Aon Hewitt Retirement Solutions Investment Insights July 2015 Global Investment Consulting In this issue Global Equity – What's the benchmark? Global Equity What's the benchmark? Summary 1 Summary 1 What are the main benchmarks available and how do they differ? 2 MSCI World vs. MSCI ACWI 2 Emerging Markets 3 Manager Preference 4 Recent Performance Most investors, especially in Canada, are using either the MSCI World Index equity managers depen We believe that the choice of indices should depend on the active equity managers' allowable exposure to emerging markets. Given most unconstrained managers have or can have some exposure to emerging markets; we believe using the MSCI ACWI to be the most appropriate for monitoring relative performance given the increased opportunity set. What are the main benchmarks available and how do they differ? Investors looking to invest in global equities are able to choose from a number of index providers to ensure they are benchmarking their portfolio appropriately. The primary benchmarks that represent global equity markets are from the long-established, well-respected providers such as MSCI and FTSE. The provider most commonly used by institutional investors for global equities is MSCI1, and we consider their indices in this report. 1 As of June 2014, according to Intersec LLC. 95% of U.S. pension fund assets invested in global equities were benchmarked to a MSCI index. Risk. Reinsurance. Human Resources. MSCI World vs. MSCI ACWI The two main indices for consideration in the global space are the MSCI World Index and the MSCI ACWI. The MSCI World Index covers developed markets only, whereas the MSCI ACWI includes both developed and emerging market countries such as China, Brazil, India, Russia, and Korea. The charts below show the difference in regional weight between the two benchmarks at the end of March 2015. MSCI ACWI Index MSCI World Index Pacific ex Japan, 4.7% United Kingdom, 7.7% Japan, 8.6% Europe ex UK, 17.8% North America, 61.2% Emerging Markets, 10.4% Pacific ex Japan, 4.2% United Kingdom, 6.9% Europe ex UK, 16.0% Japan, 7.7% North America, 54.9% At the end of April, the MSCI World Index contained 1,631 stocks from 23 countries, while the MSCI ACWI contained 2,466 stocks from 46 countries. Emerging markets accounted for just 10% of the MSCI ACWI Index's make up at the end of March 2015 and have grown in importance over the past decade in 2012 emerging markets reached over 13% of the Index. Fifteen years ago emerging markets accounted for less than 5% of the market cap in the MSCI ACWI Index. Please note that Pacific ex Japan is developed countries only. Emerging Markets Emerging markets are not one homogenous economic or geographic region, but include many diverse countries across multiple geographic areas. Although the term is loosely defined, countries that fall into this category are generally low to middle income nations with a recent record of economic liberalization, have functioning equity and debt markets, and have significant potential for both economic growth and capital market investments by foreigners. Emerging markets account 0% of the equity market capitalization. Emerging market capitalization reached approximately US$3.6 trillion in 2008, but fell to US$1.5 trillion shortly thereafter during the credit crisis. It currently stands at approximately US$4 trillion. Investment Insights | Aon Hewitt | July 2015 Overall, Aon Hewitt believes that emerging market equities are likely to outperform developed market equities over the longer term, albeit with higher volatility. We recommend that clients extend their mandates to include a separate allocation to emerging market equities, or include this region within their global equity mandates. 2 Manager Preference One of Aon Hewitt's investment beliefs is that "unconstrained" management will provide stronger risk-adjusted returns than passive investment. Within global unconstrained management we assume that a managers' investment universe can include emerging markets among other things. Many of the active global equity managers that we cover make use of the opportunity to invest in emerging markets with the exceptions being a few portfolios that are restricted to developed markets only. Although managers are often benchmarked to the MSCI World Index, investments in emerging markets can often be significant. Their investment guidelines can allow between 15% and 20% of their global equity allocation to be invested in emerging market equities. At the end of 2014, the average emerging markets exposure of the global unconstrained buy-rated managers was 7.15% and ranged from 0 to 27%. Most often this allocation is a result of bottom-up stock selection rather than a top down macro call on emerging markets. Currently approximately 40% of Aon Hewitt's global unconstrained buy-rated managers use the MSCI ACWI as their stated benchmark. We also want to note that most of the active global equity managers our clients have exposure to are unconstrained in nature. This means that the portfolio is not constructed relative highest conviction ideas which may mean that they do not reference sectors or the