 2˚C by the end of the century, relative to pre-industrial levels, global emissions must peak by 2020. That’s right; within the next two years, the emissions curve needs to change direction — not continue upward more slowly, not plateau, but reverse.

Regulators, together with nonstate actors such as businesses and cities, are stepping up their commitments, but are investors fully prepared for the pace and scale of change?

Are long-term portfolios positioned for the energy transition, already underway but expected to continue at an accelerating pace as the world shifts to the low carbon economy? Are the potential impacts of the physical damages being factored into investment, and lending, decisions?

Within the financial industry, the Financial Stability Board’s Task Force on Climate-related Financial Disclosure (TCFD) has led the way by setting out recommendations to asset owners, asset managers and companies to create a new disclosure framework to better manage climate-related risks and opportunities. The TCFD framework asks each of these financial market participants to consider

climate-related issues, apply consistent metrics and disclose related information in annual reporting to shareholders, clients and beneficiaries.

Although progress has been positive, investors cannot afford to let complacency set in. The hurricane season of 2017 provided a stark and shocking reminder of the devastation that can be caused by extreme weather events. And that is just one example among many — potentially a preview of what may unfold in the coming years and decades.

Within our sequel, we will revisit our climate change scenarios and risk factors, first developed in the 2015 research, to consider the financial impacts of climate change, primarily for asset owners. We will consider the potential impacts on investment portfolios under scenarios representing 2˚C, 3˚C and 4˚C climate pathways. We will also introduce new modeling aspects, considering the potential impact that a shorter-term market shock, perhaps driven by a disruptive technology development, may have on an investment portfolio.

In addition, we will highlight, through several case studies, the actions that some of our industry partners have undertaken over the last few years and how they are continuing to address the risks posed by climate change to their investment portfolios. We look forward to sharing our new insights in this important area with you.

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Kate Brett is a senior investment consultant in Mercer’s Responsible Investment team. Based in London, she is responsible for advising institutional investors on sustainable investment strategies and provides advice to a broad range of clients, including pension funds, endowments and insurers on integrating environmental, social and corporate governance issues throughout their investment processes. She can be reached at kate.brett@mercer.com.

We now know that the outcome of the 2015 meeting was The Paris Agreement on climate change, currently supported by 197 nations globally, a significant milestone. However, it’s important that we continue to look forward to the next key milestones for investors.

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A R T I F I C A L I N T E L L I G E N C E

Corporate communications

Valuations

Government data

Satellite imagery

Patent filing

Social media

News

Psychology

Logic

Computer science

Mathematics and statistics

Engineering

Linguistics

Cognitive science

A R T I F I C I A L I N T E L L I G E N C E A P P R O A C H E S

Narrow Learning Other-aware Self-aware

W E A R E H E R E “ A U T H E N T I C ” A I

F I E L D S O F S T U D Y

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T H E C A S E F O R A N D A G A I N S T A I

A P P L I C AT I O N O F A I

T H E R E A L I M P L I C AT I O N S O F A I

B E N E F I T S

• Handles enormous amounts of data, sorting and classifying accurately and recognizing patterns

• Is unemotional and able to reach more objective conclusions

• Facilitates around-the clock market monitoring and analysis

W E L L S U I T E D

• A well-defined task and goal

• A known set of choices and potential outcomes

• Highly replicable processes

• Known (or at the very least knowable) probability distributions associated with outcomes given any choice

P A R T R E P L A C E M E N T Mundane and repetitive tasks (e.g.,

investment report writing with lots of data) replace human efforts.

A U G M E N T A T I O N Machines enable humans to do a better

job, collecting more data and reshaping it.

E M P O W E R M E N T Human analysts are able to do more with

machines than they could have done without (e.g., monitoring internal

system usage).

S H O R T C O M I N G S

• Cannot place classifications in context

• Cannot draw insights from the patterns

• Will assume perfect logic and cannot understand human emotions and motives

P O O R LY S U I T E D

• Ill-structured problems

• Deep uncertainty (unknown and sometimes unknowable probability distributions)

• Complex and dynamic environments

• Little replicability

As technology and algorithms improve, computers are becoming highly effective tools for tackling “small world” problems, as they are less subject to failures of probabilistic reasoning.

AI can and should have a role to play in investing today.

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W H AT I T A L L M I G H T M E A N … I M A G I N E !

W H AT S H O U L D I N V E S T O R S B E D O I N G A B O U T T H E I N C R E A S I N G T R E N D T O W A R D A I ?

