In the current market environment, no asset class has as bright a future as alternative investments. Once regarded as hedging tools, alternatives—including hedge funds, private equity, real estate, infrastructure and commodities—are commanding an ever-growing market share and proving themselves useful in many ways.
So it is not surprising to learn that pension funds are embracing such strategies in the absence of reliable returns through traditional investments. But as they limp away from the battlefield that was 2009, institutional investors must tread carefully while they enter the world of alternatives. Things are not always what they seem, and there are plenty of ways to lose money.
Movin’ On Up
Recent reports on the alternatives market illustrate the steady rise of the asset class. A 2010 Towers Watson study found that pension plan allocations to alternative assets have nearly tripled over the past 10 years and now account for 17% of all pension fund assets globally. This is expected to increase to 19% by 2012.
But what’s behind the migration? It’s not like a sexy new investment strategy has been unveiled. Indeed, the asset classes themselves have remained mostly unchanged. Infrastructure is still airports, toll roads and bridges; real estate is still bricks and mortar. It turns out that, aside from hedge funds, alternative investments have performed in a stable manner both pre- and post-crisis, while their traditional brethren have not. So it follows that after a portfolio review, pension plans would bump their allocation to alternatives.
According to Janet Rabovsky, a senior investment consultant with Towers Watson in Toronto, many pension plans considered beefing up their allocation to alternatives in 2002 but changed their minds when equity markets rallied after the tech bubble. Fast-forward to 2010, where equity markets are unpredictable and bond yields are torpid, and investors are faced with few choices.
Rabovsky explains that pension funds are seeking equity-like returns (minus the volatility) and more diversified sources of return. And while vehicles such as real estate and infrastructure are currently in vogue, hedge funds have yet to redeem themselves after their disastrous experience in 2008/09.
“For many clients, hedge funds have been a disappointment,” she says. “They haven’t had the low beta they’re supposed to, and they can still be quite expensive and opaque and use too much leverage. So many people have shied away from that because it’s not giving them equity-like returns without equity volatility, and it’s too complicated.”
In comparison, the attraction of infrastructure and real estate is that they can act like bonds, but with higher volatility. Rents are paid on real estate, and infrastructure assets provide revenue (assuming they’re mature)—both of which can be index-linked, resulting in some built-in inflation protection. (For more on the realities and benefits of investing in real estate and infrastructure, see our feature in the November 2010 issue of Benefits Canada.)
Risks and Requirements
For pension plans with little or no experience in such asset classes, entering the market raises a host of new risks and due diligence requirements, explains Tom Lappalainen, a senior consultant with Russell Investments Canada in Toronto. “Most pension plans considering an increased allocation to infrastructure realize they have to improve their governance structure and their investment management expertise in order to appropriately assess and track these products,” he says.
Lappalainen’s warning is backed by Leo de Bever, CEO and chief investment officer with the Alberta Investment Management Corp. (AIMCo), who recently announced that the time for being in infrastructure had passed. He says the leverage required to achieve the desired returns has been steadily increasing, from 40% or 50% leverage 15 years ago, to 70% or 80% leverage today. “Fifty percent is not unusual for an equity investment, but 80% is starting to push it,” says de Bever. “It starts to interfere with the reason why pension plans buy infrastructure, which is to have a bit more return and a bit more risk than [something like] real return bonds. The investment proposition for infrastructure is that it provides you with stable, real returns over time.”
And for consultants, plan sponsors that view peer results and seek to emulate them can get themselves into trouble unless they can fully explain why they want to wade into alternatives.
“These things are far more complex than some people realize,” says Rabovsky. “You have to spend enough time to understand exactly what it is you’re buying. Infrastructure is a great example of this, because it’s such an amorphous area. Clients come to me saying they want to get into infrastructure and I ask them, ‘What do you want? Are you looking for income? Are you looking for capital growth?’” She then explains the attributes of each, how the funds operate, how they make returns and how much will be development versus developed assets. “If people don’t spend the time to understand that, they’re likely to be disappointed because they won’t know what they’ve bought.”
De Bever contends that, apart from the leverage required for modern infrastructure projects, regulatory risk is also a significant problem. Partnering with governments to build roads, bridges or sewage systems may look great on paper, but the chances of government changing its mind down the road makes the proposition less attractive. Plus, the space is now far more developed than it was a few years ago, increasing competition and lowering returns.
“It used to be an inefficient asset class, so you could make a lot of money because people really didn’t understand it,” he says. “But so much money has been poured into it that it’s not quite as interesting as it used to be. It may become interesting again because as governments run into fiscal issues, they’re likely to look for private capital to do more infrastructure investing.”
In the meantime, de Bever is uneasy with the popularity of alternatives among pension plans due to what he believes is a general lack of understanding of the space. “Consultants are encouraging plans to increase allocations to these things. I have a horrible suspicion that a lot of it will end up in tears because the only way you’re going to make these things work is if you can be cost-efficient in implementing those strategies. And most pension plans don’t have the capacity to do that.”
On the Horizon
Despite the black eye the hedge fund industry still sports, there are some who believe that a renaissance of sorts is in the works for that market. In particular, managed accounts—in which the hedge fund manager runs the money but everything else is left to an independent advisor and third-party service providers—are being touted as a way for pension plans to confidently invest in hedge funds again.
According to Bernice Miedzinski, executive vice-president of institutional clients, Canada, with Man Investments in Toronto, institutional investors have three primary concerns with the traditional hedge fund model: liquidity, transparency and control of assets.
“What we’ve seen is a big shift in the industry in that hedge fund managers are more willing to set up managed accounts,” she says. “Investors now have much better transparency, liquidity and control, so from a governance standpoint, a lot of the operational issues around hedge funds have been overcome. The crisis has been a catalyst to drive a lot of positive change.”
While recent surveys have suggested that hedge funds will eventually take the lion’s share of the alternatives market, that day is not likely to arrive soon. Transparency is still an issue with many investors, and managers accustomed to opacity are loath to reveal their positions for fear of pension funds front-running their operations.
De Bever adds that some hedge fund managers also have work to do on their communications with clients. “I’ve had hedge fund managers tell me, ‘Don’t worry your pretty little head about risk management, because our risk management is so sophisticated you wouldn’t even know how to interpret it.’ I’d say, ‘Try me.’”
There are niche markets within the alternatives universe that may also increase in popularity alongside the core vehicles. For example, AIMCo invests in timberlands, and some pension plans dabble in art, wine and even old coins. But de Bever believes the vehicles to watch are catastrophe bonds and lotteries, due to an increasingly volatile climate and the lottery industry’s record of stable returns, regardless of the business cycle.
It’s clear that plan sponsors, consultants and actuaries are in a very difficult position when it comes to investing. Equities and bonds are not performing well, and a switch to alternatives is a complex and risky affair. As well, the economic environment dictates that hiring additional staff to deal with the increased governance issues is a non-starter.
“[Pension plans] are under tremendous pressure to have the liabilities be valued lowly and put in a high expected return,” says de Bever. “Then the consultants put the pension plan in esoteric assets, which—particularly if the pension funds are small—the cost/benefit analysis of doing is probably not great. My advice would be to exercise caution and be sure you have access to unlisted assets at very good economic terms. Otherwise, you’re probably paying back a lot of the excess return to the manager.”