Q3 & 4 2017 INVESTED IN DISRUPTION IQ Redefining Investment Performance

The New Alternatives Paradigm

Disruption in Action

Demography and Destiny Q3&4 2017 IQ magazine provides the most relevant thought IQ leadership from State Street Global Advisors.

We live in an age of disruption, in which business models, industries and even our daily lives are being transformed. As the pace of disruption accelerates, we look at game-changing shifts that are redefining ideas around investment performance and value and how investors can navigate this new landscape.

State Street Global Advisors 2 4 ALL CHANGE While macroeconomic conditions might suggest a return to “normal,” disruptions on all sides require investors to embrace change and look for the opportunities. 8 CHANGE THE GOAL, CHANGE THE GAME In our latest investment roundtable, we look at how institutional investors are redefining ideas of performance and value beyond traditional metrics. 14 THE NEW ALTERNATIVES PARADIGM Alternatives remain an important portfolio component, but liquidity lessons and factor approaches are transforming how investors build their exposures. 20 DISRUPTION IN ACTION Automobiles, healthcare and retail are in the front lines of creative destruction: we look at what those disruptions mean for investors. 32 DEMOGRAPHIC DISRUPTION Ageing populations around the world are challenging assumptions about saving and investing.

State Street Global Advisors 3 RICK LACAILLE Global Chief Investment Officer ALL State Street Global Advisors

CHANGEAs we move into the final stretch of 2017, the global economy continues to grind higher, with overall growth for the year slated to improve for the first time in three years. While the stimulus expected from the new Trump administration has languished, the equity bull market in the US nonetheless is charging into its ninth year. Unemployment in many advanced economies has reached multi-year lows, yet wages and inflation remain tame.

State Street Global Advisors 4 While we may have reached an important inflection point in the global economic recovery cycle, the kinds of structural forces that are transforming companies, industries and economies make it difficult to think in terms of any normal: new, old or otherwise.

With a more advanced recovery While we may have reached an Game-Changing in the US, the Fed has already important inflection point in the global started to normalize monetary economic recovery cycle, the kinds of Goals structural forces that are transforming policy, while other central banks companies, industries and economies We start with disruptions in our own have signaled they will begin make it difficult to think in terms of industry, tapering their accommodative any normal: new, old or otherwise. where long-term investors are policies as well. Ten years after the Instead, we expect that disruptions on broadening the definitions of value, first tremors of what would become many levels are set to accelerate, and performance and objectives beyond a global financial crisis, are we finally discerning investors need to apply an all-change view to the world to traditional metrics. Rather than returning to “normal”? understand and capitalize on them. risk-adjusted returns alone, we need

Figure 1 Global Real Activity Has Improved — World, CPB World Trade Monitor

% Change Y/Y

Industrial Production 4 Excluding Construction

3

2

1

0 Total 1 2012 2013 2014 201 201 2017

Source: Macrobond, SSGA Economics, Netherlands Bureau for Economic Policy Analysis (CPB). Updated as of June 13, 2017. CPB World Trade Monitor is a monthly time series that aggregates and summarizes data on both international trade and industrial production.

State Street Global Advisors 5 All Change

Figure 2 Old vs New Battle of the Titans in Retail Market Capitalization (billions) 476.3

17.1 AMAZON

1998 2017

8.9 MACY’S INC 6.7

Source: Bloomberg as of September 14, 2017.

to focus on risk-adjusted outcomes, Other institutional investors are Continuing our all-change theme, we defined across a far wider array of developing similarly broad goals and look at how dynamic factor-based criteria. In our latest investment are pushing their investment strategies are disrupting the hedge roundtable, we hear from the managers to develop better data and fund world. A new generation of long/ outgoing head of the second largest processes to achieve them, as we systematic approaches is able to pension fund in the Netherlands, learn from Rebecca Fender of the capture many of the same premia Else Bos, on why she believes large CFA Institute, who leads their Future that were once the sole realm of owners need to account for the of Finance practice. We also get an traditional trading broader economic, environmental update from Lou Maiuri of State strategies, and are now available in a and social impact of their Street’s Global Exchange group, far more fee-efficient format. We investments. In her new role at the which is already applying artificial have now launched our own version Dutch central bank overseeing intelligence (AI) and machine of this approach for investors seeking pension plans and learning technologies to improve the uncorrelated sources of alpha, which companies, she will continue to quality and consistency of ESG data also help to protect on the downside. promote the national sustainability to help asset owners and asset In addition, we describe a new and development goals she helped managers better assess those more efficient way for institutional spearhead during her time at PGGM. non-financial impacts. investors to source bond liquidity in order to acquire, dispose of, or tactically shift fixed income within our large pools of seasoned credit assets.

State Street Global Advisors 6 All Change

Sector Disruption The consumer discretionary sector is Demographic also transforming before our eyes, Perhaps the quickest acceleration with Amazon redefining modern Destinies of change is happening in some of retail value chains. But what would a Finally, we introduce the work of the most traditional industries that disruptor of Amazon look like? Our Amlan Roy, our new Global Chief are being disrupted and sector analysts describe the three Retirement Strategist, who has spent disintermediated beyond technology-driven trends retailers his entire career analyzing the recognition, as our sector need to harness to challenge the intricacies of global demographics analysts describe. Major car consumer behemoth. and their effects on economies and companies are already planning markets. Amlan lays out the five for a not-too-distant future in which most important impacts of the owner-driver model that has Old Titans demographic changes and discusses prevailed since the industry’s Versus New how policymakers and investors inception gives way to large, should respond. Along with automated car sharing platforms. While aging demographics and technology-driven transformations, As GM President Dan Amman has technology advances create tailwinds demographics is perhaps one of the remarked, “we expect to see more for the healthcare industry, pricing most disruptive forces reshaping the change in our industry in the next pressures are forcing companies to global economy and capital flows. As five years than there has been over overhaul their business models to such, we consider it a key input into the last 50.” We look at the first reduce costs and accelerate the time our long-term, top-down analysis stage of that transition, as battery to market for blockbuster drugs. and investment decision-making. n electric vehicles overtake the As big data and machine learning machine that ruled the road for transform the drug discovery process more than a century: the internal itself, mergers and acquisitions combustion engine. (M&A) have become a new form of research and development (R&D), allowing companies to leapfrog the usual 10–15 year development process by acquiring more mature Perhaps the quickest pipelines for innovative therapies. acceleration of change is happening in some of the most traditional industries that are being disrupted and disintermediated beyond recognition

State Street Global Advisors 7 INVESTMENT ROUNDTABLE CHANGE THE LENS, CHANGE THE GOAL, CHANGE THE GAME As the age of disruption challenges New technology, big data and factor-based approaches are disrupting conventional approaches to portfolio long-held assumptions across management. However, we believe even more far- companies and industries, it is not reaching changes are occurring as institutional surprising that investment investors redefine their objectives beyond traditional portfolio metrics and look at the broader impact of management is also undergoing their investment choices. In this latest investment major shifts. roundtable, we speak to industry stakeholders about what this shift in perspectives on performance and value will mean for asset owners and asset managers alike as well as for the future of the profession.

State Street Global Advisors 8 Change the Lens, Change the Goal, Change the Game

LOU MAIURI REBECCA FENDER, CFA ELSE BOS LORI HEINEL, CFA EVP, Head of Head of Future of Finance CEO Deputy Global Chief Global Markets/Global Exchange Investment Officer, CFA Institute PGGM State Street State Street Global Advisors

Lori, how do you describe the trends that are redefining how institutional investors think about performance and their investment objectives?

