The Halifax Regional Municipality Pension Plan (HRMPP), which has approximately $1.2 billion in assets, has been investing in alternative asset classes since 2007. Here, it provides a plan sponsor’s view on tactics for approaching alternative investment strategies.
What are alternatives?
The definition of alternative investments is not entirely clear. Some refer to them as investments that are not mainstream. In this case, alternative investments would change over time as non-mainstream investments become more mainstream. According to data from the Pension Investment Association of Canada (PIAC), non-Canadian stocks were once alternative investments in this country, accounting for 7% of the assets of Canadian pension plans in 1990, but increasing to 28% by 2009.
Others refer to alternatives as those investments that are not publicly traded. This explains why some include real estate as an alternative, even though real estate is considered a mainstream investment for Canadian pension plans. PIAC data also indicate that real estate accounted for 4% of Canadian pension plan assets in 1990, growing to 9% by 2009.
The HRMPP defines alternative investments as those not publicly traded. Besides real estate, examples are private equity, infrastructure, private debt and hedge funds.
But don’t assume that all alternatives have the same characteristics. In some cases, some alternatives have similar characteristics to their publicly listed counterparts.
Public versus private equity – An investor that invests in publicly traded stocks hopes that the underlying stock price increases, through growing profitability of the underlying companies and/or through dividend payouts. Correspondingly, an investor in private equity hopes to increase the value of the underlying company through board influence. This would include input into strategic plans, increasing revenues, decreasing costs, merging with another company and taking the company public via an initial public offering. An investor in publicly listed stocks is buying financial assets, while an investor in private equity is investing in operating assets. With the former, an investor is buying a stock certificate. With private equity, an investor is buying a piece or all of the operations of a company. While both are long-term assets, publicly traded equities are more volatile because their value is marked-to-market daily. Private equity valuations are conducted less frequently because of the illiquid nature of these assets.
But private equity is currently not a priority for the HRMPP because other investment strategies are likely to provide better risk-adjusted returns net of fees, and the timing of private equity payouts is less predictable than other investments.
Public versus private bonds – Many publicly traded corporate bonds are unsecured. The HRMPP’s attraction to private investment grade corporate bonds was primarily motivated by risk reduction. The investment reduced risk in our overall corporate bond portfolio through increased collateral behind the bonds in case of default and through reduced exposure to bonds issued by the financial service sector. When an investor has publicly traded bond mandates benchmarked to the DEX Universe Bond Index, there is a high probability that the investor is inheriting close to 14% exposure to bonds issued by financial services.
While privately issued bonds are less liquid than publicly traded ones, pension plans can mitigate illiquidity risk by investing in a bond portfolio with a four- to six-year duration. By moving a portion of the HRMPP’s publicly traded corporate bonds into private bonds, it has improved its expected risk-adjusted returns net of fees primarily through improved diversification and improved security.
Infrastructure – Infrastructure is the essential asset—such as transportation, utilities, communication, social—a society requires to facilitate the orderly operation of its economy. Infrastructure assets typically have high barriers to entry, which minimizes competition. And stable or regulated cash flows, often tied to inflation, are usually a characteristic of mature assets.
Although infrastructure investments are fairly new to the Canadian pension plan industry, large plans, such as the Ontario Teachers’ Pension Plan, have invested in these assets since 2001.
The HRMPP plans to increase its exposure to this asset class, assuming attractive valuations, alignment of interests and low costs. Infrastructure offers us a long-term stream of stable cash flows, in keeping with the long-term horizon of our estimated future pension obligations in conjunction with an attractive expected return net of fees.
Certain infrastructure deals can be used as a proxy for long-term corporate bonds. The HRMPP tries to match the various cash flows of our pension liabilities with that of a combination of government and corporate bonds in order to reduce interest rate risk. The combination of government and corporate bonds is dictated by the mix of government and corporate spreads used by actuaries to value current and future pension liabilities. Because of the lack of availability of long-term corporate bonds, we use infrastructure as a proxy for long-term corporate bonds. Infrastructure is not a complete proxy because infrastructure assets also include an equity component.
