Recent articles in The Economist have questioned the effectiveness of certain alternative investments for pension funds. On Jan. 7, 2012, an article noted that hedge fund performance over the long term has been disappointing—other than for the managers themselves. On Jan. 28, 2012, another article noted that recent private equity performance has been driven mostly by leverage and that managers of private equity firms have also been the primary beneficiaries of the strong performance.
With all this skepticism about traditional alternative investments, what choices are left for a pension fund manager? Returns for traditional public market instruments appear to hold little promise over the next few years. Bond returns will most likely be limited to their yields, although with the Fed now planning to hold rates low until 2015, at least there will be limited risk from capital losses. Similarly, equity returns will most likely be driven by their dividend yields, with very modest expectations for capital appreciation. The resulting high single-digit returns may cover the discounted cost of pension obligations but will not allow pension plan sponsors to dig themselves out of the funding hole.
For those with an appetite for a more interesting risk-return profile, what are the options?
- Identify and secure access to only the top-quartile managers in an alternative asset class. History shows that top-quartile managers have tended to deliver attractive outcomes, but the challenge is in finding the needle in the haystack.
- Be an early adapter of a new alternative investment strategy.
In looking for new investment ideas, where are there such new untested opportunities, for both risk and reward?
Emerging market diversified funds
This refers to using active management to explore optimal capital structures in the emerging markets. Very few managers may have the ability to move seamlessly between bonds and equities, but this may be the best opportunity set for the investor.
Currency beta
Currency management using the forward rate bias allows a beta investor to benefit from the tendency of high interest rate currencies to outperform low interest rate currencies over time. This can be combined with active management of carry, trend, value factors and volatility factors.
Farmland and agricultural property
Agricultural land is in short supply globally, and Malthusian theory suggests that feeding the world’s growing population will be a challenge for some time to come.
Emerging commodities
In keeping with the agricultural theme, a savvy pension fund could consider opportunities in investments in water, phosphorus or other limited resources.
Catastrophe bonds
These are bonds that derive their risk and return profile from the insurance of environmental risks such as earthquakes and hurricanes. With a regionally diverse portfolio, a pension fund can put together a profile that is wholly uncorrelated with traditional market exposures but with an exceptional return potential.
Frontier markets
Now that most emerging markets have exceeded developed economies in their fiscal responsibility (and achieved P/E ratios commensurate with their new lower level of risk), perhaps it is time to consider the emerging emerging markets.
Of course, untested opportunities are not for the faint of heart. We all know that past performance is not indicative of future performance. But, without track records, all we can point to is the potential of uncertain future performance.