Questions to ask to gauge asset manager readiness and response

to this evolution in the industry:

With new and unusual sources of data available and increasingly accessible, information might flow through to stock prices more quickly, perhaps reducing the level of market volatility.

Fee reductions?

Changes in research teams?

Insights reached more quickly?

Lower volatility?Further bifurcation in the market?

Time horizons?

What resources are you investing in?

Are you changing your investment

process?

What actions are you taking?

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Suzanne Lubbe is a senior researcher within Mercer’s Equity Boutique and is co-lead researcher for global and EAFE (global ex-US) equity. In her role, she prioritizes and coordinates Mercer’s research of global equity managers around the world, as well as undertakes primary research herself. Suzanne works with clients from all parts of Mercer’s worldwide business. She can be reached at suzanne.lubbe@mercer.com.

With new and unusual sources of data available and increasingly accessible, information might flow through to stock prices more quickly, perhaps reducing the level of market volatility.

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C R Y P T O C U R R E N C I E S : F O O L’ S G O L D O R T H E F U T U R E ?

Eye-watering cryptocurrency price appreciation was the speculator’s delight of 2017. The proliferation of new coin launches and the bandwagon that adhered to digital currencies hinted at the existence of a speculative bubble. The uninitiated joined in with the long-term investors (or “hodlers” [sic], to use cryptocurrency terminology) in a wave of anti-establishment euphoria. Prophets of doom foresaw complete capital obliteration, while charlatans rebased their calls for Bitcoin to reach $10,000 per coin with calls for an eye-watering $100,000 per coin. In the end, cryptocurrencies behaved as they have in the past and followed rapid price rises with a hefty slump. Hysteria died down, with skeptics muttering half-convincingly, “I told you so,” while hodlers hardly blinked. In this article, we outline the drivers behind the enthusiasm and consider some of the challenges facing cryptocurrencies as an investable asset.

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C H I P S O F F T H E B L O C KAlthough the goal of this article is not to canvas the mechanical aspects in depth, we can summarize by saying a cryptocurrency is a decentralized digital form of exchange in which cryptographical techniques are used to control the creation of new units of currency and to verify the transfer of funds. With the major examples to date, new coins are created via a “mining” process, whereby “miners” are rewarded with coins for solving cryptographical puzzles. Most cryptocurrencies are designed to have a gradual decrease in production of the currency, with some placing an ultimate cap on the total amount that will ever be in circulation, thus mimicking the finite supply of precious metals.

The underlying transaction record for a cryptocurrency is the “blockchain.” The cryptographical puzzle solved by the miners is part of the process of validating transactions. In a conventional digital transaction, you, the counterparty and your banking provider are aware of a transaction. However, in the blockchain, typically thousands of “aware parties” would be keeping a record of such transactions, and this negates tampering via an attack on an individual copy.

It’s important to distinguish between blockchain technology and cryptocurrency. Blockchain is an infrastructure that has been heavily invested in by major players in the world of digital transactions, and applications are also being developed for nonfinancial sectors. Blockchain is therefore an exciting development that could have a significant impact on the finance sector and wider economy over the coming decade.

T H E H O P E A N D T H E H Y P EThe huge interest in cryptocurrencies has been driven by a number of features that distinguish them from government-backed fiat currencies:

• Cryptocurrencies aren’t controlled by central banks. If a central authority cannot print large sums of the currency, it could potentially have more legitimacy as a store of value (some view cryptocurrencies as a form of digital gold). A motivator behind the introduction of the first cryptocurrency, Bitcoin (which has a limited supply of 21 million coins), was the large-scale quantitative easing programs introduced after the Global Financial Crisis.

• Cryptocurrencies offer a degree of anonymity. In May 2017, a piece of ransomware called WannaCry was released globally. For the unfortunate individuals and institutions whose computers were infected, this often meant that they had to pay a ransom to remove the harmful program from their computers, and this was achieved by paying a sum in Bitcoin. Bitcoin’s cloak of secrecy in this case proved helpful to the extortionists behind the virus. Individuals are also able to make anonymous purchases for illegal items using cryptocurrencies. For example, it’s been estimated that just over a quarter of the UK’s drug users have purchased banned substances on the Dark Net, generally using cryptocurrencies.

• Crypocurrencies generate social media excitement and “fear of missing out” (FOMO). The interest around cryptocurrencies has been amplified by the effect of discussion and shared news reports on social media. As with any asset exhibiting astronomical price rises, individuals are drawn in as they act on a FOMO on further increases. This is despite Bitcoin sporadically experiencing dramatic falls in value — sometimes 10%–20% or more over a matter of days (one recent example being the 35% decline in late December 2017).