HEINEL I think there are three transformations underway. number of different client objectives that go beyond The first is moving from a short-term mindset to a returns per unit of risk. You can think of various outcomes long-term one. After all, most investors’ objectives are like income per unit of risk or inflation protection per unit long-term, whether it is saving for retirement or financing of risk. In essence, this is also what is driving the shift long-term spending plans. Managers should align from products to multi-asset solutions: a more holistic solutions to those longer horizons. Changing the lens view of what investors are trying to achieve over a longer CHANGE THE GAME to focus on the long-term has several benefits. The best time horizon. example involves the tools that active managers have But I think the third trend is really a game-changer for at their disposal, whether on the fundamental or the industry. That is the way in which clients are quantitative side, to capture insights about a company’s increasingly focused on outcomes that may be unrelated future earnings power or growth prospects and generate to conventional measures of performance at all. Investing alpha over the long-term. You also gain a very different with a view toward environmental, social and governance perspective on risks and opportunities when you take a (ESG) factors is certainly is one of the strongest examples long-term perspective. of that. And now we are beginning to see more asset The second shift is recognizing that focusing on relative owners responding to their stakeholders’ desire to performance or conventional risk-adjusted return metrics understand the broader impact of their investments on doesn’t necessarily align with a client’s ultimate objective. the environment, the economy and society as a whole. We saw that very clearly, for example, with liability-driven That has huge implications for how we think about investing (LDI). Just focusing on returns alone without performance and value. understanding the liability stream did not always achieve the desired outcome. Yet LDI is just one example of a

State Street Global Advisors 9 Change the Lens, Change the Goal, Change the Game

Else, in many ways the Netherlands has been at ...For us I think being a the forefront of this trend. long-term investor means How did that shift come investing in companies about for PGGM? that can make a difference in the real economy BOS It was a journey that began about 15 years ago and was very much driven by the interests of our clients. As you know, we manage a very large pool of assets for the ELSE BOS PFZW, which is the big pension plan for the Netherlands’ care and cure sector. So these are beneficiaries who are quite involved with what happens in the world around them. These ESG issues are important to them and they want us to incorporate those considerations into the investments we make on their behalf. The early steps in that direction involved both exclusion and engagement.

But the big step forward has been focusing explicitly on impact over the last five years. Building on what Lori said, for us I think being a long-term investor means investing in companies that can make a difference in the real economy. The other very important part is that we continue to look at this from a risk-and-return perspective. So we look at risks beyond traditional metrics, and we look at opportunities in terms of both returns we can harvest but also as ways to improve the world we are living in. Taking those two dimensions together has been very important in the way we have handled this.

State Street Global Advisors 10 Change the Lens, Change the Goal, Change the Game

Rebecca, how does PGGM’s evolution in thinking align with what your survey on the future of finance found?

FENDER When we did a major survey of more than 1,000 BOS I agree that it is important to consider all of global investment leaders at the end of last year to get a the players in the value chain. When I think of the sense of how they see the future of the investment Netherlands’ national plan of action for executing the management industry, the results showed that they are United Nations’ Sustainable Development Goals (SDGs), seeking a more purposeful capitalism. While only 11% bringing together all of the main players up front was said the investment industry currently has a very positive a key accomplishment. So now, because we have the impact on society, more than half said it could in the regulators and the asset managers, asset owners, future, contingent on stronger principles. We also found companies and the government involved, it makes it that having a long-term investment horizon means that easier for us to push the initiative forward. That broader there is deeper thinking about the interconnectedness of coalition of stakeholders is important because it means various players in the industry. you start to think differently. You focus not just on your own set of challenges but on the higher purpose behind CFA Institute believes that we need a smarter way of the initiative. thinking about investing. Central to that is recognizing that our profession is part of a complex ecosystem. There A very important part of our efforts has to be the are many points of connection and a reflexivity dynamic recognition that if you really want to get serious about of mutual effects. If you consider individual investors or moving sustainable investment and the SDGs forward, the organizations that are investing on their behalf as well you need to get the public behind them. People have to as the broader context of society, the environment and the start talking about them rather than just investors alone, economy, then there really are far more stakeholders than because as beneficiaries they will then start asking we’ve acknowledged in the past. Once you start to tease questions of their asset owners like us and we can then out those different connections, you begin to understand start pushing our asset managers. Getting the regulators the broader impact of investment management. involved was important, too, as they influence the thinking of asset owners and drive the transparency and reporting around these goals.

The CFA Institute has long argued that we need a smarter way of thinking about investing. Central to that is recognizing that our profession is part of a complex ecosystem

REBECCA FENDER We’ve joined forces with some tech firms that are using artificial intelligence to scour unstructured ESG data to identify intangible value and related non-financial risk factors embedded in investment portfolios.

LOU MAIURI

HEINEL Of course, one of the more difficult challenges as MAIURI The quality and consistency of ESG data is a we move beyond traditional performance metrics is the genuine problem. We’ve joined forces with some tech question of how do we measure these new attributes? firms that are using artificial intelligence to scour How do we get companies to report relevant data on a unstructured ESG data to identify intangible value and consistent basis? Moreover, it becomes even more related non-financial risk factors embedded in investment challenging to measure intangible attributes around portfolios. Our dataset is based on SASB’s Materiality long-term value creation. For example, it is easier to Framework and we are working with them to promote measure the carbon or water intensity of a particular the industry data standard for ESG investing. Whether it’s company than to measure how engaged their workforce is. risks or opportunities related to ESG, you can’t manage what you can’t measure. BOS I think we’re all struggling with that measurement question. One of the reasons I like initiatives like Focusing HEINEL At the same time, through our stewardship efforts Capital on the Long Term (FCLT), which both PGGM and we are trying to guide companies as to the kind of State Street are part of, is that it brings together asset granular ESG reporting that would help us capture the owners, asset managers, corporates and regulators to data we need. We’re also involved with other asset owners think through these problems collectively. and asset managers in a project EY is spearheading to come up with new accounting metrics that capture FENDER I agree, and it is good that we have so many great long-term value. EY’s CEO Mark Weinberger likes to minds focused on this, whether it is the Task Force on illustrate the shortcomings of today’s metrics by pointing Climate-Related Financial Disclosures or other groups. out that if, for example, a company spends a significant We work closely with SASB and recently announced a amount of money on robots, that is registered on its partnership with PRI in which we will be talking to balance sheet as a capital investment. Yet if the company investment professionals over the next six months about spends the same amount of money on retraining or non-financial factors and the kind of data they will need to up-skilling its workers, it is considered an expense. better analyze these factors. We want to see how we as a profession can move toward standards that help people BOS Yes, I believe we need to adjust our views around make better decisions. Our Future of Finance survey what constitutes “value.” showed that nearly three-quarters of investment leaders FENDER That also means that as a profession, we need to expect that ESG factors will become more influential continually update our training for the next generation of in our profession. It’s just that we don’t have the financial analysts, so that they will understand how to standardized data yet to make that happen. assess a broader set of new criteria.

State Street Global Advisors 12 Change the Lens, Change the Goal, Change the Game

So where do you think we go from here in terms of redefining performance and objectives to include the kinds of attributes and metrics that are important to a broader group of stakeholders: beneficiaries, employees, policymakers?

