More and more pension schemes are investing in alternative assets, but what areas are classified as ‘alternative’ assets and what do you need to know about the market? Scott Donaldson of Hymans Robertson discusses.
Trustees are presented with three challenges when looking at alternatives – finding asset classes which offer diversification from equities, determining whether their return prospects (relative to equities and bonds) are attractive and being able (or brave enough) to make a meaningful allocation. Few asset classes would be expected to perform as well as equities over the long term; those that do might be considered to be even riskier.
A further difficulty relates to fees. Institutional investors can obtain passive exposure to equities (i.e. to capture equity maket returns) for less than 0.1% p.a. using an index-tracking portfolio. By contrast, alternative assets usually involve products with high fee structures, typically 2% p.a. of value and 20% of outperformance generated. Many of these products may be capacity constrained; if too much money is deployed, future returns might be reduced. It can therefore be difficult to determine whether historical return patterns will be repeated.
Private equity involves providing finance for business development. These businesses are unquoted; their value (both at the time of investment and subsequently) is hard to determine. The worth of the business can only be established accurately when it is realised, normally several years after the private equity investment is made. Private equity represents a higher risk form of equity investment. Returns should therefore be expected to be higher than those earned in quoted equity markets because of the higher risk, the illiquidity of private equity products and the use of leverage.
Hedge Funds are the ultimate unconstrained investment. They have no strict guidelines. As a consequence, they are not an asset class, as such, but are instead a whole range of products or funds. Generally speaking, they hold short positions (i.e. selling securities they do not own) as well as long positions (i.e. conventional holdings). They usually employ significant leverage. In order to act as a significant source of diversification, it would be necessary to allocate as much as 10-15% of a scheme’s assets to hedge funds. We doubt that many fiduciaries are prepared to make such a significant allocation to investments which are hard to monitor. Most reported allocations are of relatively small amounts (1-2% of Scheme assets), at which level any impact is so negligible as to be irrelevant. However, this might be early phase investment as trustees build confidence.
Tactical Asset Allocation (TAA) refers to the situations when an investment manager uses the discretion they have been given by the trustee to hold positions in asset classes (and currencies) that differ from their benchmark weights. These are “tactical” positions because the views expressed are generally relatively short term. Global tactical asset allocation (GTAA) translates this into a hedge fund structure where the manager goes short and long in equity and bond index futures and currency forwards (applying leverage). They can be managed for high volatility so require low levels of capital.
Active currency management is similar in concept to GTAA but restricted to currency forwards. Currency markets are very large, liquid and cheap to trade. They are transactionally efficient but not necessarily price efficient, since turnover is dominated by highly constrained participants such as industrial and commercial companies, central banks and even tourists, rather than profit seekers. Statistics show that, within currencies, the average active manager has been able to add value over time, in contrast with equity or bond managers. This is likely to persist so long as it is possible to exploit the participants with agendas other than profit.
Infrastructure is a relatively recent alternative asset class. In the UK, the majority of exposure is likely to be through Public Private Partnerships (PPPs) such as the Private Finance Initiative (PFI). These are vehicles used to finance and build government-sponsored infrastructure projects, such as hospitals, schools and roads, in partnership with the private sector. The key merits supporting infrastructure as a potential investment are the potentially long term and sustainable cashflows and the likely low correlation to other asset classes. There is a limited but growing amount of capacity available. There may already be too much money chasing the opportunities.
Commodities are primary goods such as oil and gas, industrial metals such as copper, aluminium and iron ore, precious metals such as gold and platinum and agricultural products such as wheat, coffee and soya. Commodity futures exchanges have developed as the buyers and sellers of these goods seek to guarantee their buying and selling prices in advance. We do not believe there is compelling evidence to support holding a strategic position in commodity futures; historic return statistics have depended significantly on backwardation, a feature that appears to have been driven out of the market by an excess of capital chasing the “China effect”.
Trustees looking at alternatives are unlikely to find the streets paved with gold (or any other commodity). Today’s “alternatives” may well be tomorrow’s “mainstream”. Weight of money can continue to drive these markets forward, but new investors need to ask what is already priced in. The discerning investor surveying the investment landscape for opportunity might already need to look for the next alternative, and ideally get there in advance of the herd.