More Canadian pension funds are looking at alternative investments in the ongoing search for additional returns. Yet new research suggests that concerns around risk management and lack of investment education may be holding them back.
It appears that Canadian defined benefit (DB) pension plans are at a crossroads when it comes to alternative investments. While many plan sponsors are very interested in using alternative investments to drive excess returns, it seems that many have yet to turn some of their intentions into actions.
Last year, the Canadian Defined Benefit Survey by Pyramis Global Advisors saw plan sponsors on the verge of making changes to their DB plans, with many set to increase their exposure to alternative assets and strategies. This year’s survey shows that while interest remains high, plan sponsors have encountered some challenging, but not insurmountable, realities in adopting these strategies. Plan sponsors’ main concerns include a need for more education about alternatives, the investment guidelines of their plans and, last but not least, an approach to integrate alternative investments into their existing risk management systems.
The Thrill of the Chase
Let’s start by taking a look at the 2007 survey results. At that time, plan sponsors intended to give their alternatives a boost. Taken in aggregate, alternatives accounted for 8.6% of the average Canadian pension fund portfolio. However, nearly a quarter indicated that they were considering increasing their exposure to alternatives in the future—74% had plans to increase their allocations to asset classes such as private equity, venture capital, hedge funds and infrastructure. This shift was led by large public plans, which were ahead of their mid-size and corporate counterparts on the allocation front.
Another strategy that was gaining more interest was 130/30, with many respondents looking closely at extension strategies that would allow them to mix traditional long-only portfolios with some limited shorting. Last year, 26% of respondents said they were considering 130/30, led again by large public plans. However, only 5% of respondents were actually using 130/30 strategies.
Fast-forward to 2008. To get a clearer picture of where DB plan sponsors stand when it comes to alternatives, the research drilled down into individual categories and looked at specific strategies to more precisely gauge attitudes and intentions. While allocations to alternatives are still on the rise, a few high-profile strategies have not seen the same rise in interest as other alternative asset classes. The hunt for alpha is still on, but it appears that plan sponsors are now facing some challenges.
Setting Their Sights
Let’s start with the front runners. The alternative of choice this year appears to be infrastructure, with 43% of respondents planning to give their portfolios a boost in this area. Real estate is similarly poised for a jump (34%), while an additional 25% of plan sponsors are seeking greater exposure to private equity and venture capital. Hedge funds continue to be a major area of focus, with 27% of plans currently using these strategies. Additionally, 16% of respondents say they plan to increase their allocations to hedge funds this year.
For those that already have hedge funds in their portfolios, diversification seems to be the name of the game. More say they use collected single-strategy funds, multi-strategy funds and fund-of-funds than single-strategy funds—22%, 17% and 26%, respectively (Figure 1).
In the future, diversification will remain a major driver. Among those increasing their allocations to hedge funds, 29% plan to do so through multi-strategy funds, while another 29% are looking at long/short equity or a mix of strategies.
Despite their reputation as good diversifiers in tough markets, hedge funds have been adopted by only about one-quarter of plans in Canada, which raises the question, Why the holdup on hedge funds compared to other alternatives?
It could be that plans don’t feel that traditional risk management tools can properly gauge the risk of these strategies. Moreover, many respondents said they feel that risk management is more challenging overall with alternatives (Figure 2). However, hedge funds have consistently delivered superior risk-adjusted returns in a non-correlated fashion over the past several years compared to major stock market indexes. Plan sponsors may be missing out on the diversification benefits and returns that hedge funds can deliver in both good and bad markets.
Extending the Range
When it comes to alternatives, where else are plan sponsors looking for returns?
For 2008, it seems that many plan sponsors are looking at, but not necessarily adopting, extension strategies such as 130/30. Overall, almost half of public plans and more than one-quarter of corporate plans are either using or seriously considering using 130/30 strategies. In addition, 27% are still exploring and have yet to make a decision on whether or not these types of strategies could fit into their plans. However, the research shows that 43% of corporate plan sponsors and 22% of public plan sponsors say they still need more education on 130/30 (Figure 3). This is not surprising, given that 130/30 is still a relatively new strategy in the Canadian marketplace.
As well, 37% of plan sponsors say their current investment guidelines do not allow shorting, and 12% believe that 130/30 would be too difficult to explain to their pension committees. Clearly, plan sponsors need more information before a real increase in the use of extension strategies can occur.
Future Game
Whatever the future holds for alternatives in the Canadian pension landscape, it remains much different from the rest of the world, even in today’s post-Foreign Property Rule investment environment. While Canadians have tended to stay at home, reaping the benefits of stellar domestic market performance, global plan sponsors have their sights set on a wider universe of investment opportunities. Notably, they are proceeding with more confidence than their Canadian counterparts when it comes to alternative investments— particularly hedge funds. With the global hedge fund market valued at $1.9 trillion and growing, plan sponsors are turning to these strategies more frequently.
How does Canada compare globally? Canadian plan sponsors seeking to increase exposure to diversified hedge fund products are in line with their worldwide peers. Currently, the use of single-strategy hedge funds is outpacing that of diversified hedge funds in some areas, particularly in long/short and equity market neutral strategies versus fund-of-funds. However, future intentions point to an increasing prominence of “basket” funds such as fund-of-funds and multi-strategy funds. Equity market neutral strategies should also stay well positioned in global pension funds.
Clearly, there is still much more room for the Canadian market to grow its alternative allocations, especially judging by these global trends. And with no foreign investment caps holding them back, the stage is set for major change down the road. Whether this will happen next year or several years from now, only time and future research will tell.
Changing investment guidelines and increased education will help, and there’s still room for innovation on the risk management front. New tools to help manage alternative assets will open up new worlds for Canadian pension funds. If they can innovate, then the future will definitely be alpha-filled.
Joseph H. Morgart is senior vice-president, alternative investments, with Pyramis Global Advisors, a Fidelity Investments Company. joseph.morgart@fmr.com
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