MAIURI First of all, I am confident that we will begin to classic old cars like a ’67 Mustang? The point is that to make good progress on the measurement front by as asset managers we need to expand our ideas around applying new technologies that will allow us to improve performance and value to encompass a much wider array both the quality and consistency of ESG data, even when of criteria than we have in the past. it comes to more intangible kinds of attributes. This is Moreover, both asset owners and asset managers need to key for moving the industry forward, and that is the acknowledge the new reality that we face a broader group commitment that we are working toward. of stakeholders who are disrupting our conventional ideas BOS I believe that the focus on impact will continue to about performance. As Else mentioned, it is the multiple spread throughout the industry, driven by the interests of players in the value chain who need to come together to our beneficiaries but also by the realities of our world. The move the industry to its next level. As asset managers, we reason I am interested in circular economic principles is need to work collaboratively to do the necessary research because, however you look at it, a rapidly growing middle and develop the expertise and metrics to help all of our class worldwide means we are going to bump up against stakeholders invest in the kind of world they want for resource constraints fairly soon. I think that will by themselves and future generations. n definition force important questions around how we use and reuse resources. This will have an enormous impact on business models as companies change their thinking from “pay for ownership” to “pay for use.” It will change how manufacturers think about the lifecycle of products. This in turn should have a big effect on how investment ...as asset managers analysts assess the sustainability of companies and their we need to expand business models. our ideas around HEINEL I agree that asset managers will need to develop performance and new kinds of scorecards for assessing performance. I use the analogy of cars to show how the definition of value to encompass performance today is already broadening beyond alpha a much wider array alone. For example, someone buying a Maserati is probably first and foremost interested in a high- of criteria than we performance engine. But what about buyers of Teslas, have in the past. which offer both high performance and a lower carbon footprint? Or what about the emphasis on safety that LORI HEINEL draws buyers to Volvos? Or the emotional connection THE NEW ALTERNATIVES PARADIGM Balancing Liquidity and Opportunity

DON TOREY CIO Alternative Investments DAVID SELBOVITZ, CFA, CAIA Portfolio Strategist for Alternative Investments

The new investment reality of more challenging markets requires long-term investors to cast a critical eye on their portfolios to ensure they are allocating their capital in the most risk- and fee- efficient ways. As the underlying drivers of risk-and-return are better understood, institutional investors recognize that alternatives play an increasingly important role in enhancing return potential, diversifying risk and providing downside protection. But as with other portfolio components, investors need to understand the distinct risk-and-return trade-offs that come with alternative investments, including liquidity and operational risks.

State Street Global Advisors 14 The New Alternatives Paradigm THE NEW ALTERNATIVES

PARADIGM Moreover, in the same way that factor-based public pension plans or endowments and foundations approaches are challenging traditional long-only active with long-term, ongoing liabilities or spending plans. managers, long-short factor approaches are disrupting Also, we acknowledge that “alternatives” is a broad many hedge fund managers, requiring them to term for very differentiated asset classes and trading demonstrate their distinctive value-add. Still, a strategies that provide orthogonal exposures with growing number of institutional investors recognize complementary characteristics. When it comes to that alternatives have moved into the mainstream and creating an alternatives portfolio, there is no one-size- will remain a critical building block in helping them fits-all approach. achieve their long-term investment objectives. , real estate, and hedge funds are the three largest alternative asset classes; PWC projects Fit For Purpose that together the three will comprise nearly 75 Sizing the Appropriate percent of overall alternative assets by 2020.1 Worldwide alternative Alternatives Portfolio reached a record of roughly $8 trillion as of year-end 2016, with private investments accounting for more Clearly the size and type of alternatives allocations will than half of this total.2 Alternatives have enjoyed vary according to investment objectives: corporate DB exponential growth in recent years, as investors have plans close to full funding and wishing to defease their searched for incremental risk-and-return in a modest liabilities are likely to have less of an appetite for return environment. Figure 1 shows the targeted illiquid alternatives with extended lock-ups than, say,

State Street Global Advisors 15 The New Alternatives Paradigm

Figure 1 Target Allocation by Alternative Asset Class

<5% <5–9.9% <10–14.9% <15–19.9% >20%

Hedge Funds

Real Estate

Private Equity

Source: Prequin Investor Outlook, Alternative Assets, H1 2017 as of February 2017. Asset allocation does not assure a profit or guarantee against a loss. allocations of more than 500 private market alternatives that had 5.7 million total U.S. firms.3 institutional investors surveyed by capital commitments that spanned Moreover, the number of listed US Prequin. While a notable, but over a decade. The resulting companies has declined by almost diminishing portion of investors denominator effect drove private 50% over the last 20 years because remain with minimal exposure, market alternatives allocations much of higher costs, greater regulatory especially to private equity, we higher than the intended exposure, burdens and other constraints.4 believe that the complexities related leaving portfolios less liquid and Private equity thus provides access to to manager sourcing, portfolio forcing some institutional investors a vast opportunity set of less efficient construction, and liquidity to sell assets at distressed prices to markets. In our private equity management will recede as barriers fund portfolio liquidity needs. investments, we expect to earn a in this new investment reality. That return premium of 300 to 500 basis Access to liquidity is not static. It is said, liquidity management remains points over public markets. We important to consider the liquidity a crucial component of any expect that illiquidity premium to of alternative investments and their alternatives allocation. drift to the lower end of that range in underlying positions, specifically the interim as public market returns during periods of market duress. move below trend and a surplus of Allocations to the illiquid GFC Lessons market liquidity remains. components of alternatives are and Learned should be thought of as a long-term Real estate markets, meanwhile, A Paradigm Shift commitment of capital. remain relatively well supported by in Liquidity steady job growth, investors’ search for income, and low financing costs. One of the most dramatic lessons of Alternative Real assets like property may also the Global Financial Crisis (GFC) Strategies provide investors with a measure of was a greater appreciation of liquidity A Robust inflation protection and capital risk during market shocks and the preservation. However, the need to stress test portfolios for Opportunity Set distinctive attributes of individual liquidity events. During the crisis we By the latest count, public companies properties and markets coupled with saw declining asset values along with comprise just 0.1% of the more than the risk of overpaying where prices

State Street Global Advisors 16 The New Alternatives Paradigm

have recovered since the global their portfolios away from risk- HEDGE financial crisis highlight the need to seeking investments and towards FUNDS work with managers who are well risk-reducing ones. We believe it is • Disruption caused by factor-based versed in local market conditions. important that the components of strategies is raising the bar on hedge fund an alternatives portfolio span the managers to demonstrate their value-add, Within public markets, hedge funds liquidity risk spectrum to best net of fees. provide greater access to price address an investor’s risk-and-return • Lower correlations should drive dispersion dispersion and idiosyncratic trading. objectives. For example, pension across securities, assets, and geographies The rise of factor-based, long/short plans with a lower funded status and investing is poised to disrupt the • Combining systematic and discretionary longer-term liabilities can use their strategies for complementary exposures traditional hedge fund industry. long time horizon as an opportunity can produce a more capital-efficient hedge Factor-based hedge funds can to capture the illiquidity premium fund program capture a diversified range of with a meaningful allocation to systematic returns, while providing private equity. REAL enhanced transparency, lower fees, ESTATE and better liquidity than traditional A lesson we learned from the GFC, • Important to diversify across the capital hedge funds. Hedge fund managers which we apply to the pension plans structure and geographic regions that provide a differentiated, skill- we manage through our outsourced based approach that cannot be easily CIO business, is to assign a dollar • Provides long-term total returns and current income as investors search for yield in a systematized will continue to target to illiquid investments; as low rate environment command a premium. Many hedge plans de-risk, that dollar value is fund managers have struggled in reduced. We then fund alternative • Offers lower duration than private equity recent years to deliver on their allocations pro rata based on the investment mandate. However, we component mix of risk-reducing and PRIVATE believe that as we move into a more risk-seeking assets. This is an EQUITY normalized monetary policy important shift from the traditional • Considerable “dry powder,” so it is environment, higher return portfolio percentage approach and important to consider valuations dispersions along with lower asset needs to be addressed when • Important to be invested throughout class correlations should provide a determining the appropriate size and the cycle, so diversify across sectors more supportive environment for mix of an alternatives portfolio. and vintages hedge funds. Other institutional investors like • Work with strong management teams with experience across economic cycles endowments, foundations and Alternatives for sovereign institutions might have a • Select managers that have access to much more diversified alternatives a robust network to source deals Pension Plans program across both liquid and Large pension plans are increasingly illiquid investments with alternatives adopting a liability-driven approach comprising 25% or more of their that seeks to match the duration of portfolios. For the three major their assets to the duration of their alternatives categories, here are the liabilities. As funded status issues we think investors should keep increases, sponsors are switching in mind:

