Investors are boosting their alternative allocations and accessing alts differently

We keep hearing about institutional investors’ shift from traditional asset classes to alternatives such as hedge funds and real estate. But this march is actually old news. Towers Watson’s 2013 Global Pension Assets Study shows that Canadian pension plans’ allocations to alternatives were only 6% in 1999 but hit 23% in 2012.

Since average asset mix is determined on a dollar-weighted basis, the world’s biggest pension plans—including the Canada Pension Plan—dominate this trend. Allocations for plans with less than $1 billion range from 10% to 15%, on average; allocations for plans with less than $500 million are between 5% and 10%. For most Canadian plans (excluding the largest ones), investment in alternatives has traditionally focused on real estate and infrastructure, with smaller allocations to private equity and hedge funds. But this appears to be changing.

Entry Points
How pension plan sponsors invest in these assets is also changing. Towers Watson’s 2013 Global Alternatives Survey found that, among the top 100 alternatives managers, the allocation of investor assets, in aggregate, is as follows:

  • fund of hedge funds – 6%;
  • private equity fund of funds – 10%;
  • direct hedge funds – 20%;
  • direct private equity funds – 23%;
  • direct real estate funds – 34%;
  • direct commodity funds – 4%; and
  • direct infrastructure funds – 4%.

Canadian pension plans that moved into alternatives years ago are shifting away from a fund of funds strategy (in which the investor holds a portfolio of several investment funds instead of investing directly in public or private securities) and toward direct funds or hybrid programs (a mix of fund of funds and direct funds). That’s especially true for private equity and hedge funds. Investing in real estate, infrastructure and commodities has always been via direct vehicles. In fact, globally, the percentage invested in funds of funds shrank to only 16% in 2012 from 34% in 2009.

If pension plans are comfortable with the extra governance requirements of direct fund programs—such as more time spent on selecting funds to create a diversified portfolio—they’ll benefit from a lower overall cost, since an extra layer of fees is removed. Some funds create these direct programs themselves; others get help from investment managers and consultants that offer custom portfolios. Plans that choose funds of funds generally prefer the broad diversification and lower governance that comes with those vehicles. The lower governance stems from the fact that the fund of funds manager selects the funds, does the due diligence on them and monitors them, while the investor monitors the manager and fund exposures. For some, the appeal is the ability to access specialty parts of the market such as venture capital. For all of this, they’re willing to pay an extra fee.

Lower Fees, Please
Fees for alternatives have been decreasing, and that’s expected to continue. Managers have had to become more creative in justifying their fees, as investors seek to manage the higher costs associated with alternatives through greater use of separate accounts, co-investment and secondary transactions. Many private equity and hedge fund of funds managers now build custom portfolios for larger clients, while investors actively manage their private equity portfolios, creating a new source of secondary deal flow. The move to alternatives is here to stay. The good news: pressure on fees will likely continue as investors learn more about how value is created and explore more creative ways to access alternatives.

Janet Rabovsky is a director with Towers Watson.

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