Alternatives on the agenda
In a seesaw market, where uncertainty is the king, pension fund managers are getting more and more eager to find “alternative investments”. Some examples of this asset class were given at the Pension Forum organised by Ryan Labs in New York. They include an innovative real estate investment proposed by the Property Funding Group, hedge fund derivative products structured by Carpe Diem Capital, new “silent index” ETFs (Exchange-Traded Funds) thought up by Nuveen and TIIS (Treasury Inflation-Indexed Securities) and praised by Brown Brothers Harriman.
According to Ryan Labs’ recommendations, pension funds should invest in alternative assets only a portion of their surplus, which can be put at risk in order to achieve higher performance. By contrast, they may turn to alternative assets if they have accumulated a significant deficit and are looking for any means to fix it.
During the last 25 years the Property Funding Group (PFG) has invented a new kind of real estate investment focused on land. Only recently PFG has started offering this product to pension funds, promising an outstanding yield of 11% per year. PFG’s managers claim they are not concerned about the overvaluation of the US real estate markets, which looks a lot like the stock market’s bubble of the 1990s, according to some experts. “Our transaction structure allows a pension fund to effectively purchase buildings for the cost of the land underneath them,” explains Richard Gross, PFG’s chairman.
Actually, the transaction is a very complicated one. It has a sale-leaseback structure, where a corporation sells the land and the corporate building on top of it; a pension fund buys only the land; another entity (arranged by the corporation) buys the building and leases it back (with the land) to the corporation for – let’s say – 20 years. The building buyer pays the ground rent and interest to the pension funds and, at the end of the lease term, will surrender the building to the pension fund, which in turn will be able to sell or refinance the real estate asset and to realise cash returns. To the pension fund the main risk is the corporate tenant’s default. Not to mention that the transaction is profitable for all the players, thanks to special tax rules: if taxes change, also the financial operation must adapt.
“To match real liabilities, which companies will have to pay to current active workers, you have to invest in real assets like equities”, stresses Edward Doherty, managing director of Carpe Diem Capital. A strategy he suggests is a mix of equity investments and guaranteed bonds: a structured note terms sheet. This is the deal: a bank or insurance company issues a five to 10 year note with a rating of A to AA. The principal is guaranteed by the note issuer at maturity with a zero to 2% semi annual coupon, but actual returns come from a basket of hedge funds in which the capital is invested. The NAV (net asset value) of funds is calculated monthly; the liquidation of the note is possible after 12 months at NAV minus 1%. The minimum investment should be $20m (E23m) and the projected returns are from 7 to 12% year. “The secret is the right selection of hedge fund managers, diversified according to different styles,” explains Doherty. The multi-strategy fund managed by Carpe Diem invests 40% in arbitrage funds (convertible, merger, capital structure, mutual fund arbitrage), 36% in hedged equity funds (market neutral, long/short, Reg-D) and 24% in directional funds (macro, trend followers, commodity trading advisors, short sellers). Since the inception in 1997 the Carpe Diem fund’s NAV has grown by more than 105%.
Standard ETFs are often poor holdings for an institution according to Gary Gastineau, managing director of Nuveen Investments. The reason is that institutional investors can get the same index exposure at a lower cost. Besides, the basic idea of the indexing pioneers – that is to achieve cheap diversification while maximising expected returns relative to risk – is not fulfilled anymore by indexed funds and ETFs. In fact index licenses have become more expensive and above all the market impact on index changes and reconstitution have raised the real costs of indexed investments. “Benchmark index funds are the only portfolios which operate with prior disclosure of their trading plans,” points out Gastineau. The alternative is to base index funds on ‘silent indexes’, which do not disclose precise rules for index composition changes and keep them a secret of the fund manager”. The SEC (Securities and Exchange Commission, the US stock market watchdog) has not yet recognised silent indexes. But Nuveen is lobbying in favour of this innovation, mentioning among other advantages that silent indexes should stimulate institutional use of ETFs.
Christopher Kinney, the TIIS specialist for Brown Brothers Harriman & Co, emphasises how these kind of bonds are a gift for pension funds: they offer higher returns compared to real inflation and they can be used as the most secure hedge against unanticipated inflation.