Lynn Strongin Dodds looks at the use of alternative assets as a means of protecting against inflation.
For the past few years, pension funds have embraced commodities, infrastructure and, in some cases intellectual property as part of their alternative asset drive. The diversification and promise of higher returns were the main allure but now their inflation protection attributes are attracting the greater attention.
Naturally this is due to prices, particularly energy and food, steadily climbing higher, but as Alan Rubenstein, European head of pensions advisory at Lehman Brothers, notes: “I think irrespective of whether pension funds think inflation is heading up or down, they should protect themselves from unexpected rises. It is one of the greatest risks that they face. Fund managers typically use inflation swaps to hedge out the risk but they have also increasingly looked at assets such as commodities and infrastructure that are also linked to inflation.”
The large Dutch and Nordic pension funds first moved into alternatives about five years ago but more recently, US pension funds have decided to create a specific inflation linked asset class category. For example, earlier this year, the $245bn (€157bn) California Public Employees’ Retirement System - the largest US pension fund - announced its intention to focus on the inflation hedging components of four main groups - commodities, forest products, inflation-linked bonds and infrastructure. Last year, the $35bn Pennsylvania State Employees’ Retirement System allocated $2.5bn to inflation-linked assets such as commodities.
Most schemes, though, particularly those in Europe, do not have a separate group but monitor closely their level of inflation protection. There is no doubt that inflation has moved to the top of the agenda across the globe, according to the latest economic report from the International Monetary Fund. Annual consumer price inflation is currently running at 4% in the US, and analysts in the UK were surprised by the recent April figures that showed the consumer price index (CPI) figure escalating at the fastest rate in more than five years to a heady 3% from the previous figure of 2.5%. On the broader retail price index (RPI) that includes housing costs, annual inflation rose to 4.2% from 3.8%.
This puts inflation within a shade of the 3.1% threshold at which Mervyn King, Bank of England governor, must write to the chancellor explaining how he plans to bring inflation back to target. By contrast, eurozone inflation slipped to 3.3% in April from 3.6% in March as the European Central Bank (ECB) has refused to cut interest rates.
“We said last year that we were worried about inflation remaining high in Europe due to rising food and energy costs,” says Ronald Wuijster, head of strategy and research at APG Investments, the asset management arm of Europe’s largest pension fund ABP, with €216.7bn under management. “I don’t think the situation has changed dramatically and we do not believe things will get out of control because the ECB’s main goal remains curbing inflation. We are interested in inflation hedging via swaps. However, we do see constraints because of our size, the fact that we only want to pay fair value - no high insurance risk premium - and the fact our flexibility would be constrained by this kind of hedging. We also believe that the hedging of inflation and interest risk has to be looked at integrally as there is a link between them. As a pension fund, our participant’s liabilities are impacted by inflation and we are also looking at asset classes such as infrastructure and intellectual property rights,” adds Wuijster.
APG recently purchased the music catalogues of Universal Music Group as well as bought Boosey & Hawkes, a music publisher and manufacturer of musical instruments, from private equity firm HgCapital Trust for £126m (€158m). The main draw of music publishing, which can generate revenues from sources such as television, advertising and video games, is its steady cash flow and stability.
“There is a certain amount of inflation hedging in intellectual property rights, which include music publishing rights. For us, they are a profitable investment category and are geared for a long term investor focused on absolute, real returns,” says Wuijster.
APG is not that keen on commodities because of the volatility of returns with some periods of significant under and over performance, according to Wuijster. “We believe they are good diversifiers and can generate strong returns but we do not see them as an inflation hedge.”
Others disagree, although as with any asset class, timing and selectivity are key criteria. The basic argument for commodities is that returns generally move in the same direction as inflation which is a priority for public service funds whose retiree payouts are pegged to the consumer price index. Catherine Claydon, managing director, pensions advisory group at Lehman, believes the use of commodities as an inflation hedge depends on a pension fund’s timescale. “For example, if a pension fund had ten years of known liabilities, I would recommend using inflation swaps because they are a better match with inflation,” she says. “However, for a 25 to 30 or longer year plan, I would use commodities as part of a balanced and diversified portfolio in order to protect against price shocks and to generate absolute returns.”
The big concern today is how much wind is left in the commodity sector’s incredible run, which kicked off in 2001. According to historical cycles, the typical run is about nine years which means this cycle should end around 2010. Naturally, prices never move in a straight line and this one is no exception. While few are willing to predict when the music will stop, all agree that global demand will buoy prices for the next several years.
“If you look over a long time frame such as 200 years, there have been periods where commodity cycles lasted 20 to 30 years,” notes Jonathan Blake, head of Baring’s global natural resources fund. “It depends on what the key drivers are and today, we believe that the industrialisation and urbanisation of China, and emergence of countries such as India and Brazil will extend the typical duration.”
Fund managers usually play the commodity game via equities, exchange traded funds or investing passively in one of the main indices such as the S&P Goldman Sachs Commodity Index or the Dow Jones Dow Jones-AIG Agriculture Total Return indices. Others such as Insight Investment have taken a more proactive approach and short the index, directly buying futures. Patrick Armstrong, co-head of the multi asset group at Insight Investment explains, “There is about $120bn buys and sells of the near-month future, in a clear and well-publicised roll schedule every month. However, with so much money chasing one particular contract, the second month futures price becomes distorted from the longer dated futures. Active investors can add more value. At the moment we are focusing on soft commodities such as wheat, corn, sugar and soya beans. All four are benefiting from higher demand and prices in the food, feed and fuel space.”
Blake also likes soft commodity companies and to this end Baring is launching a new global agricultural fund to take advantage of the growing demand for these types of crops. The global natural resources fund is broadly based and consists of energy, precious and base metals as well as agri-fertilising stocks.
Forestry, which many pension funds view as a commodity, has also gained momentum. The main reason is that wood prices have historically increased faster than inflation. Most recently surging demand from China and India has pushed timber prices to record levels. For example, in the UK nearly 16,000 hectares of woodland were sold last year, at an average price of about £4,250 a hectare - a staggering 80% rise compared with 2006.
Aside from commodities, infrastructure, which has become popular as an asset class in its own right, is also gaining traction as an inflation hedge. The high barriers to entry as well as the monopolistic features of many of the assets means that performance is not tied to the economic cycle as many other asset classes. In addition, they are generally low risk, plus, particularly in the regulated sector, they generate long-dated inflation-linked revenues.
Serkan Bektas, managing director, head of UK pension and insurance solutions at Barclays Capital in London, notes: “The main argument in favour of infrastructure as an asset class is expectations of long-term stable cash flows. Pension funds are looking to infrastructure and property as long term fixed-income-like assets that deliver higher yields. The recent adjustments in property prices have increased the appeal of this asset class to investors.”
Unlike most investments, though, where the major risk relates to financial market volatility, the biggest risks within infrastructure investment are political and regulatory.
As a result, investors are advised to be selective, according to David Morley director of institutional business for Henderson Global Investors. “There are aspects of infrastructure which will provide you with a reasonable hedge against inflation, but it depends on which part of the market that you are in,” Morley says. “There is quite a full range of choices with less regulation and greater unpredictability of returns from assets such as airports at one end; to lower risk, public-private partnership type concessions at the other.”
Morley prefers the concession-based arrangement whereby the private sector builds, for example, a new hospital, in exchange for regular payments from the government. “This is the more predictable end of the market because there is a higher degree of regulation and greater predictability of revenues. Within the concessions space there is a difference between primary or greenfield investments which carry bidding and construction risks, and operational brownfield investments. There is more risk for airports for a number of reasons including part of their profits coming from more volatile retail and commercial activity.”