One of the first investment lessons learned is to invest according to one’s risk tolerance and the investment constraints imposed by the nature of your liabilities. In the defined benefit world, assets that enable you to meet long-term retiree benefit obligations without taking investment risk will look like some kind of long-dated nominal or CPI-indexed government bond. In recent decades, though, longer retirement periods(and sometimes, shorter working lives) have made financing retirement inherently more costly. Plans have responded by investing in riskier assets like equities, based on their higher expected long-term return. To make that remotely prudent, gains from years with better than expected return should be retained to fund deficits during years in which markets yield disappointing returns. In the 1990s, some plans threw that caution to the wind. The large plan surpluses generated by “new economy” equity returns proved irresistible to many plan sponsors, who cut contributions or boosted benefits or both. The new millennium brought a double whammy of collapsing equity markets and a drop in long-term interest rates to long-term historical averages, which pushed up liability values. Many plans have never recovered. What’s more, the outlook is not encouraging. The double-digit equity returns of the 1980s and 1990s were not the norm: the long-term historical return on equity is in the range of 6% plus CPI inflation. Long-term bond returns are about 2% plus CPI. In other words, plan sponsors are going to have a hard time closing funding gaps relying on such assets.FINDING RELIGION
As a result, and somewhat belatedly, many retirement plans have suddenly found religion on asset-liability matching. Most interest has focused on alternatives to standard investment portfolio assets such as real estate, timberland, infrastructure, commodities, private capital and, of course, hedge funds. Until recently, hedge funds generated the most buzz with their promise of high, market-neutral absolute returns. But lack of transparency has made it difficult to assess risk. Moreover, markets will inevitably eliminate excess returns on some of these hedge fund strategies. High hedge fund failure rates have also made investors wary. Other alternative assets may be a more natural fit for long-term institutional liabilities. Many have payout profiles that extend beyond the 30-year term that, in North America at least, is generally the limit for any degree of certainty about conventional asset returns. The predictable, multi-decade returns of assets like infrastructure and real estate give them timing characteristics similar to long-term obligations like retiree income and health benefits. Their risk-reward profiles exhibit low correlations with conventional assets, making them excellent portfolio diversifiers. Many alternatives—commodities being a strong example— also provide a good long-term hedge against unexpected inflation, one of the more insidious risks inherent in defined benefits. Furthermore, alternative assets can offer excess return opportunities not available to smaller investors. Many of these markets are less liquid and less widely researched than mainstream assets. The resulting pricing inefficiencies can be exploited by investors large enough to develop enough expertise to get into these assets ahead of the crowd, and with a long enough investment horizons to have little concern about tying up capital for long periods. In contrast to listed assets, the returns of long-term alternative assets are partly driven by the ability to take and manage operational risk. EACH ALTERNATIVE UNIQUE
Of course, each alternative asset carries its own unique set of risks and opportunities. In timberland, for example, one of the attractions is that the inventory keeps growing in size and value—8% a year in some climates. If you don’t like the market price, just let the product grow. And while the global supply of commercial forest land is unlikely to grow, demand growth remains strong. The biggest current risk may be paying too much, as timberland seems to have become a “flavour of the month.” In infrastructure, the needs are huge and governments are having to turn more and more financing over to the private sector. But politics remain the biggest risk as regime change can lead to changes in regulation or retroactive attempts to change contract terms to the disadvantage of investors. Commodities are volatile investments on their own, but have a very low correlation with more mainstream investment assets—and a negative correlation with equities. Their high correlation with inflation makes them a good hedge against liability inflation risk. Despite recent volatility, the long-term outlook for commodities markets is bullish as long-term demand growth in huge emerging economies like China and India confronts supply constraints resulting from underinvestment in the 1990s. By definition, average value added from security selection in the S&P 500 is zero. In private capital, that may be true as well, but the payoff from first quartile security selection is higher. Any excess value created is probably largely a return on operational risk that doesn’t exist with publicly listed securities. <p>Another factor that looms larger with private capital than with public securities is the need to focus on returns after fees. Standard private capital fees of 2% of assets and 20% of profits over about 8% require very high manager skill levels. They likely will not be sustainable for investments in steady, lower-return assets like infrastructure unless returns are leveraged by taking on debt. CHALLENGES
Experience at the vast majority of retirement plans has been largely limited to stocks and bonds. That experience does not prepare them for investing in alternatives. So, the first rule of alternative investments is the same as for any other investment: don’t buy what you don’t understand. Due diligence has to be more thorough than with traditional assets to build confidence that any additional risk will have incremental returns. In portfolio optimization studies, alternative asset risk measures should be adjusted upward for low apparent volatility(because of less frequent pricing)so that they can be compared to listed security risk. Managing alternative investments requires different skills than managing a portfolio of stocks and bonds. Because private capital investments bring operational risk, investors need to feel comfortable taking an active role in decisions about tax and capital structures, management changes and mergers, among other things. Expertise in those areas is not necessarily the same as that required for traditional portfolio management.A lack of understanding(along with a sense of urgency among institutional investors about being invested in such assets) may help explain the recent rich valuations in many alternative asset markets that may not fully reflect the risks. The return premiums that are supposed to be available to early movers are already getting harder to capture. The popularity of real estate has virtually eliminated any illiquidity premium in that market. Infrastructure valuations have also become “frothy,” although the long pipeline of developments means there will be plenty more opportunities in years to come. Even timberland returns have been coming down as investors pile in. Opportunities among alternative assets still exist; this “irrational exuberance” simply highlights the need for a thorough understanding of risk and fair value to avoid being caught up in the euphoria.Alternative assets are not a panacea for matching to long-term liabilities. While publicly traded stocks and bonds will still constitute the biggest chunk of most retirement plan assets, alternatives can be a helpful source of diversification and incremental return. If you can cover off the operational and risk management issues, the case for alternatives can be compelling. They have strong similarities with longterm retirement liabilities and plan sponsors are able to provide the large, long-term capital pools required for these investments.Leo de Bever is the executive vice-president of MFC Global Investment Management. Leo_de_Bever@mfcglobal.com |