State Street Global Advisors 17 The New Alternatives Paradigm

HEDGE FUND DISRUPTION Alternatives Go The returns generated by many Investors are increasingly allocating Mainstream hedge funds are driven by well- capital based on factors. According established trading strategies that to a Citi survey of investors and We believe institutional investors can be described as compensation intermediaries, primarily will continue to need alternatives to for taking systematic exposure to institutional, representing $935 augment public market returns and alternative risk factors. These billion of combined AUM, 81% of diversify away from public equity factors have attractive properties, respondents are currently investing market risk. However, not all including minimal market in, or looking to invest in, factor- alternatives are created equal. directionality and low correlation based solutions, and 69% of Given the important role with traditional markets. Unlike respondents prefer to access alternatives play in delivering long-only Smart Beta strategies, factor-based strategies through a non-correlated alpha and reducing factor-based hedge funds express hedge fund vehicle.5 AUM in portfolio risk, we think it is more both long and short views in factor-based funds are projected to important than ever to construct a dynamic trading strategies. These rise from $265 billion in 2014 to $1.2 durable, efficient, objectives-based factor-based strategies can trillion by the end of 2019 — making alternatives portfolio. complement discretionary hedge this the fastest growing product set Compensation for the illiquidity of 6 fund managers to provide investors in the industry. private capital may ebb and flow. But with a hedge fund program that for investors with long time horizons offers enhanced liquidity, greater and known funding requirements, we transparency and overall lower fees. believe exposure to the illiquidity premium, alpha opportunities and diversification benefits of private % equity should be part of an alternatives portfolio.

Direct real estate investing is one of the oldest forms of alternative 86INCREASE investments. Its characteristics of Expected Factor- an attractive yield less tied to the Based Investments direction of interest rates and in the Next 3 Years purchasing power protection are as useful now as they have ever been. %

14MAINTAIN

Source: 2016 Citi Prime Finance Survey as of May 2016 State Street Global Advisors 18 The New Alternatives Paradigm

Hedge funds will remain an important source of unconstrained access to public markets and downside risk protection. In our ...We think it is more view, factor investing will disrupt a segment of the traditional hedge fund important than ever to industry, while complementing construct a durable, discretionary hedge funds that provide true idiosyncratic alpha. efficient, objectives-based The new paradigm for institutional alternatives portfolio. investors will involve building more capital-efficient alternatives programs that are customized for their specific needs in a more transparent, fee-conscious and liquidity-aware format. n

1 PWC, Strategy &, “Alternative Investments: It’s time to pay attention,” 2015. 2 “US Alternative Products and Strategies,” The Cerulli Report, 2017. 3 Joan Farre-Mensa, “Comparing the Cash Policies of Public and Private Firms,” SSRN, April 2014. NYSE and NASDAQ capitalizations were approximately $12 trillion and $5 trillion as of July 2012. 4 Rayhunal Ibrahim, “The number of publicly traded US companies is down by 46% in the past two decades,” Yahoo News, August 8, 2016. 5 2016 Citi Prime Finance Survey. 6 Increasing Institutional Portfolio Complexity & the Resulting Shift from a Product to a Solutions Mindset, Citi Business Advisory, June 2015.

State Street Global Advisors 19 DISRUPTION IN ACTION

Photo by Oli Scarff/Getty Images. Workers at an Amazon fulfillment house prepare for Cyber Monday. AUTOS HEALTHCARE RETAIL CREDIT

Technology-driven disruption and disintermediation have turbocharged DISRUPTION Josef Schumpeter’s more gradual view of capitalism’s creative destruction and evolution. The pace of change is speeding up. Who can imagine life without smart phones, even though those pocket computers have only been around for a decade? Entire industries are being upended in ways investors need to understand in order to identify the winners and losers. Automobiles, healthcare and retail are three sectors in the front lines of creative destruction and transformation, while new technology and regulation could alter how institutions access liquidity in the credit markets. Our analysts describe what the changes mean for investors.

State Street Global Advisors 21 Electric Vehicles Drive Change in the Auto Industry JOHN SAAGER

Figure 1 Energy Density and Cost Reduction of Electric Vehicle Batteries by Generation

10s201 S S AO 2012020 2020s 2030s

Source: AB Bernstein Research estimates and analysis as of March 10, 2017.

With battery electric vehicles (BEVs) As countries announce plans to ban Range Anxiety rapidly approaching cost parity with sales of fossil fuel–powered ICEs to internal combustion engines (ICEs), tackle air pollution, and battery More efficient battery technologies investors should be aware of the costs fall faster than expected, could mollify consumers’ implications for the auto industry Tesla’s progress in making BEVs understandable anxiety about and its upstream partners — from popular and affordable is forcing purchasing electric vehicles with raw materials mining and auto industry leaders like limited driving range. For a lithium- semiconductors to the utilities that Volkswagen, Toyota and Volvo to ion battery to be cost effective support the charging infrastructure. radically change their business plans. relative to an ICE, it would need a In the future landscape of mobility In our view, the path for BEVs to take range of around 300 miles at a price services and autonomous vehicles, the lead over ICEs is open, but there of $100 per kilowatt hour (kWh).1 the very idea of owning and driving are hurdles to further market Based on the long and steady history cars will change. penetration that must be cleared. of improvements in battery Consumers will adopt BEVs when the chemistry and gains in production cars are well designed, with range at efficiency, cost parity between BEVs competitive cost and access to fast and ICEs could be reached by 2022 or charging stations. 2023 (see Figure 1).

State Street Global Advisors 22 Disruption in Action

Charging Figure 2 Electric Vehicle Charging Station Networks will Expand Infrastructure 2016 2023 and Efficiency To allow wider use of BEVs over ICEs, significant capital expenditures will AMERICAS 823k 5.6m be required to provide adequate access to fast charging stations.2 The infrastructure improvement process has made a promising start, as the Environmental Protection Agency’s EMEA 1.1m diesel emissions settlement with 8.7m Volkswagen has mandated that $2 billion be spent on the construction of charging stations throughout the US. In addition, we have observed broad government commitments to expanding charging station ASIA PACIFIC 1.0m 18.5m networks globally in the coming years (see Figure 2).

BEV charging stations must also shorten the time to repower. Even the industry-leading Superchargers Source: IHS, China’s 13th Five-Year Plan, US Department of Energy, exclusive to Tesla take at least 30 Berenberg estimates as of February 10, 2016. minutes to fully recharge their batteries. So a 1000-mile trip would still take longer in a 300-mile range BEV than in a conventional ICE.