regional composition of a benchmark. The benchmark these managers state is mainly used for performance comparison over longer time periods. In discussions with these managers, they generally agree that the MSCI ACWI may be a better representation of their investible universe. A few managers will use the FTSE World Index or the FTSE All World Index as their stated benchmark. There are a few differences when compared to the MSCI indices, but generally the performance patterns are very similar. As MSCI is the most commonly used benchmark provider for global equities, we favour it over FTSE and other benchmark providers. In addition, a number of active global equity managers have already made the transition from using the MSCI World Index to the MSCI ACWI as their benchmark. This is in recognition that this benchmark is a better reflection of the investment universe. There are still however, a significant number of managers that continue to use the MSCI World Index as their stated benchmark. This is to a great extent driven by the administrative tasks associated with changing benchmarks, communicating this to clients, and gaining their acceptance, rather than the manager not accepting it as a relevant benchmark. In general, we come across relatively few managers that are precluded from investing in emerging markets. Investment Insights | Aon Hewitt | July 2015 3 Recent Performance Given the more volatile returns from emerging markets, this can have a strong influence when comparing the two indices. The relative performance of the MSCI World Index compared to the MSCI ACWI will be lower in some years (e.g. 2009 and 2010 when emerging markets performed strongly), and higher in other years (e.g. 2013 when emerging markets underperformed developed markets significantly). The chart below shows the performance for the two benchmarks (in CAD) since 1999. Over this period the MSCI ACWI Index has outperformed the MSCI World Index by 0.2%. Comparison of returns to 30 April 2015 Comparison of returns to 30 April 2015 40% 30% 20% 10% 0% -10% -20% -30% -40% 2015 YTD MSCI ACWI Index (CAD) 19.5% -11.2%-10.9%-20.2% 9.6% 6.8% 8.1% 20.5% -5.3% -27.7% 14.3% 6.8% -5.1% 13.6% 31.0% 13.5% 10.1% MSCI World Index (CAD) 18.1% -10.1%-11.6%-20.7% 8.9% 6.4% 6.7% 19.6% -7.5% -25.8% 10.4% 5.9% -3.2% 13.3% 35.2% 14.4% 9.5% Relative Performance 1.4% -1.1% 0.7% 0.6% 0.7% 0.5% 1.3% 0.9% 2.2% -1.9% 3.9% 0.9% -1.9% 0.3% -4.1% -0.8% 0.6% 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 1 Year 18.6% 18.5% 0.1% 3 Years 20.1% 21.5% -1.3% 5 Years 13.6% 14.5% -1.0% 10 Years 6.6% 6.5% 0.1% Since Inc. 3.3% 3.1% 0.2% It should be noted that while the MSCI ACWI has a slightly higher risk profile, it is not significant over recent periods. Over the past five years to 30 April 2015 the annualized standard deviation of MSCI ACWI Index has been 9.25% compared to 9.18% for the MSCI World Index. Given recent weaker performance from emerging markets, valuations in this region look relatively attractive compared to their developed counterparts. Overall, as mentioned earlier, Aon Hewitt believes that emerging market equities are likely to outperform developed equities over the longer term, albeit with higher volatility. We recommend that clients extend their mandates to include a separate allocation to emerging market equities, or include this region within their global equity mandates. Investment Insights | Aon Hewitt | July 2015 4 Contact Information If you would like further information on any of these topics, please contact your Aon Hewitt consultant at info@aonhewitt.com. Aon Hewitt publishes Investment Insights for the purposes of providing general information. The information in Investment Insights does not constitute financial, legal, or any specific advice and should not be used as a basis for formulating business decisions. Investment Insights contains information that is proprietary to Aon Hewitt and may not be distributed, reproduced, copied or amended without Aon About Aon Hewitt Aon Hewitt empowers organizations and individuals to secure a better future through innovative talent, retirement and health solutions. We advise, design and execute a wide range of solutions that enable clients to cultivate talent to drive organizational and personal performance and growth, navigate retirement risk while providing new levels of financial security, and redefine health solutions for greater choice, affordability and wellness. Aon Hewitt is the global leader in human resource solutions, with over 30,000 professionals in 90 countries serving more than 20,000 clients worldwide. For more information on Aon Hewitt, please visit aonhewitt.com. © 2015 Aon Hewitt Inc. All Rights Reserved. This document contains confidential information and trade secrets protected by copyrights owned by Aon Hewitt. The document is intended to remain strictly confidential and to be used only for your internal needs and only for the purpose for which it was initially created by Aon Hewitt. No part of this document may be disclosed to any third party or reproduced by any means without the prior written consent of Aon Hewitt. Risk. Reinsurance. Human Resources.