Back to the basics on liquid alternatives

“Canadian pension plans have, for a long time, had allocations to the strategies that I was talking about, but they’ve had them often via illiquid vehicles ⁠— hedge funds,” says Sager, noting that firms are now offering access to these assets in a liquid form.

For instance, he says, CIBC can offer liquidity within two trading days, instead of at least a three-month lockup, which is typical at traditional hedge funds. “We can offer you the same strategies, with lower fees and more liquidity,” he says. “So it’s kind of disruptive to the hedge fund model of the world.”

Pension funds are worried about big loss periods, notes Sager referring to periods like the global financial crisis, when equities were down 10 or 20 per cent. “They need other parts of their portfolios to offset those losses. So what’s really interesting, when you dig into the data, a lot of the illiquid strategies that are so attractive to people at the moment, things like private equity, real estate and hedge funds, didn’t protect you. They lost money and . . . a similar amount of money to equities during the global financial crisis. So they didn’t help you at all.”

Active currency is one example of a strategy that helped in that period. “Active currency actually made money during those two years — 2007 and 2008 — so [it] absolutely did what you would want from a strategy like that. It offset losses to your equity portfolio.”

One reason plans are adding liquid alternatives is low expected returns, says Sager. “Return expectations are low, but you still need to pay benefits. So you need to find alternative sources of return. One way pensions are doing that is by allocating away from traditional assets into alternatives.”

Another reason is that the typical traditional portfolio for small or medium pension funds is heavily dependent on equities. “You get quite volatile performance, depending on what’s going on in the macro world,” he says. “So you want to diversify away from that. Again, the idea is that alternatives can help you smooth out returns, have less risk concentrated in equities, so more return, less risk concentration is pushing people towards alternatives broadly.”

The third piece of the puzzle is that, in the past, allocation has traditionally been to illiquid alternatives, which can cause problems in times of economic downturn, he adds. “If you think about a mature pension plan that needs cash to pay benefits, if you’re too illiquid, if you’re too focused on illiquid alternatives, where do you get that cash? Well, you have to have a sale of your liquid stuff ⁠— your equities. The trouble is, with that, those equity prices are already low and you’re going to sell at distressed prices.”

Liquid alternatives offer a way for pension plans to get returns without too much illiquidity. “You don’t want to hugely increase your allocation to cash,” says Sager. “It’s liquid, but it’s not return-enhancing, so people are focusing on liquid alternatives, which offer you t-plus-two liquidity, but they also offer you return.”

He also notes many multi-asset liquid alternatives focus on a return target around five per cent plus the cash rate. Often, this would be attractive relative to equities and very attractive relative to bonds.

“When people think about illiquids, they think private equity. You might get 10 per cent, something like that, but to get that 10 per cent you have to have a huge amount of leverage. You have to have a huge amount of debt added to your portfolio. Whereas, for liquid alternatives, they use much, much less leverage. So if you think about it in return per unit of risk, [for] illiquids, it’s typically one per cent return for every two per cent risk. For liquids, it’s typically one per cent return for one per cent risk. So it’s a much more efficient use of your risk capital.”

Also, using liquid and illiquid alternatives is actually complementary, says Sager. “Think about private equity: You sign up to allocate private equity or infrastructure and then you wait, and you probably wait about three years for your capital call. Well, in those intervening three years, what are you going to do with the cash? Are you going to leave it in cash earning nothing? Probably not. Are you going to leave it in public equities, the very risk you were trying to get away from to some extent? Probably not. So you need a complimentary source of return.”

This can be liquid alternatives, he notes, because when the capital call comes, there’s t-plus-two liquidity and the capital has been earning return. “You can see the really nice complementarity between traditional assets, illiquid alternatives and liquid. They all go together and they really work as one to improve. It’s all about getting the optimal allocation, I think, and understanding what you own.”