How do plan sponsors feel about alternatives? Do they consider them a riskier outlook? What alternatives are they investing in or considering investing in?
Bélanger: Our view on alternative investments hasn’t changed as a result of the market volatility. Since we have a defined contribution (DC) plan, many types of alternative investments are not appropriate since they don’t have adequate liquidity. If there’s something the recent market volatility has highlighted [it’s] the liquidity risk of those investments. The only type of alternative investment we may potentially consider is real estate.
Racioppo: Plan sponsors have mixed views with regard to alternatives. Clearly, some alternatives did not behave as advertised or simply were not properly understood by clients. Nevertheless, there is still a trend in place to take funds out of traditional stocks and bonds. And I believe it remains driven by consultants looking to satisfy clients’ desire for more diversification, beta, better asset/liability matching, etc. However, the lessons learned in the last year are such that decisions on alternatives must go beyond quantitative calculations.
More specifically, sponsors have learned that long-term investing does not imply you should give up on liquidity. Leverage can come in many hidden forms, financial stability analysis should not be left to one outside opinion (rating agency or other), and the people behind a product are as important as a CEO and the management team in a publicly traded stock.
Arnold: We experience a wide range of feelings related to alternatives, which spans from ‘No way, not ever’ to ‘Did you see these returns? We gotta get in this fund.’ The great challenge when implementing alternatives is balancing the client’s bottom-up perspective on alternatives within the context of what they really need to do to meet their obligations. This is largely a top-down process via risk budgeting. This process is intended to be much more holistic and quantify and qualify what the objectives for the pension plan are. In other words, [there’s] not much point in spending considerable time and money funding an alternative that is not going to help meet the plan objectives. Once we get through the asset allocation and manager structure decision, the search and selection process for an alternatives candidate can be a numbing experience dealing with items such as lock-in periods, high-water marks, complicated fees, etc. This does not suggest that sponsors should not consider alternatives, but they need to clearly understand that the homework required on their part is much greater than traditional investments before they invest, during the investment and when exiting.
Chepelsky: Plan sponsors continue to treat alternatives with trepidation. The main reasons for this are the overwhelming choices, the lack of internal expertise, the lack of comparatives to judge performance, short histories related to performance, the challenge in educating the governing body, and the cost and time to perform proper due diligence on such complex strategies. We would advise plan sponsors to consider alternative investments that focus on new sources of beta that offer relatively low correlations to plain vanilla asset classes, such as private equity and infrastructure funds, rather than alpha-generating strategies.
Smith: We still believe that areas such as infrastructure, venture capital and managed futures, to name a few, can certainly benefit a portfolio longer term. From a portfolio management perspective, we will continue to look at alternatives for ways to enhance the risk-return profile of our portfolios. I think that in aggregate there is still a fairly low level of understanding of what alternatives are and how they may complement traditional asset classes within an overall portfolio. 2008 was not kind to many alternative investment approaches due to the drying up of liquidity and access to leverage. As a result, alternatives suffered a black eye just like many other traditional investments, which is unfortunate, as we believe that longer-term investments in alternatives will enhance the risk/return profile of a portfolio.
Winch: The reaction by plan sponsors to alternatives has been mixed. Although some are leery of the complexity of alternatives, many realize that alternatives may be essential to managing the risk in their overall portfolios. While not many Canadian plans have holdings in hedge funds, the few that had directional hedge funds are feeling discouraged. Despite some pockets of apprehension, we are seeing more interest in non-directional, market-neutral, low-correlation funds. For the most part, the plans with direct real estate and infrastructure holdings are pleased. Real estate investment trusts have seen a recent upswing in popularity, but the last 18 months have been challenging. We have seen very little demand for private equity, perhaps because plan sponsors have concerns regarding the lack of liquidity and the long-term lock-in periods.
Finally, we are seeing tremendous interest in risk capture products. Products where weights of the asset classes are set such that each contributes a similar amount of risk to the overall portfolio—thereby seeking to defend against negative economic outcomes. It’s a type of product that works for both DB as well as DC plans and provides them with an opportunity to better manage their risks.
Lorimer: The Christian and Missionary Alliance is not pursuing alternative investments as an additional investment option for our DC plan membership. We’re sticking with ‘bread and butter’ options of equities and bonds. Having said that, our Canadian fixed income managers may invest in real return bonds as part of their discretionary fixed income mandate (0% to 10%), so there is the possibility of an inflation-linked product in the fixed income mandate.
There’s already a challenge in a DC world of educating/advising plan members on the basics of investing in equities and bonds. The unique risk/return characteristics of various alternative investment products are not likely well understood by most plan members. From our perspective, it seems best for those investments to be done by plan members outside of their ‘bread and butter’ DC investments, where the education/advice is happening outside the scope of an employer’s capital accumulation plan (CAP) responsibilities.
Chiappinelli: We are entering a phase that we refer to as ‘Alternatives 2.0.’ There is little doubt that the market crisis tapped the brakes on the slow but steady adoption of alternative strategies, particularly hedge funds. However, it is just a temporary slowdown, not a turnaround. We are entering a new phase characterized by a more discerning evaluation of which hedge fund strategies make more sense and what firms/business models plan sponsors want to deal with. Hedge funds is a big term and encompasses a variety of strategies. The lesson of the past year is not that hedge funds failed, but that some strategies may be a better fit than others in a pension setting. Examples could include a wider adoption of truly market-neutral strategies (zero-beta) instead of directional strategies (many of which surprised investors on the downside this past year).
And the criteria they are using for ‘best fit’ is clearly changing as well, which, again, is why there is a tilt toward strategies that can provide liquidity, better transparency and leverage-existing risk models.
Thoughtful plan sponsors view alternatives from a number of different perspectives—in relation to other asset classes in a portfolio construction and from a risk management perspective.
In a portfolio construction, plan sponsors clearly see value in alternatives in relation to other asset classes, or rather, other strategies, in their portfolios. Despite the recent financial crisis, we believe that plan sponsors will continue to migrate further out of traditional asset classes, specifically long-only equity, and into alternatives. It is the clear finding of our own survey work in Canada, survey work from other industry watchers and anecdotal evidence from the marketplace. The portfolio-construction motivations are many:
• desire for uncorrelated beta;
• desire for more balanced risk allocation;
• desire for additional and uncorrelated alpha sources of alpha;
• desire for more efficient ‘alpha capture’ by releasing the long-only constrain; and
• desire for asset classes that bear a tighter relationship with their liabilities.
In risk management, there is, however, also a palpable tension in that the plan sponsor community understands well that measuring and managing risk in alternative space is different and more difficult. We call this tension ‘embracing what is hard to get your arms around’—a strong desire to incorporate alternatives for all the right reasons, but an equally strong realization that they will need additional and more sophisticated risk management systems and processes. We see strong interest in zero-beta equity market-neutral strategies, whose attributes—skill-based, low correlation with the equity markets, better liquidity than many other hedge fund strategies, transparency, synchronicity with current risk management tools, etc.—are in line with current objectives today.
