Alternative asset classes include investments that don’t fall under the umbrella of either a stock or a fixed income portfolio. Examples include direct real estate, direct infrastructure, private equity, private debt, hedge funds and commodities.
The first Canadian institutional investors to access alternatives were larger pension plans, such as the Ontario Teachers’ Pension Plan, with the scale and resources to develop in-house expertise. Since the turn of this century, alternative asset classes have grown in both importance and accessibility. Data from the Pension Investment Association of Canada and Greystone calculations suggest that alternative exposures grew by more than 10% from 2002 to 2011. With the growth of alternatives, more options exist than ever before for small and mid-size pension plans (those with less than $1 billion in assets).
While being smaller shouldn’t prevent investors from accessing alternatives, it’s important for all investors to ensure that their investment is the right fit. Using three simple checklists, smaller and mid-size pension plans can narrow their options and highlight key considerations.
Checklist No. 1: Plan Objectives
This first checklist helps institutional investors to match the appropriate alternative asset class with their objectives. Many investors will have more than one objective and will align with more than one asset class. For smaller DB plans, real estate and infrastructure may be a good first step, given their broad alignment with many objectives.
Liability matching looks at an alternative strategy’s ability to help match longer-dated liabilities or shorter-dated cash flows.
Return enhancement and diversification highlight the key benefits of alternatives. Adding alternatives to a portfolio contributes to lower overall volatility compared with a portfolio of only traditional asset classes.
Inflation hedging is important for pension investors with obligations that increase with inflation. Revenues from alternative investments are often linked to real economic growth and can provide a hedge against rising consumer prices.
Checklist No. 2: Fund Structure
This checklist will help investors to narrow down the structures they will use to access alternatives. The majority of small and mid-size institutions will access alternative investments through a fund rather than directly purchasing the assets. Investing directly requires the scale to create in-house investment teams that can analyze and execute deals. Using a fund allows smaller investors to access the same assets but with the expertise of a third-party manager.
Most investors are familiar with open-end funds, which allow for regular contributions and withdrawals from the investment pool.
Alternative assets that are not traded daily (private equity, infrastructure, private debt and real estate) were initially offered through closed-end funds, which accept contributions only during a limited window and return client money by selling assets when the fund winds down. This allowed asset managers to hold investments without the risk of client redemptions forcing sales at inopportune times. It also makes sense for investments that generate the majority of their returns through capital appreciation and may be therefore considered riskier.
Listed investments—those that are listed on stock exchanges—are found mostly with real estate and infrastructure. They can take the form of either the company stock of corporations that operate in the asset class or investment funds listed on a public exchange. Listed investments offer the most liquid vehicles for exposure to alternatives, as well as the greatest latitude for accessing funds. Unfortunately, since they are publicly traded on exchanges, many listed securities wind up having equity-like volatility, which reduces their long-term diversification and return-enhancing potential when compared with open- and closed-end investments.
Over time, there has been an evolution toward open-end structures for asset classes that provide sufficient underlying cash flows. Most notably, real estate, infrastructure and mortgages are available in funds with a perpetual life. This provides clients with the ability to contribute and redeem as needed, and to hold on to assets for long investment horizons.
Checklist No. 3: Comfort With Environment
Alternatives present a different environment than traditional asset classes. Higher fees, less flexibility on cash flows, infrequent market valuations, legal frameworks, use of leverage, alignment of interests and policy matching can all add complexity to the decision. Investors should be comfortable with this environment, and they can take steps to reduce the complexity.
In addition to these challenges, there are several governance matters that investors need to understand. Given that many alternative investments involve privately traded assets, there are potential difficulties with respect to benchmarking performance and matching policy benchmarks. For infrastructure and private equity, there is no consensus in the industry on what the appropriate benchmark should be. Depending on each investor’s objectives, the benchmark for these asset classes can range from absolute return, to inflation-based, to equity-based.
Finally, managing alternative asset classes generally requires more work, so investors should also be comfortable with fees higher than those of traditional asset classes.
None of these issues should be a barrier for smaller pension plans to access alternatives; however, it’s important to work with providers and consultants to understand and gain comfort with the differences between alternative and traditional asset classes.
Alternative investments can help to reduce portfolio volatility, enhance returns and better align assets with liabilities. Investors of all sizes now have the opportunity to access a variety of alternatives to gain the broad benefits found in non-traditional asset classes.
As with most things in life, the first step is usually the most difficult. Using checklists to define objectives can help small and mid-size pension plans to narrow the universe of possibilities and set them on the path to alternative investing.
Louis Martel is managing director and chief client strategist with Greystone Managed Investments.
Get a PDF of this article.