State Street Global Advisors 23 Disruption in Action

Industry however, as high government that when it becomes widely subsidies in Korea, Japan and China available, it will pave the way for even Realignment will likely keep competitors’ returns more disruption in the auto industry. down despite the massive ramping up Despite these obstacles, automakers In the meantime, we believe the of both supply and demand. have shifted gears to increase the better way to ride through these variety of BEVs in development and Drilling and distribution of fossil transformations is to go upstream on the market. Volvo has even fuels for ICEs will eventually be in the value chain where there is announced that it will discontinue challenged by the transition from already demand, rather than in the the production of pure ICE vehicles refueling to charging stations, automobile industry itself. For starting with its new models in 2019. although not for some time. Even example, we would look in the This trend is likely to persist as global with our ahead-of-consensus materials sector for companies that environmental regulations continue estimates for 8% to 12% BEV mine the lithium compounds used in to tighten and consumer preferences penetration by 2025, we expect that batteries or in the technology sector shift toward the technologically sales of cars with at least partially for semiconductors and other advanced, socially responsible and gas-powered engines will actually be devices. We expect to see little return increasingly fashionable BEVs. higher in 2025 than today. What will among the automakers that have to likely change is that the gains in invest so much capital to change their As we see it, investors should sales will be slower than their entire manufacturing processes, recognize that the surge in BEV traditional pace in line with GDP while automotive suppliers are at a adoption will have massive and population growth. point in the cycle where their implications for many different valuations are stretched. industries. Miners of raw materials Truly viable BEVs would clear a used in batteries — including lithium, major roadblock to the development 1 Estimates on cell costs vary, but we estimate that nickel, copper and cobalt — should of autonomous vehicles by allowing Tesla is somewhere in the $105–$115 per kWH range, with traditional automakers coming in near experience positive fallout, along them to be recharged cheaply and the $140–$150 range. with producers of the chemicals, quickly while not in use. This in turn 2 According to Matt Teske, 20-year automotive semiconductors, anodes and could accelerate the trend to replace industry veteran, BEV marketing/strategy consultant and founder of Chargeway (www.chargeway. cathodes needed to meet increased car ownership with fleet vehicles for net). While slower charging stations with only 1–2 demand from battery manufacturers. ride-sharing apps and other mobility plugs rated at 50 kilowatts can cost as little as The benefits of rising BEV $50,000, each of Tesla’s supercharging stations with services. While reliable self-driving 4–8 plugs rated at 120 kilowatts is estimated at production may not be a boon to technology may still take many years $450,000. battery manufacturers themselves, to perfect, we agree with the futurists

State Street Global Advisors 24 Healthcare M&A as the New R&D JOE LAWLOR & BILL SANDOW

Figure 1 Does Healthcare M&A Add Value?

Excess Returns for Acquisitive Firms (3 years post deal) % change by quintile 200

100

0

100 1st Qatil 2 Qatil 3 Qatil 4t Qatil t Qatil

Source: “Worth the Premium? A Systematic Approach for Assessing Acquisition Skill” by Tom Hillman and Chris Morck, Credit Suisse HOLT, January 2015.

One of the sectors most affected by and approvals still takes 10–15 years sectors, there is still a large technological disruption and at a whopping average cost of USD dispersion in outcomes (see disintermediation is healthcare. 2.5 billion — and only 5% of Figure 1). According to our analysis, Advances in technology and big data compounds make it through to the we estimate that around 40%–50% are expected to help accelerate the end. Adding to big pharma’s cost of deals actually destroy shareholder process of discovering the next pressures are those products close value. Each transaction must be blockbuster cure, even as the to the end of their patent protection considered on its own merits, of industry itself undergoes cycles. Moreover, the huge growth in course, but we found that deals unprecedented consolidation and healthcare costs in markets like the focused solely on cost-cutting convergence. Pricing pressures are US is putting pressure on drug tended to be unsuccessful. forcing the adoption of new business makers to lower prices. models that reduce intermediaries Taken together, these forces have and emphasize efficiencies of scale Innovate or Die helped drive periodic waves of and cost structures. merger and acquisition (M&A) In our experience, the most Despite new technologies, drug activity in the sector over the past successful deals have focused on development remains a lengthy, 25 years. In total, there have been innovation and growth, rather than expensive and highly risky process. close to 600 deals, each with a value cost-cutting. Obviously if companies The research and development above USD 1 billion, during this overpay for acquisitions, that (R&D) lifecycle for advancing new period. While M&A in healthcare destroys value as well. But with the drugs through multi-stage testing tends to be less dilutive than in other cost of developing drugs so high,

State Street Global Advisors 25 Disruption in Action

many companies have found that Game-Changing For example, through Roche’s acquiring an advanced drug pipeline involvement with Genentech — first and innovative therapies is one of the Therapies acquiring a majority stake in 1990 most cost-efficient ways to bypass and then buying out the minority So what are the more promising years of research and billions shareholders in 2009 — its clinics areas of drug innovation? We think of dollars spent on development. For have discovered, developed and the revolution in immunotherapy for many companies, we believe M&A launched many monoclonal cancer treatment offers some of the has become the quickest and antibodies that have become the most exciting game-changing cheapest path to effective R&D. standard of care in the fight against therapies. The first generation Acquiring new compounds that are cancer, including blockbusters like involves a new wave of drugs that can more advanced in the R&D process Herceptin, Avastin and Rituxan. prime the immune system to seek out can also be an effective way for and destroy cancer cells, potentially Another milestone M&A deal in companies to offset the declines in improving cure rates and extending oncology was Merck’s acquisition of revenue from products whose patent life expectancy for patients with Schering Plough in 2009, gaining protection is expiring (see Figure 2). certain types of tumors. access to a patented antibody

~ Figure 2 Leapfrogging the R&D Timeline R&D TIMELINE WITH M&A 5 YEARS

TYPICAL R&D TIMELINE ~ 15 YEARS

Drug Discovery Preclinical Clinical Trials FDA Review 1 FDA Approved Drug 10,000 compounds 250 compounds 5 compounds

M&A can help companies leapfrog over several stages of the drug R&D cycle. It is also:

• LOW RISK • COST EFFECTIVE

State Street Global Advisors 26 Disruption in Action

compound discovered by Organon, Finding the We think large-cap biotech can be an which Schering had acquired from attractive area of opportunity, as Akzo Nobel in 2007. That compound, Winners bigger companies may be better Keytruda, has been taken through positioned to expedite the regulatory Despite a more recent slowing of the R&D process by Merck, approved approval and patent processes. And M&A activity in the healthcare for a range of tumors by the FDA and with deeper distribution networks sector, we believe companies will been on the market for three years, for selling their newly acquired continue to consolidate and with sales projected to hit USD 11 innovations to a wider audience, they restructure because of persistent billion by 2022.1 can accelerate revenue generation to price-cutting pressures. Healthcare offset the high costs of R&D. With Thanks to these acquisitions, Roche is one of the last sectors to rationalize populations aging around the world, and Merck are likely to be major its supply chains, so we expect to see the sector will continue to enjoy players in the next wave of therapies new business models developing that strong tailwinds. The individual for cancer and other rare conditions, will also include service rationing to winners will be those who use which may involve techniques like keep costs down. innovation to keep their pipelines gene editing that hold the promise of In drug and device development, we filled, lower their costs and grow not just treating but curing disease. expect the most successful their revenue base. Such curative approaches may companies will be those that can 1 initially be more expensive than Bloomberg consensus estimate as of August 10, 2017. harness innovation through M&A current standards of care, but may and are adept at integrating the lead to longer-term savings to the acquisition. They will be better healthcare system as patients who protected against pricing pressures. get better will no longer require At the same time, companies that fail treatment for chronic conditions. to innovate will be negatively affected in an outsized way.

