An Alternative Viewpoint
Nick Martindale examines whether pension funds are looking beyond the 'typical' types of alternative investments for their portfolios.
The economic conditions of the past few years have challenged conventional assumptions made by many pension funds regarding both investment strategy and asset allocation. Equities have proved even more volatile than they had previously been given allowance for, while even the once 'safe' haven of sovereign debt is now seen in a new light.
One result of this is that pension funds have become somewhat more open-minded about some of the less common asset classes. A few years ago, this was likely to mean private equity or hedge funds but there is now a much more varied choice for those looking elsewhere for the kinds of return they need to feed hefty liabilities.
"The key consideration for all alternatives is no or low correlation to capital markets," says PDL International managing director Sven Kuhlbrodt. "If the investment selector is confident that this is likely, then other important factors come into play including levels of return and volatility, counterparty risk and liquidity."
High-yield funds and some elements of distressed debt are proving particularly tempting in the current climate. Dexia Asset Management head of asset allocation Fabrice Cuchet says these funds have tended to outperform most asset classes, with an annualised growth rate of eight per cent over the last decade and only one negative year, in 2008. "The future is also positive, especially because a low-growth environment with very low interest rates is favourable for high-yield markets, especially for corporate issuers," he says.
Cheyne Capital president and co-founder Stuart Fiertz also reports a rise in interest in credit-oriented strategies. "The objective in today's environment is to buy good quality assets at stressed pricing rather than investing in distressed debt," he says. "That way the investor is positioned to benefit from a recovery in price without being exposed to the heightened economic sensitivity that there would be if you were investing in distressed debt or leveraged companies."
The current pressure on European banks to deleverage also presents opportunities for pension funds, through investing in risk-sharing transactions on banks' core corporate loan books, says Fiertz. "These trades enable banks to raise capital and give investors exposure to loans and investment-grade credit that wouldn't be available in more traditional bond or loan portfolios," he says. This clarification around this area issued in December 2011 by the Basel committee has reinvigorated the market and is likely to lead to a surge of activity over the coming months, he adds.
Insurance-linked investments are also becoming popular on account of their ability to combine diversification and non-correlated income with an attractive return portfolio, says Leadenhall Capital Partners chief executive Luca Albertini. "The key risks are those embedded in the investment, such as a large natural catastrophe," he says. "But the reason they are perfect for a pension fund is that, when the risk is correctly underwritten, it is inherently profitable over the medium term."
Interest in life-related products such as trade endowment policies and life settlements is also picking up compared to last year, says Kuhlbrodt. "This is because the heavy underweighting in alternatives emanating from the fallout of the financial crisis "" due to significantly increased due diligence requirements ruling out many alternatives "" has now been rebalanced," he says. "Rather than simply reducing exposure to all alternatives, investors are now looking at the options and being more selective."
Others, though, are turning to more physical assets. Real estate is well established as an asset class but there has been increasing attention on more specialist areas such as derivatives and IPD structured notes, as well as indirect or debt investments, says CBRE Real Estate Finance director Rod Lockhart. "A number of mezzanine debt real estate funds managed by specialists in their field have launched in the last 18 months," he adds.
European commercial mortgage-backed securities and UK residential mortgage-backed securities (RMBS) also offer decent opportunities in the current climate, suggests Fiertz.
"A senior RMBS instrument with a loan-to-value ratio of 50 per cent could yield in the order of 10 per cent," he says. "One can get nearly twice the yield compared to that on direct property or where banks are making real estate loans, while gaining from a substantial amount of subordination protection that would insulate the pension fund from a further decline in property prices," he says.
Another alternative for pension funds is investing in infrastructure; an idea which has been given extra impetus by governments looking to finance new projects without incurring balance sheet debt.
"We like asset classes that can pay contracted cash flows that will remain undented by economic and other headwinds and which have the potential for capital growth," says M&G Investments head of institutional distribution Bernard Abrahamsen. "Infrastructure equity ticks both of these boxes. Here you have big, proven assets such as ports, toll roads, schools and renewable energy projects which can pay regular and robust levels of income."
Other areas vacated by traditional providers in the post-crisis shake-up are offering new opportunities for pension funds. An example of this is investing in the real economy as the banking sector continues to restrict lending, suggests Fiertz. "We've seen a heightened interest from institutions in our direct mezzanine lending business on the real estate side and would expect to see a provision of mortgage financing directly by pension funds going forward," he says.
This is an area that Creechurch Capital chief executive John Greenwood also highlights. "While banks remain committed to shrinking their balance sheets and interest rates remain low this situation will continue," he says. "The risk lies in the fact that some options have been built on poor foundations with a mismatch in liquidity. Investors should avoid fad funds with no longevity."
Other individual assets are also coming on to the radar for pension fund managers. Sciens Capital head of business development for UK, Ireland and Australia Michael Hart says funds that invest in real assets, such as aviation and coloured diamonds, have the advantage of being uncorrelated to mainstream asset classes.
"Coloured diamonds make a very interesting investment proposition as the price of these assets has not declined since 1959 and on average has increased 10 per cent per annum," he says. "With supply dwindling and demand anticipated to increase exponentially, in particular from countries such as China, India, Russia and Brazil, we anticipate that prices will continue to rise."
Traditional alternatives are also enjoying strong attention at the moment. SL Capital Partners partner Graeme Gunn says private equity leveraged buyouts are particularly appealing due to their long-term outlook, while market conditions make private equity in general an attractive proposition.
"Pricing of deals has reduced from the highs of 2006 and 2007 and leverage has become more conservative," he says. "Funds are focused on acquiring high quality companies that can be operationally improved, allowing continued top and bottom-line growth, even in these difficult economic environments." Pension fund clients generally allocate around five per cent to this asset class, he says, although in some cases this can be as high as 20 per cent.
Natixis Global Asset Management head of UK and Ireland business and global consultant relations Terry Mellish, meanwhile, reports a growing appetite for 'smart beta' strategies such as hedged equity and hedge fund beta replication. "Their advantages are similar to hedge funds in that they look to share in the equity upside, but also manage risk by protecting against the downside," he says. "This makes them attractive portfolio components to complement traditional holdings."
Despite the attractions of alternative asset classes, they are often a response to temporary market conditions and a means of securing decent returns while the more conventional options stabilise. Quite when that will happen, though, is another matter.
Cuchet, for one, thinks alternative strategies will be a necessary element for pension fund managers for some time. "Equities will recover, but visibility on economic recovery will remain low in the coming years, interest rates are not paying any more for the embedded risk and many current challenges faced by developed countries are here to stay," he says. "In that environment, we are convinced that the trend towards alternatives strategies and assets will gain in momentum. They are a must-have for all investors."
by: bryanrobbinscapital
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