Written By: Matthew Craig
Matthew Craig examines why uncertainty for equities and bonds has meant that local authorities are increasingly turning to alternatives in the search for stability and returns
The term “alternative” is normally used to imply something different, or unusual. But alternative assets are now becoming investment staples at many pension funds, particularly if private equity, real estate and infrastructure are included in the alternative assets category.
A survey on the use of alternative assets from Aberdeen Asset Management recently found that 82% of defined benefit (DB) pension funds have exposure to property, 53% have exposure to hedge funds, 47% to private equity and 45% to infrastructure. Aberdeen Asset Management global head of alternatives, Andrew McCaffery, commented: “In a persistently low-yield environment, all investors are having to cast their nets far and wide in search of returns. The research shows that pension fund managers and trustees are open to alternative investments, but would benefit from more information, education and pragmatic support to navigate the complexities of this area.”
Andrien Meyers, Treasury and Pensions Manager at the London Borough of Lambeth, commented: “We have 32% of our portfolio in alternatives, if you include 12% property as an alternative asset. In addition to property, we have 10% in hedge funds, 5% in diversified growth funds and 5% in private equity. They have all done well in the last three years.” Meyers explained that there are good reasons for the different alternatives to be in the portfolio. “Our reason for holding private equity is that as a London borough pension fund, 97% of our members are employed with Lambeth council. This means there is a possible strain on contributions if, for example, the number of employees at the council fell due to spending cuts. By investing in private equity and property, we have a source of income from distributions generated by the investments.” Meyers explained that because of the “J-curve effect” which means that it can take a few years to see funds returned after an initial investment in private equity, it is important to keep topping up the allocation, so there is a steady return stream back to the investor.
As well as providing income, alternative assets play an important balancing role in portfolios. In this regard, local authority pension funds face the same challenges as other long-term investors in the current environment. The global financial crisis of 2008 shook investors’ faith in listed assets; in the bond market liquidity evaporated, while equity values took a terrible fall. As part of the long-term reaction to that, alternative assets can help stabilise portfolios. Assets such as infrastructure and real estate depend on long-term economic growth, but their valuations are less susceptible to short-term pressures that can hit assets priced on a daily basis. These assets are illiquid, but investors know that and can plan around it, which is preferable to holding an asset which can be liquid until a crisis occurs, when it becomes illiquid.
The Avon pension fund and the Dorset county pension fund recently awarded mandates for £227 million to infrastructure manager IFM Investors following a collaborative procurement process. As infrastructure offers cash generation with inflation protection, it can be extremely useful for liability matching at pension funds. IFM Investors director, Annabel Wiscarson, commented: “Investors are getting more comfortable with infrastructure as an asset class as their understanding of it grows and we expect appetite to remain strong.” The recent government decision to alter the taxation of private placements is also expected to boost infrastructure investing. Allianz Global Investors said it welcomed the news and added that it plans to invest £3 billion in UK infrastructure debt over the next three to five years. Direct lending could also become more popular with investors looking for alternatives to traditional assets. With banks cutting their financing of middle market firms, pension funds have an opportunity to lend on attractive terms to corporate borrowers, as well as through real estate and infrastructure debt.
Looking at the investment landscape, some experts believe that investors will see a transition from a relatively stable, post-crisis climate, when the major central banks injected liquidity into the global economy, to a more differentiated environment. There are signs that this is already happening, with the US and UK recovering, while the Eurozone risks stagnation and Japan continues to apply QE in order to stimulate growth. This environment could be much more volatile than the immediate past for equity and bond investors. Consequently, investors may be unable to rely on simple market returns, or beta, but need to obtain returns from alpha, or returns produced through manager skill or other aspects of investment creativity. Morgan Stanley Alternative Investment Partners managing director and head of diversified alternatives, Joe McDonnell, commented: “Alpha was not needed so much in the last three or four years, as it was a big beta environment. Looking ahead, there is likely to be more weight placed on alpha and I see local authorities looking at three areas.” McDonnell explained: “The first area is absolute return fixed income, a more aggressive “diversified” benchmark agnostic proposition. Some of these offerings may bridge public and private credit markets. The second is what has been called new style balanced management, or diversified growth funds (DGFs). I think of this as a DGF manager taking an investor’s existing asset allocation, shuffling it around and handing it back to you. It comes from a general desire to have a lower equity beta in a portfolio.”
The third area of alternatives for local authority funds is in liquid alternatives, which can be part of a diversified alternatives bucket. McDonnell said this area could also be attractive if you believe that equities and bonds will not do as well in the future as they have in the last few years. Liquid alternatives aim to find alpha from a range of different sources, ranging from stock selection-based strategies, to macro trend-following strategies and to alternative beta strategies. In the past, these strategies were often wrapped up within a hedge fund. Now, there is greater transparency and these strategies are available as individual products. Hedge funds have been a useful part of the alternatives bucket for many investors but there are signs that their popularity is declining. One factor is a feeling that hedge funds have in the past charged high fees for average performance that depended on general market trends, rather than manager skill. As a result, many investors now see hedge funds as a way to diversify, rather than a source of very high returns. Lambeth’s Meyers commented: “Both of the hedge fund managers we have offer us some downside protection if there is a market correction.” Diversified growth funds, which invest in a mix of assets, can be used as an alternative to hedge funds. Meyers added: “We invest in diversified growth funds in order to generate some alpha, and also for diversification. Indeed, all of the alternative assets give us diversification, while property and private equity generate income. Over the last year, the average return from LGPS funds has been 6.4% annualised, but we have exceeded this, with an annualised return of 7.7%.”
One question mark over hedge funds and other alternatives is the appropriate benchmark to be used. A recent report from consultancy Clerus criticised the use of cash-like benchmarks for alternative assets such as hedge funds. In a recent report, it said that 27% of LGPS assets placed in hedge funds were benchmarked against cash, with the rest benchmarked against a cash-plus benchmark, as at March 2013. It said that doing this understated the risk of these assets and the returns being expected by schemes. Whatever the benchmark used, hedge fund performance for 2014 has not been stellar. Up to early December, the HFRI-weighted composite index had a year-to-date return of 3.73%, compared to 13.95% for the S&P 500, the main US equity index, and 6.21% for the Barclays Capital Government/Credit Bond Index.
For local authority pension funds, alternative assets look like being increasingly valuable, whether markets remain relatively stable, or become more volatile. In the former case, assets such as infrastructure or real estate can offer income with the prospect of growth, while if volatility rises, alternatives can offer a useful counterbalance to listed asset classes. From being seen as a niche activity, alternative assets are becoming a mainstay of many pension funds.