State Street Global Advisors 27 New Ways to Make the Consumer Connection JEFFREY LOOBY & MICHAEL NEFT

NOT AVAILABLE OTHER BETTER CONVENIENCE BETTER PRICE IN LOCAL STORES REASON QUALITY

REASONS CONSUMERS SHOP ONLINE* (Averages shown in percents) 53.9 29.6 10.6 3.0 1.8

Averages Breakdown

Groceries or personal care itemsa 48.3 29.2 12.5 5.5 2.4

Clothingb 45.5 28.6 19.2 2.9 2.4

Furniture or household goodsc 40.7 39.7 12.3 3.0 2.9

Electronics or appliancesd 38.3 50.5 6.8 1.8 2.0

Books, music or DVDse 48.7 34.9 12.0 2.3 1.5

Travel-related items 58.9 29.4 8.5 1.8 1.0 (plane tickets, hotel rooms)f

Tickets to live events, like sporting 68.5 14.4 12.7 2.5 1.2 events, concerts or moviesg

Food delivery or carryouth 82.2 10.3 1.0 3.9 1.1

State Street Global Advisors 28 Disruption in Action

Disintermediation of the value chain Disintermediating get feedback from current or and personalization of products and potential customers. Learning about services will change everything about the Value Chain what consumers really want can the customer’s experience of buying. streamline product development The consumer value chain has This will fundamentally alter what it and inventory management, conventionally been broken down takes to be profitable in the consumer avoiding the potential miscues into product branding/intellectual sector and influence the types of derived from the limited sampling property, manufacturing, logistics companies investors should consider. and longer lead times of traditional and retailing. Technology has market research approaches. Amazon is king of the hill now. When allowed many firms to consolidate Through such connections, decision- it comes to selling standardized these multiple functions into their making can be more effective, goods out of centralized distribution businesses, creating advantages over helping brands stay relevant in their centers, we would argue that no one traditional models. fast-moving end-markets. — not even Wal-Mart — offers greater For instance, technology has enabled choice and convenience at lower cost, Looking ahead, in an extreme but Amazon to establish direct which are by far the primary reasons plausible disintermediation scenario, relationships with its customers, that shoppers go online (see Figure 1). a producer could merely supply raw build an online marketplace offering materials or blueprints to a customer. Growing from an online bookseller to hundreds of millions of goods and From these inputs, the consumer the largest supplier of cloud services,1 guarantee two-day delivery on would create a customized end- Amazon has captured market share millions of these items. The company product using technologies like across a vast array of products and has invested large amounts of capital three-dimensional (3D) printing or services that consumers are now to internalize many logistics computer numerical control (CNC) looking to buy online. This is functions typically provided by third cutting machines. In this case, especially remarkable in the ever- parties. Amazon has done this at a traditional intermediaries in the changing retail landscape, where scale whereby the company can value chain would be completely yesterday’s prince has become deliver goods to customers with eliminated. today’s pauper — think Sears. shorter shipping windows and at a lower cost versus the competition. What could challenge Amazon’s To date, companies with more Personalizing dominance? In an industry traditional models have lost share to characterized by constantly Amazon, as they have had difficulty Products shifting consumer preferences, we combining new technologies with As long as Amazon’s value see rapidly evolving technology existing bricks-and-mortar assets. proposition depends on wide amplifying three forces that are selection, low price and fast delivery likely to determine tomorrow’s Brands have been able to partially of mass-produced goods, we think leaders: disintermediation, disintermediate Amazon and the personalization may prove to be an personalization and customer traditional consumer value chain by area where competitors can make experience. In our view, other firms using technology to interact directly inroads. Again with technology will be able to challenge Amazon’s with customers, rather than facilitating the link between brands leadership position if they are as good depending on market research or and consumers, firms could engage or better at anticipating the future retailers for consumer feedback. with market segments as small as one state and adapting their business Owned e-commerce sites and social individual. Digital connectivity models to master these trends. media, for example, have let brands

State Street Global Advisors 29 Disruption in Action

enables two-way information sharing shoppers, then suggest related Positioning to Fend so that products can be customized products and extend discounts to to meet the explicit tastes of tempt reluctant buyers. When a Off Competitive consumers — think of Nike and desired item is out of , this can Challenges Converse inspiring buyers to design be an opportunity for upselling to a their own unique footwear, L’Oréal more expensive alternative, rather For the time being, Amazon is still blending makeup to match a than losing the sale to a competitor. the dominant force in retail, taking a particular skin tone, Modern Tailor Brands can add value through 36% share within e-commerce, or Proper Cloth making a custom product education and services which accounted for 11.5% of retail shirt to measure. offered both before and after excluding food service, autos and gas purchases, such as free shipping in 2016.2 But even with Amazon’s Brands offering this degree of and returns. supremacy, we have found personalization may be able to opportunities as global investors in differentiate themselves from the But for brands to outperform select luxury and mass affluent mass-selling business model and aggregators on experience outside of brands, like athletic footwear, which build deeper emotional bonds with personalized products, they have to have been able to defend their consumers. And we are already provide brand-specific opportunities franchises through customer loyalty seeing advances in manufacturing — for example, early access to new and their reputations for quality. We technology helping to ring in an era releases, exclusive invitations to are also interested in categories that of mass personalization and local events and interactions with brand are more immune from the current production, as more versatile ambassadors. When the exchange of challenges posed by Amazon, such as automated factory equipment can information between buyers and home improvement, convenience accelerate retooling and make small sellers is viewed as mutually stores and restaurants. batch sizes economically viable. beneficial, the direct-to-customer model allows brands to be more Going forward, we are looking to responsive, enabling them to invest in companies with strong Enhancing maintain a deeper knowledge of brands that can offer personalized the Customer their markets. This trend creates and unique customer products and space for niche players to defend or experiences, while controlling Experience expand market share against manufacturing and delivering those Owners of intellectual property also low-cost competitors by connecting products directly to consumers. and resonating with their customers, have the potential to leverage their 1 “AWS dominates cloud computing infrastructure brand equity by exercising more building even more brand equity in market, bigger than IBM/Google/Microsoft control over the sales process and the process. combined” zdnet.com as of February 6, 2017. 2 Sources: US Census Bureau, Department of creating a better buying experience. Commerce “Advance Monthly Sales for Retail & Food Through e-commerce data analytics, Services” as of July 14, 2017 and “Quarterly Retail brand websites can track browsing Sales Report” as of May 16, 2017; Amazon.com Inc. as of July 28, 2017; SSGA estimates as of July 31, activity to learn what interests 2017.

