Going in alternatives direction
IPE asked three pension funds – in the UK, Belgium and Finland – the same question: ‘Do alternative asset classes serve a useful purpose or are they too complex and too expensive?’ Here are their answers:
Richard Stroud, chief executive at The Pensions Trust, which has AUM of £3.3bn (e4.8bn)
“I’m a bit sceptical on this. One of the difficulties we have in the UK is that professional advisers are running for cover in response to new regulations from the Pension Protection Fund and the new Pensions Regulator. They may be worried about being sued if they give what turns out to be the wrong advice, so they are looking to match assets and liabilities and are advising funds to go into bonds big time.
“So what happens? If a huge amount comes out of equities it has an impact on equity prices, it goes into bonds and the yields are all reduced. It just seems to be one big geometrical progression to disaster. Long bonds are now yielding about 3.8%.
“So you’ve got people thinking they are not getting much out of bonds and asking could they do better elsewhere, and seeing property as a good substitute. Then they pile into property and the yields are all reduced on property as well.
“Then the advisers suggest an absolute rate of return solution and put forward hedge funds. I’ve read a lot about hedge funds but I still don’t properly understand them. But what I do know is that there are loads of hedge funds you can go into, but for it to deliver you need to be able to choose a really good hedge fund manager who is also lucky.
“We will be looking at hedge funds as an alternative, although we are advised this may not be the right time to do so. We will also be looking at commodities and seeing whether we can find managers to deliver absolute rate of return, which almost sounds like going back to the balanced fund days.
“We are happy to use derivatives on a secure basis but we could not even consider using them on a speculative basis. We allow some of our managers to use derivatives, but purely to take positions. They’ve got the cash to settle everything so none of it is geared.
“However, my clients are very fee conscious because they are charities and, win or lose, the fees are absolutely horrendous. I’d like it that if we were to lose, the manager should go down as well. If you ask them how much of their own money is tied up in the investment it’s basically none, all they want is ‘carried forward interest’, a lovely phrase that just means that the fees are utterly unbelievable.
“My clients take it for granted that they are going to get a reasonable rate of return, but when they look to the costs charged to their account and complain. So selling these things to them is quite difficult. They are quite resistant.
“I have some 4,000 charities participating in my scheme, with around 3,000 in one fund, 700 in another, 200 in third and then we have 35 others with smaller assets. So basically I have got to get about 40 segregated arrangements into a linked asset liability structure.”
Edwin Meysmans, managing director and pension fund secretary of KBC Pensioenfonds, the corporate pension fund of KBC, which has AUM of €850m
“What one means by alternatives can differ from country to country. In Belgium it is everything apart from equities, bonds and real estate. And for us at KBC one of the more traditional alternatives is private equity.
“In 1998 we decided to make private equity part of our strategic assert allocation, with an initial 2.5% of our portfolio. Recently, we considered increasing this because we are happy with the performance, but decided not to, so we are keeping our exposure at that rather low level.
“You can always find two good reasons to invest on a particular asset class – higher returns and diversification, decorrelation from traditional classes. Some asset classes claim that they feature both of these elements but private equity does not because, after all, it is equity. So we are only looking at the higher return we expect as an illiquidity premium because you are tying up money for seven or eight years.
“And it has delivered. So far it has out performed listed equities by some 500bps on average. This has been difficult given the high returns by listed equities in recent years but with our private equity portfolio we aim at a return of some 13-14%.
“In addition, we have dipped our toe into infrastructure, a new alternative, with a €5m allocation to the Macquarie European Infrastructure Fund. We are making it part of our real estate allocation as we are not quite sure yet where to put it. It has some very good bond-like features, steady cash flows - indexed cash flows most of the time - and most of the investments are based on monopolies, so it’s not really growth but it’s really high value. We see a lot of potential there.
“We have looked at hedge funds and derivatives, but one of the issues is that you need too convince your board. They understand infrastructure, real estate and private equity but it is more difficult with hedge funds, and certainly derivatives. For the time being we have decided not to go into hedge funds and have not even considered derivatives.
“So yes, I believe that alternatives, certainly private equity, can deliver on their basic promise. But yes, they are complex and consequently time consuming. For example, our private equity allocation is only 2.5% of my portfolio but it takes a disproportionate amount of time and work before you invest in a fund - it’s reporting, it’s investor meetings, it’s long shareholder agreements - compared with other asset classes. And that is one of the reasons why you don’t invest more.
“And then there are the fees. They fall into two parts. The first is the management fees which tend to be about 2%, compared with 35bps for the active and 25bps for the passive management for listed equities.
“We don’t mind the second, the performance-related ‘carried interest’ fees, where the normal split is 80% of the profits after a threshold going to us and 20% going to the general partners, because every time they make money I make money.”
Markus Pauli, chief investment officer of alternative investments at the Finnish Local Government Pensions Institution (Keva) which has e19.5bn AUM
“We made out first commitment to the alternatives area, into private equity, in 1994 and it has been a separate asset class for about five years. Now we are invested in private equity and hedge funds. We haven’t done anything yet with commodities, largely due to a lack of internal resources so it may be that we will in the future.
“We have a target alternative allocation of 4.5% plus or minus 1.5% and the real allocation has been pretty stable at about 3.5% for quite some time.
“The main reason we have included alternatives as a separate asset class is their favourable correlation characteristics with the so-called traditional asset classes but also, and especially the private equity, for high returns.
“And yes, we are satisfied with the programme, although we must remember that when we started in 1994 the commitments we made were very small. They became larger from 2000 so our programme is still fairly young.
“On the private equity side we are investing directly into funds, so we are like an internal fund of funds. It requires a lot of resources but our alternatives team is only three strong.
“Nowadays the problem is not so much identifying the good names as getting access, even in European buy-outs. We have been quite successful but it requires a lot of effort, our 10-years history in private equity helps.
“But costs are definitely an issue, they are too high. But that is the industry standard and if you want to be in this game you just have to accept them. And in the end we are only interested in the net not the gross returns. If we are able to choose first quartile managers, then the expected net returns are high enough for us.
“So far on the hedge fund side we have chosen a different approach. We have only invested in a couple of fund of fund managers. Again, the main reason is because we are such a small team and we are more focused on the private equity side.
“And while we are mostly looking for diversification we also require alpha.
“But while hedge funds are still seen as alternatives my feeling is that they will become more mainstream as investors put more money to work and require more information about the underlying funds. This is particularly so for long-short managers as many public equity investors are putting the major part in indices and then trying to outsource and getting some alpha. And investing in hedged equity managers could be one way of achieving that.
“For the moment, though, most institutional investors lack the necessary resources or knowledge to understand what the underlying hedge funds are doing. They are usually such complicated instruments that they are still more or less like black boxes for most people.”