Luba Nikulina and Alessandra Pasquoni outline the opportunity Italian pension funds have to invest in non-listed assets
Investors are often surprised to learn that a significant share of the global economy is in private ownership: a quarter of the US economy by capital and 98% of it by the number of companies, for example, is controlled by private capital. Yet, despite this huge economic representation, the role of private markets in the portfolios of many institutional investors is still relatively small.
We believe private markets – private equity, private debt, real estate and infrastructure investments – deserve greater attention. They provide exposure to unique market segments that are difficult to access through listed vehicles. They also offer diversification from other assets and can both protect portfolios in an economic storm and enhance returns compared with public markets.
In their investments in private markets, Italian investors have traditionally over-weighted real estate, with fewer investors making significant allocations to private equity, private debt and infrastructure. The regulatory structures in Italy allow for investment in private markets via both first and second pillar pension funds.
The regulation of both pillars is undergoing a lengthy review, as regulators seek to address the liquidity issues that emerged during the financial crisis. This already elongated review has been further delayed by the advent of the European Union’s Alternative Investment Fund Managers Directive (AIFMD), which is due to be transposed into Italian law later this year. The AIFMD imposes limits on the leverage that can be used and demands that fund managers appoint independent valuers and custodians. However, neither of these regulatory processes should prevent Italian investors from making or maintaining significant allocations to private markets.
First pillar pension funds dedicated to self-employed professionals (so-called casse di previdenza) already have some allocation to private markets and we think there are sound reasons to continue diversifying and also to increase exposure to other return-seeking alternative assets. This is particularly so, since many of these funds already have quite a high allocation to direct local real estate, which they should consider diversifying into global opportunities.
Pre-existing second pillar pension funds currently have a small private markets allocation, which includes real estate, and which is mainly direct investment by Italian local managers. Here, too, we believe that a more diverse private market portfolio – not just geographically but also having different strategies and return drivers – would produce more robust and efficient portfolios.
Second pillar pension funds, set up after 1993, have not invested much in private markets because of limits imposed by legislation, and many of those funds are small and have limited governance budgets, further deterring diversification into private markets. However, new less strict legislation is expected soon which, combined with stronger governance, may boost diversification into private markets and other alternative assets.
A bigger question for investors than regulatory impact is how to successfully select private markets investments and implement them in portfolios.
We think alternative assets, including private markets investments, should be considered in much the same way as any other asset. Private market investments are not, in our opinion, separate asset classes or entities, but a combination of return drivers. In this sense they are no different to equities or bonds – although the range of return drivers may be wider. Return drivers include liquidity, inflation, interest rates, governance factors, manager skill and more besides.
When investors select investments they should consider which return drivers they seek rather than which asset classes. These return drivers should be chosen and combined to correspond to investors’ desired returns, their liabilities and their attitude to risk. Trying to do this by considering asset classes alone is a far blunter instrument.
Assessing skill levels
So when we help our clients to construct portfolios, we think in terms of these return drivers rather than asset classes. The return drivers provide varying degrees of diversification and are managed with different levels of investment skill, ranging from no skill at all to high-level expertise. We categorise the skill levels as bulk beta, smart beta and alpha.
Bulk beta involves little or no skill: it is typically index-like exposure to liquid asset classes, such as equities, fixed income and sovereign bonds. Smart beta is market exposure that is more unusual, innovative and less-correlated (to mainstream indices). It typically cannot be accessed passively through an index, and requires implementation via a fund manager. In this respect, there is some skill involved.
Smart beta is a catch-all term for a wide range of strategies that can be divided into thematic beta, diversifying beta and systematic beta.
Examples of thematic beta are overweighting emerging markets or demographic themes, where a degree of manager skill is necessary to identify the themes. Diversifying beta includes infrastructure and real estate investments, which are illiquid and not available to smaller investors with insufficient governance to manage the investments or to investors with shorter-term investment horizons. Systematic beta includes risk-weighted or value-weighted indices, which offer an alternative to cap-weighted indices.
The highest skill level is alpha. This is pure value that a manager adds to a portfolio and includes classic active management, skill in managing alternatives and tactical asset allocation.
Private markets encompass investment strategies that use manager skill as the primary (but not the only) driver of investment returns. The range of value creation tools for alpha generation is much wider in private markets than in listed markets and it is natural that investors turn to private markets in search of superior manager skill and higher returns.
Flexible thinking on portfolio construction
Adopting a holistic approach with a clear demarcation between beta, smart beta and alpha provides the framework for investing in private markets.
How this framework is then put into practice in a portfolio can add considerable value. The nature of private markets allows investors to take long-term views, explore macro themes and position their portfolios to benefit from tomorrow’s trends. We recommend developing a thematic approach to alpha and beta portfolio construction based on the medium-term outlook for financial markets and various sectors and regions. We refer to this approach as adaptive portfolio management.
The key features of this approach are its ‘adaptability’ to the rapidly-changing economic environment and prioritising long-term investments to optimise the risk-return profile.
We live in a rapidly changing world and our adaptive portfolio management approach ensures investors are constantly re-evaluating attractive investment themes and focusing on actively managing their exposures rather than following rigid asset class guidelines.
As well as a strong understanding of the key return drivers and risks in private markets strategies, adaptive portfolio management means defining your beliefs about the investment world. It is founded on a well-conceived investment strategy customised to specific investment objectives and a well-aligned and cost-effective implementation model. It also demands careful long-term planning of new commitments to effectively manage liquidity.
This approach will lead to the creation and prioritising of an inventory of investment themes and frequent re-evaluation of allocations rather than annual planning cycles. This enables investors to respond to emerging opportunities rather than ‘sticking to the plan’.
So, instead of choosing a static allocation of, say, 5% private equity and 10% real estate, allocations to private markets strategies will fluctuate according to regular assessments of the macro environment, pricing and other idiosyncratic return drivers.
What does this mean in terms of specific investments? In terms of private equity, Towers Watson has identified opportunities in distressed and turnaround private equity managers, emerging markets managers or resource-focused strategies, to name a few.
Indeed, there are nearly as many types of vehicles through which investors can access private markets as there are strategies. The key to allocating to them successfully is by developing and maintaining a coherent strategy.
Private markets can be a complex area of investment but reward investors via improved long-term risk-adjusted returns relative to traditional assets. However, we believe a holistic approach to portfolio construction is not only optimal for building and managing exposures, but is an ideal way for Italian investors to access these opportunities.
Luba Nikulina is global head of private markets and Alessandra Pasquoni is head of Italian investment at Towers Watson