State Street Global Advisors 30 Credit in the Cloud? MATT NEST

Institutions have struggled to find liquidity in fixed income markets Challenge Solution ever since financial regulations A large corporate pension plan In this scenario, we suggested that restricted investment banks from approached State Street with a the client transition assets and warehousing risk, especially in problem: they wanted to increase an cash into an ETF. Then we moved smaller, less frequently traded areas already sizable allocation to high a slice of assets out of the ETF into of the market. But the large pools of yield bonds, but they were unhappy a commingled fund, and the client seasoned credit assets managed by with their active manager. When they received shares in that fund. This big global firms, like State Street asked us to index the portfolio, they approach resulted in an extremely Global Advisors, offer a new avenue were also concerned about the cost diversified portfolio of indexed high for investors to source liquidity in a and time it would take to make the yield bond exposure, implemented in faster, more transparent and cost- transition, as regulatory changes days at a cost that would be hard to efficient way. have reduced the amount of bonds replicate accessing capital markets State Street’s vast pool of global warehoused at banks. Typically such directly. Now the client also has their fixed income assets increasingly transitions can take a number of high yield assets managed by State resembles a liquidity model similar business days and involve additional Street at a lower cost. costs paid to intermediaries. to the cloud computing model that We believe this is just one of the has transformed information many new ways a combination of technology (IT). Large investors can regulation and technology is acquire, dispose of or tactically shift Engagement disrupting institutional fixed fixed income assets at a lower cost As one of the world’s largest asset income investing. n with more scale, volume and managers, State Street manages USD efficiency by working directly with 1 As of August 2017. 21 billion in high yield assets in index a large asset manager. This is and active strategies in exchange especially important for those parts traded and commingled fund of the market, like high yield, where formats.1 Clients move into and out liquidity is thinner. State Street is of these products daily, so we trade well positioned to work closely with billions in volume each year. Given counterparties and clients to ensure State Street’s large and varied that we appropriately balance the participation in the high yield various trade-offs with respect markets, we have insight, access and to liquidity, cost and time, helping to tools that few others managers can benefit both new clients and existing bring to bear. We also have a client- shareholders in our products. Below centric, solutions-oriented approach we highlight one of the many ways we that allows us to help find the best are working with institutions to approach for our clients. provide new, disintermediated ways to access the fixed income liquidity they need. State Street Global Advisors 31 DEMOGRAPHIC DISRUPTION Why We Need to Save More and Invest Differently

AMLAN ROY Global Chief Retirement Strategist

Unprecedented demographic changes are under way across the world, and their speed and magnitude are greater than ever before. Like the technology disruptions overturning conventional wisdom about industries and business models, demographic disruptions will force countries to rethink foundational policies around retirement, labor force participation, healthcare and much more. Investors will need to rethink savings and spending objectives over much longer time horizons. We believe the impacts of these demographic shifts have not been adequately assessed and accounted for.

State Street Global Advisors 32 Demographic Disruption

Demographics Is About More While age is a factor in how people behave, it is not the only one. People behave differently as workers Than Aging and consumers depending on their gender, income, education, wealth, family background and Demographics are often thought to refer only to environment. Technological advances and increases in life expectancy and the numbers of young globalization trends also exert a big influence. versus old. In fact, demographics pertain to a much This heterogeneity of behaviors has complex effects on broader set of “people characteristics,” that is, those economic growth, inflation, debt, asset prices, of every consumer and worker. At a macro level, both geopolitics, migration and sustainability,1 all of which consumer and worker behavior affects GDP: the need to be understood in order to formulate the former consumes much of what the latter produces. At correct policy responses from governments and help a micro level, consumers and workers influence the investors construct their portfolios. income statements and balance sheets of individuals, households, companies and countries.

State Street Global Advisors 33 Demographic Disruption

Five Big Demographic Disruptions There are many ways in which demographics are disrupting normal economic and financial conditions. Of these, I believe the following five have the greatest impact. 1 Demographic Time-Bomb First is the so-called demographic time-bomb, which better access to contraception and lower infant mortality describes the combination of big increases in life rates. Such a change is also historically unprecedented. expectancy with dramatic drops in fertility rates, to an However, the impact on economic growth of these extent that is unprecedented in human history. Below is a changes has been significant. Economic growth relies on chart showing how global life expectancy and fertility growth in population, productivity and hours worked. As rates have changed since 1700 (see Figure 1). population growth falls and the available labor force The greatest increase in life expectancy occurred in the shrinks, GDP growth weakens — something we are 20th century, with the average life span more than already witnessing in some advanced economies, even as doubling from 30 years to 65 years due to advances in they recover from the 2008 financial crisis. Lower medicine and healthcare. Meanwhile, global fertility rates growth, inflation and interest rates coupled with rapid have decreased from five children per woman in 1950–55 urbanization across the world are exacerbating inequality to 2.5 children per woman in 2010–15. This has been and creating environmental problems. Just under half of driven primarily by changes in developed markets, for us currently live in cities. By 2030, that proportion will example, greater female participation in the workforce, be closer to three-quarters.

Figure 1 Life Expectancy and Fertility Rates since 1700

Number of Children Per Woman Age 7 0

0 4

3 30 2

1

0 1700 170 100 10 100 10 2000 200 2100 0

Source: R Lee (2003), “The Demographic Transition: Three Centuries of Population Change.”

State Street Global Advisors 34 Demographic Disruption

2 Unsustainable Pressure on National Budgets The second disruptive change has been the growing Figure 2 pressure on the budgets and national debt of advanced Others countries from past promises made on pensions, 3% healthcare and long-term care. As people live longer Unemployment % % 41 and require more care, but still retire in their 60s, 5 Pensions Survivors governments are switching money away from public 6% services to fund pensions and health, as we can see in Breakdown of the example for the European Union in Figure 2. EU Spending on Disability 7% Benefits in 2012 In most countries, age-related expenditures currently account for 20%+ of GDP and are projected to increase % Family & Children 8 % further.2 This is unsustainable now and will become 30 Sickness/ even more so in the future without radical reform. Healthcare Company pension plans are facing shortfalls for similar Source: European Commission. reasons and matching or reducing liabilities has become the focus for many schemes. 3 Demographic Dividend in Emerging Markets The third important disruptor is the “demographic dividend” of emerging markets,3 4 which is crucial to EM growth. Many assume that this applies to the higher number of young people in emerging markets as opposed to developed markets, which coupled with better population growth, should result in a bigger workforce. While these developments are occurring, they are not enough for emerging markets to grow. To achieve this, countries need to invest in the education and skills of their young people, ensure greater female participation and create more jobs.

State Street Global Advisors 35 Demographic Disruption

4 Mass Migration in a Globalized World Large flows of people within and between countries for Work, or economic migration, was the main reason for economic or security reasons are proving to be a challenge migrant inflows into Japan, while it was family in France, for even the most liberal countries.5 From 1990 to 2013, Italy and the US and free movement in Germany and the global migration increased by 50% from 154 million to UK. Such mass movements of people are creating tensions 232 million and has continued to rise in the wake of between migrants and natives, furthering geopolitical conflict in the Middle East and the prospects of a better unrest and triggering surprise electoral outcomes such as life in the West. Figure 3 shows how migration in 2013 Brexit and the election of President Trump. broke down across countries and reasons for migration.

Figure 3 Migrant Inflows, 2013

REASON US GERMANY UK FRANCE ITALY JAPAN

Work 75.9k 24.3k 86.4k 26.8k 73.1k 2 5.1k

Family 735.0k 56.0k 64.7k 104.6k 81.1k 20.6k

Humanitarian 119.6k 30.7k 20.7k 11.7k 8.8k 0.2k

Free N/A 77.9k N/A Movement 354.8k 98.3k 95.5k

Source: OECD, ILO, CS. Numbers within circles represent the biggest reason for inflows into a given country.

State Street Global Advisors 36 Demographic Disruption

5 Behavioral Differences Between Generations The final disruptor is unexpected differences in behavior The effects of all these disruptions are deep, long-lasting across the generations.6 Many had assumed that so-called and accelerating. From an economic standpoint, the millennials (born in 1983–2000) would behave in the greatest consequences will be for growth, inflation, debt same way as the post-war baby boomers. In fact, and asset prices. Demographics are also weighing on millennials are getting married and having children later, mechanisms such as monetary policy levers and, in some not seeking a single occupation for lifetime employment cases, rendering them ineffective amid low interest rates and having a different economic impact. and inflation. (This topic has been widely discussed at central bank conferences over the last decade.8) Today’s young adults, for example, consume relatively less than their corresponding cohorts born a generation From a social perspective, the most profound impact is or two earlier. They start accumulating assets later due on geopolitics, climate change and dealing with the to longer years in education. High youth unemployment human costs of migration. and high student debt levels have created additional pressures, causing them to embrace the “sharing economy.” Job uncertainty is also leading to increased precautionary saving among workers and can affect overall economic confidence. Simultaneously, differences in savings and investment patterns across generations are affecting capital flows and current accounts.7

State Street Global Advisors 37 Demographic Disruption

How Should Policymakers and Investors Respond?