To date, we have co-invested alongside other pension plans. We prefer co-investing with a large experienced plan that wishes to syndicate a portion of its newly acquired infrastructure investment. But, to do this effectively, we have chosen to pool our investments with other like-minded plans in order to get to the minimum size for an investment in the syndication. The benefits of doing so include sharing of legal and due diligence costs, improved due diligence and alignment of interests. Ongoing costs are typically significantly lower than investing in a third-party pooled fund since the profit motive is eliminated.
Instead of investing in a blind pool and leaving it up to the manager to pick the investments, the investor can:
- invest alongside the larger plan that has already conducted thorough due diligence on the asset and usually keeps 90%-plus of the investment;
- invest alongside other smaller plans through a consortium; or
- invest in only certain deals that it deems attractive.
Cost savings are extremely significant. A typical third-party infrastructure fund charges a base fee of 1.25%, plus a 20% performance fee. This equates to a 1.65% flat fee, assuming a 10% rate of return and an 8% hurdle rate [1.25% + 20% (10% – 8%)]. If the infrastructure investment is expected to earn 10% gross of fees, this would equate to an 8.35% net of fee return before operating expenses are deducted. Co-investing, on the other hand, allows the investor to earn a net of fee return that is closer to the gross return, which, in this example, is 10%.
Another benefit of investing alongside pension plans is that the parties are likely to have similar time horizons (i.e., 30-plus years). Most third-party infrastructure funds have terms of 10 to 12 years. A shorter time horizon may appeal to some pension plans that want a predetermined arbitrary exit date. But usually, a 10-year time horizon is present in third-party infrastructure funds as a mechanism for the investment manager to recoup its performance fees within a reasonable time period.
Real estate – A relatively common investment for Canadian plans, real estate comes in a variety of types: retail, industrial facilities, residential and office space.
Profitability of a real estate investment may be tied to factors such as consumer spending and industrial production (with retail and industrial facilities) or the level of employment and corporate spending (with residential or office facilities). Plans looking to invest in real estate have the option to invest indirectly using a publicly listed security such as a real estate investment trust, or directly in real estate assets as part of a group or individually.
The HRMPP likes conservative real estate investments because real estate is long term in nature, provides relatively consistent cash flows, has the potential for capital gains and gives some inflation protection. These investments include mature properties where most of the expected return comes from rental income. Full or partial inflation protection associated with real estate is a major benefit to pension plans, especially those providing indexation of benefits to pensioners and/or career average DB plans.
Hedge funds – The CFA Institute describes a hedge fund as “an investment vehicle designed to manage assets according to any of several strategies. The investment strategy often employs arbitrage trading and significant financial leverage, while the compensation arrangement for the manager typically specifies considerable profit participation.” PIAC data show that Canadian pension plans in aggregate don’t have significant exposure to hedge funds.
Hedge funds are not a priority for the HRMPP because they lack transparency, have relatively high fees and may typically require a lock-up for investments that are not typically long-life assets.
Other considerations
A chief investment officer or investment committee needs to understand what percentage of the pension plan’s assets can be in illiquid assets without triggering the need to liquidate other publicly traded assets at inopportune times—for example, the 2008 credit crisis. Considerations are whether the pension plan is net cash flow positive or negative, and understanding how liquid the pension plan’s other assets would be when assets, other than Government of Canada bonds, may not be easily liquidated.
Currency risk comes into play for any foreign investment, whether publicly traded or privately held. The HRMPP’s policy is to hedge all foreign alternative investments because adverse currency movements could quickly wipe out the expected stable returns from the alternative portfolio in any one year.
The above are practical considerations from the HRMPP’s perspective. Other plans will think differently about alternatives, because of different investment beliefs, risk tolerance levels and resources. But if you are considering adding alternatives to your investment lineup, gather as much information on alternatives and get as many experiences from other plans as you can.
Terri Troy is the CEO and chief investment officer of the Halifax Regional Municipality Pension Plan.
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