Alternative investments and local authority pension funds

Written By: Matthew Craig LAPF Investments

Investment in alternative assets might be generating more talk than action, but alternatives to the mainstream asset classes are indisputably becoming more common in local authority pension fund portfolios. Over the last 10 years, local authority pension funds have increased their allocations to alternative assets, such as hedge funds, private equity, infrastructure, commodities and currency, from around 1% to 10% on average. This gradual increase is the result of a number of trends followed over the past decade by large institutional investors. One such trend is a decline in equity exposure. Investors holding the classic 60:40 portfolio, with around 60% of assets in equities, have tended to cut their equity allocations, partly due to the extent that equity risk dominated their portfolios. The effect of such exposure was vividly demonstrated at the end of the technology boom, around 2002, and later in the global financial crisis. In both cases, equity slumps hit funding levels at pension funds. One result has been a greater interest in different growth assets and reducing overall volatility. Equally importantly, there is now an increased supply of alternative asset products to institutional investors, backed up by a feeling among investors that they should investigate the full range of investment opportunities open to them.

A recent survey by Greenwich Associates found that real estate is the most popular alternative asset among UK pension funds, although many would question whether real estate should be defined as an alternative asset. In the corporate sector, the amount of assets in hedge funds and private equity has steadily increased in the last three years, whereas the use of these assets has remained relatively flat in the local authority sector. Commenting on the current trends, Greenwich Associates principal, Lydia Vitalis, said: “At present there is more talk than action, however my sense is that UK local authorities are taking a twofold approach to alternative assets. First of all to invest in them for diversification purposes, but also to use alternatives such as real estate and infrastructure as a solution to the income challenges they face. Many local authorities are now looking at their cash flow, and the income from government Gilts is very low, so locking in a cash flow from infrastructure and real estate is a good alternative.” It is possible that the latest round of actuarial valuations will spur moves into alternatives. AllenbridgeEpic senior adviser John Jones, who also has experience of working at local authority funds, said: “Most local authorities are doing their actuarial valuations and once they have the results, they will look at how they are going to deliver the returns that are needed and they will take their investment strategies forward.”

Infrastructure has been much talked about as a useful alternative asset for long-term investors and outside parties, such as the UK government, are keen to see pension funds step into the gap left by cuts in capital expenditure. But there is a mismatch here, according to some observers. Morgan Stanley Investment Management (MSIM) managing director and head of alternatives, Joe McDonnell, commented: “There is a significant mismatch in my experience. Talking to trustees on the local authority side, they see the UK government looking for almost private equity-type infrastructure investing, where investors give up liquidity for long periods and take on construction risk, in order to get a return on equity. But most local authority investment staff that I speak to are more interested in yield-based, brownfield infrastructure. They want investment in fairly mature infrastructure, giving an income of 6-10% and which is diversified globally.” Another issue with infrastructure is scale, which is why UK investors are now clubbing together to form the Pensions Infrastructure Partnership as a means of creating a suitable investment vehicle. And in the debate over the future of the London borough pension funds, it has been argued that a consolidated fund would have the necessary size to invest directly in infrastructure projects such as airports and rail links.

As well as infrastructure, local authorities and other pension fund investors are considering other real assets, which offer non-correlated returns and an income component. Aquila Capital managing director, Stuart MacDonald, said: “Given the need to repair deficits and possibly find income sources, the obvious places to look are real assets, hedge funds and risk parity. Real assets, such as agricultural land, renewable energies and forestry have the capacity to generate recurrent income, as well as capital gains.” McDonnell agreed that there is a strong argument for having an allocation to real assets, but brings in inflation protection as a factor here. “Local authorities are underweight inflation linkers compared to corporate defined benefit pensions, but have offset this with a higher allocation to real assets. If an investor does this well, they can have a portfolio that does well should inflation be a problem, but which also does well if inflation is not a problem. In comparison, if you go down the inflation linker route, returns will not be very good unless inflation becomes a significant factor.”

Relatively esoteric areas such as insurance-linked securities, shipping, and aircraft leasing are part of the real assets sector, but McDonnell said capacity can be an issue for institutional investors. There is also the issue of the governance resources required for what could be small allocations. MacDonald added: “There is certainly a greater openness to new ideas, as some local authorities with issues over deficits highlight the attractiveness of alternative approaches. It is perhaps unrealistic however, to expect widespread early adoption as long as most local authorities portfolios are run in their current fashion.”

Hedge funds are an important part of the alternative assets universe, but many local authorities, like other investors, are on their guard after 2008. MacDonald said: “2008 was a poor year for hedge funds, but it was abysmal for most of the traditional benchmarked and long only equities-biased strategies that dominate the bulk of local authority portfolios. Hedge funds generally suffered less than half the losses of these strategies. They do not always capture all of the upside in rising markets (such as in 2009), but they generally provide superior downside protection.” However, Parametric managing director, Paul Bouchey, said investors are now wary of paying high fees for strategies like hedge funds that lack transparency, and are showing interest in options-based strategies that aim to provide absolute returns. “I was recently on a smart beta discussion panel with some investors who were interested in buying generic risk premia using swaps in the belief it will give exposure to trends that will outperform in the long-term, such as the value effect.” However Bouchey added: “It seems like a horrible idea to me. You are following some of the most well-known and popular quant factors in a simple, mechanistic way. It seems to me that active managers will take advantage of that in an adaptive market.”

Risk parity is one area that local authorities could add to their toolkit according to MacDonald. “Risk parity has the capacity to capture the benefits of diversification in a sustainable way. It can provide a way to rebuild capital and repair deficits without taking undue risk. With its capacity to ride through interest rate rises and other developments, this is an alternative strategy that is certainly attracting attention.” He added that while risk parity is not widely known or understood, it is gaining traction, particularly with local authorities advised by the more progressive consultants.

Another option for some local authority pension funds is to use a single manager for a diversified alternatives strategy. McDonnell said MSIM manages a number of diversified alternatives mandates for local authorities. Under this approach, the manager allocates between different alternative asset classes, taking day-to-day decision-making and some of the governance requirements away from the end investor. “Most local authorities don’t have the governance budget to manage a wide range of alternatives. Another problem is selling discipline; part of our remit for managing a diversified alternatives portfolio is that if something comes in, something goes out. The logic of partnering with someone who does a lot of work for you is attractive to local authorities, which are under a lot of pressure to cut costs, but the requirements on governance are going up,” McDonnell said.

For local authority pension funds, deciding the best way to deploy their asset and governance resources when faced by an array of alternatives can be a tricky balancing act. Developments such as the formation of the Pensions Infrastructure Partnership could play a part. If this takes off, it could offer an attractive infrastructure vehicle for many pension funds. Diversified alternatives funds could prove useful to some local authorities, while others may pick a particular real asset, be it farmland, timber, commodities or shipping, and build up some expertise. As with other parts of the investment portfolio, alternative assets have to make a case for inclusion based on factors such as their diversification attributes, income generation and growth potential, as well as their transparency, cost and liquidity.