Governments Governments will need to take multiple actions9 to deal already switched from incentivizing all workers to retire with these complex issues, the most pressing of which is to early to persuading them to work for longer. increase economic growth. Lower long-term growth will One way to encourage people to stay in work is to abolish mean lower GDP per capita — a measure of prosperity — mandatory retirement ages and allow flexible retirement that is, future generations will be less well off than their for workers into their 60s and 70s. Another is to promote parents and burdened by large amounts of public debt. To lifelong training and education, so that people can switch achieve higher growth, governments need to encourage careers or upskill later in life. There may also be a role for more people of working age into the labor force, improve selective migration with benefits to both host and donor their productivity or increase the hours that they work. countries and the movement of jobs rather than people via This has implications for labor market reform, gender outsourcing and offshoring. equality,10 immigration, productivity and technology, as well as skills and education. Governments also have to wrestle with inequality and youth unemployment even as technology and automation Figure 4 shows the different rates of labor force threaten further disruption. The best outcome may be to participation across advanced countries in the G6. Older marry the experience of older employers with the energy countries such as Japan, Germany, Italy and France could and drive of younger ones, making both more productive. all increase growth by encouraging more women to enter and remain in the workplace. Several countries have

Figure 4 Labor Force Participation G6 — 2015 Gender Labor Participation Differences

FEMALES MALES

52% FRANCE 61%

54% GERMANY 66%

40% ITALY 58%

49% JAPAN 70%

57% UNITED KINGDOM 68%

56% 69%

Source: World Bank, International Labour Organization (ILO).

State Street Global Advisors 38 Demographic Disruption

Investors 1 Consumers and workers influence economic A. Roy and S. Aggarwal, “A Demographic Perspective of Economic Growth,” CS Demographics Research, 2009; A. Roy, “Why Demographics Matter? And How?” fundamentals, which in turn drive growth and investment CS Demographics Research, 2006; A. Roy, “A Demographic Perspective of Fiscal returns, and affect how capital markets behave. So the Sustainability: Not Just the Immediate Term Matters,” CS Demographics Research, 2010. most important action investors can take is to integrate 2 CBO, “The 2012 Ageing Report,” European Commission, Eurostat, Hagist and an understanding of demographic effects into their Kotlikoff, 2005. decision-making. 3 A.Roy, A. Boussie and M. Yuan, “Latin American Demographic Focus: Structural Reforms Are Critical for Future Growth,” CS Research, 2016 Pension funds and insurers, in particular, need to evaluate 4 A. Roy, S. Punhani and A. Hsieh, “Africa’s Demographic Promise: Opportunities & how demographics will affect not only liabilities, but also Challenges,” “Assessing Asia’s Demographic Promise,” 2012. 5 Samuel Huntington, The Clash of Civilizations, Simon & Schuster, 1996; A. Roy, A. assets. They also need to encourage pension holders to Boussie and M. Yuan, “A Perspective on Migration: Past to Present,” CS Research, save more and seek independent advice when considering 2015. how to invest for a longer retirement. 6 A. Roy, A. Boussie and M. Yuan, “Demographic Focus: Changing Global Consumers”, CS Research, 2015. To cope with the complexity of the new environment, 7 A. Roy, “Demographics, Capital Flows and Exchange Rates,” CS Research, 2007. 8 investors need to adopt multi-period financial models11 Gagnon, Johannsen and Lopez-Salido, “Understanding the New Normal: The Role of Demographics,” Federal Reserve Working Paper 2016-080; P. Imam, “Shock from that can handle a broader range of asset classes, time- Graying: Is the Demographic Shift Weakening Monetary Policy Effectiveness?” IMF varying risk premia, correlations and volatility. Finally, Working Paper 13/191, 2013; A. Roy, “Why has recent macro-policy not been that effective? A demographic view,” CS Research, 2015. they need flexible, lower-cost, multi-asset solutions that 9 G. Keating, R. Hokenson and A. Roy, “The Demographic Manifesto: New Jobs, New factor in future scenarios for growth, inflation and asset People,” CS Research, 2000. prices and can adapt to different market conditions. 10 See footnote above: the author has been advocating the need for reduced gender inequality across more than 50 countries Without this appreciation of how demographic forces 11 A. Roy, “Demographics & Asset Prices,” CS Research, 2010. are disrupting our world and how we should respond, investment opportunities may be missed and longer- term risks may become acute. n

State Street Global Advisors 39 GLOSSARY

Commingled Fund refers to a that pools Denominator Effect describes the phenomenon of Illiquidity Premium is the amount an investor the assets of multiple accounts in order to reduce risks falling values in public markets causing allocations must be compensated for holding an asset that and costs. to illiquid asset classes to go over the (generally) cannot be easily converted into cash. CPB World Trade Monitor is a monthly time strict allocation guidelines. Portfolios then must sell Liquidity Event is the process through which series that aggregates and summarizes data on both out of their best performing assets in order to meet investors in illiquid assets convert their investments international trade and industrial production. allocation requirements. to cash. Demographic Dividend describes the rise in Factor-based Hedge Funds are hedge funds that Time-varying Risk Premia refers to the fluctuations a country’s economic growth that is fueled by its employ strategies to capture the factors driving risk- over time in financial compensation demanded working-age population becoming a larger share of and-return in various asset classes. by investors. the population than its non-working-age population. Group of Six (G6) refers to the US, UK, Germany, France, Italy and Japan.

State Street Global Advisors 40 CONTACTS

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State Street Global Advisors 41 State Street Global Advisors Worldwide Entities Branch (Sede Secondaria di Milano), is registered in representation or warranty as to the accuracy of the Australia: State Street Global Advisors, Australia, Italy with company number 06353340968 - R.E.A. information and State Street shall have no liability for Limited (ABN 42 003 914 225) is the holder of an 1887090 and VAT number 06353340968 and whose decisions based on such information. Australian Financial Services Licence (AFSL Number office is at Via dei Bossi, 4 - 20121 Milano, Italy. T: The views expressed in this material are the views 238276). Registered office: Level 17, 420 George 39 02 32066 100. F: 39 02 32066 155. Japan: State of each of the respective authors noted as of 14 Street, Sydney, NSW 2000, Australia. T: +612 9240 Street Global Advisors (Japan) Co., Ltd., Toranomon September 2017 and are subject to change based 7600. F: +612 9240 7611. 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State Street Global Advisors 42 About Us For nearly four decades, State Street Global Advisors has been committed to helping our clients, and those who rely on them, achieve their investment objectives. We partner with many of the world’s largest, most sophisticated investors and financial intermediaries to help them reach their goals through a rigorous, research-driven investment process spanning both indexing and active disciplines. With trillions* in assets under management, our scale and global reach offer clients access to markets, geographies and asset classes, and allow us to deliver thoughtful insights and innovative solutions. State Street Global Advisors is the investment management arm of State Street Corporation.

* Assets under management were $2.61 trillion as of June 30, 2017. AUM reflects approx. $34.06 billion (as of June 30, 2017) with respect to which State Street Global Advisors Funds Distributors, LLC serves as marketing agent; State Street Global Advisors Funds Distributors, LLC and State Street Global Advisors are affiliated.

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