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D I G I T A L D I L E M M A SCryptocurrencies face a number of significant challenges in attempting to establish themselves as serious alternatives to fiat currency or gold, thereby countering their suitability as an investment or store of value at this point in time:

• Hacking and theft. In 2016, hackers managed to exploit a weakness in the coding of an online crowdfunding platform (The DAO), which used the cryptocurrency Ether, and stole approximately US$50 million in cryptocurrency. More recently, in January 2018, the cryptocurrency exchange Coincheck was hacked and US$530 million of NEM cryptocoins were stolen. Individuals have also been robbed of cryptocurrency at gunpoint. Thefts occur frequently and are likely to reoccur. Even so, the blockchain itself is rarely, if ever, compromised. What this means is that hackers have so far carried out exceptionally large robberies but have not fundamentally altered the viability of a cryptocurrency — for example, by forgery.

• Survivorship. Well over a thousand different cryptocurrencies are in circulation, and the field is widening with further “ICOs,” or Initial Coin Offerings. Twenty-nine cryptocurrencies have market capitalizations of over US$1 billion, with Bitcoin leading the way at c.US$156 billion as of May 8, 2018. Even most of the large players are likely to be surplus to requirements if and when a mature cryptocurrency payment framework emerges. It is therefore possible that many, if not all, cryptocurrencies with very high valuations today will be worth close to nothing at some point in the future.

• Government intervention. Governments can intervene to outlaw or regulate certain aspects of cryptocurrencies, and 2018 looks set to be a year in which such scrutiny comes to the fore. For example, policymakers could make owning, mining or running an exchange illegal and/or increase the compliance burden on exchanges. Some of these actions are

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Bitcoin Price History

Source: www.coindesk.com

20,000

25,000

15,000

10,000

5,000

Jun 16 Sep 16 Dec 16 Mar 17 Jun 17 Sep 17 Dec 17 Mar 18

0

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harder to do than others — some exchanges have been shut down, but it’s very difficult to eradicate ownership of cryptocurrency. Despite this, it would certainly be a large setback if a cryptocurrency were outlawed in a major territory (China and South Korea recently launched crackdowns on digital currency activity).

• Congestion. The network of the predominant cryptocurrency, Bitcoin, isn’t currently able to handle a large transaction volume. Given the current state of the technology, payments would grind to a halt if there were widespread uptake of the system. This places pressure on transaction fees. Although early in the history of Bitcoin transactions were seen as essentially free, the average transaction fee at the end of 2017 was US$25. Such fees, alongside slower processing speed, mean that Bitcoin cannot function as a high-throughput small payments solution in the same way that credit cards do.

• Exchange fees. As well as the fees due to the miners for validating transactions, cryptocurrency exchanges also take a spread on transactions. For example, on Coinbase, one of the major exchanges, spreads range between 0.25% and 1% for purchases of digital currencies. Other fees can be incurred on transferring hard currency to and from exchange accounts, either by your traditional bank provider or by the exchange.

• Sustainability. In terms of energy consumption, the Bitcoin network, for both mining and transacting, consumes about the same amount of energy as Morocco. Although some of the large cryptocurrency mining firms have often been using surplus hydroelectric power, this clearly makes it hard to regard cryptocurrencies that involve mining as “green” investments. From a social perspective, the link to cybercrime, drugs and money laundering overshadows Bitcoin heavily.

W H A T N E X T ? T W O S I D E S O F T H E C O I N The above quotes highlight that the future success of digital currencies is far from clear. The blockchain technology that underlies their use undoubtedly holds promise in areas such as trade processing and settlement, with many other potential applications under active development. However, in our view cryptocurrencies have yet to prove that they offer much more than the benefit of anonymity and the potential for huge price fluctuations.

Although some argue that cryptocurrencies can be considered a form of digital gold, the key difference with physical gold is that it has played a role in financial systems and been seen as a store of value for thousands of years. With no way of assessing the fair value or longevity of different cryptocurrencies, holders need to contemplate the very real possibility that many, if not all, cryptocoins may be close to worthless at some point in the future. Although it is possible that one or more cryptocurrencies might survive and even thrive as the underlying technology and unforeseen applications develop, it is also possible that many will disappear altogether.

“Bitcoin is the beginning of something great: a currency without a government, something necessary and imperative.”

– Nassim Taleb (financial author)

“My best guess is that in the long run, the technology will thrive, but that the price of bitcoin will collapse.”

– Kenneth Rogoff (economist)

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W O R T H A P L A C E I N P O R T F O L I O S ?To be clear, we do not view cryptocurrencies in their current form as an investable proposition or a store of value — either directly, via futures or via hedge funds set up to speculate on price movements. They offer no income to the passive holder of coins (that is, nonminers), and assessing fair value is close to impossible. In addition, the wave of cryptocurrency launches and the spectacular price rises witnessed in 2017 exhibit many of the hallmarks of a speculative bubble, notwithstanding some deflation seen in recent months. We suggest that investors sit it out and marvel as the story unfolds.

The blockchain technology underlying cryptocurrencies holds significant promise in areas such as trade processing and settlement, with many other potential applications under active development.

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Cryptocurrencies have yet to prove that they offer much more than the benefit of anonymity and the potential for huge price fluctuations.

Phil Edwards is the Global Director of Strategic Research within Mercer’s Wealth business, with responsibility for developing intellectual capital on portfolio construction, asset-class views and key investment themes. Phil sits on the Global Strategic Research Committee, which has responsibility for driving Mercer’s research agenda and bringing new ideas to Mercer’s client base. He may be reached at phil.edwards@mercer.com.

Matt Scott is a research associate within Mercer’s Global Strategic Research Team, with responsibility for supporting the development of intellectual capital on portfolio construction, asset-class views and key investment themes. Matt and the team feed into Mercer’s Global Strategic Research Committee, which has responsibility for driving Mercer’s research agenda and bringing new ideas to Mercer’s client base. He can be reached at matt.scott@mercer.com.

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P O S T C A R D F R O M A L E X I S C H E A N G

After 15 years in the responsible investment (RI) industry, I was thrilled to see Mercer recently recognized as the “Number One Investment Consulting Firm” globally in Sustainable and Responsible Investing by the Independent Research in Responsible Investment (IRRI) Survey 2017.

Having started my career as an environmental, social and governance (ESG) research analyst in London in 2003, then moving into proxy voting and engagement in Boston, and then moving back to London in 2007 to help run an SRI fund and develop new ESG investment products, it’s clear

to me how much the industry has matured and diversified over the years. Mercer has been very much a driver and shaper of those changes, and that’s testimony to the strength of our global RI team, who received six of the top 20 individual awards in this category.

I moved to Sydney, Australia with my husband in 2013, and it’s great to be in a market that really

understands ESG and is starting to incorporate that in a meaningful way in its investment beliefs, policies and portfolios. It’s also a real blessing to be living in such a vibrant and sustainable city, where I can raise a family and enjoy beautiful beaches, excellent food and a diverse cultural mix. London, I miss you, but I’m not moving back any time soon!

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Alexis Cheang is a partner and the Head of Responsible Investment for Australia and New Zealand in Mercer’s Investments business. Alexis works with clients to develop and implement RI strategies based on clear RI beliefs, policies and practices throughout the investment process. This includes integrating ESG factors into the investment process, developing active ownership strategies through proxy voting and engagement, considering and implementing exclusions, and allocating to sustainability themes. She can be reached at alexis.cheang@mercer.com.

A B O U T M E R C E R

Deb Clarke LondonGlobal Head of Investment Researchdeb.clarke@mercer.com +44 20 7178 6936

Phil EdwardsBristolDirector Global Strategic Research phil.edwards@mercer.com +44 117 988 7548

Mercer is a leading global provider of investment services and offers customized guidance at every stage of the investment decision, risk management and investment monitoring process. We assist with every aspect of institutional investing (and retail portfolios in some geographies), from strategy, structure and implementation to ongoing fiduciary management.

Our Manager Research team consists of experienced individuals based in various locations throughout the world. There are four specialist boutiques that provide comprehensive research into the strategy offerings in the relevant asset class. Each boutique is staffed with professionals who have research and consulting capabilities; conduct forward-looking, institutional-quality research on investment management products and work closely with both internal and external clients on manager structuring and selection projects. The research process is consistent across all boutiques and across all regions, providing a common language and a seamless offering to clients.

M E R C E R

I M P O R T A N T N O T I C E SReferences to Mercer shall be construed to include Mercer LLC and/or its associated companies.

© 2018 Mercer LLC. All rights reserved.

Information contained herein has been obtained from a range of third-party sources. Although the information 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 presented and takes no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in the data supplied by any third party.

No investment decision should be made based on this information without first obtaining appropriate professional legal, tax and accounting advice and considering your circumstances.

Investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.

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Mercer, Mercer Investment Consulting LLC; Mercer Investment Management, Inc.; Guy Carpenter; Oliver Wyman; Marsh and Marsh & McLennan Companies are affiliates of MMC Securities.

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