Diversified alternatives strategies place an emphasis on the client’s needs and the manager’s role, and have found favour with London Borough of Newham, as John Turnbull explains
Attitudes to alternative investments among pension funds has changed markedly in three years. While it is widely accepted that greater transparency, alignment and a robust due-diligence process will remain key priorities for pension funds who seek managers of alternative investments, there is also an expectation that alternative managers need to have a better appreciation of who they are managing for, and why.
As allocations to alternatives have increased, competing models have developed concerning how to optimise exposure to alternatives. One school suggests that pension funds should gradually select individual strategies and managers. This approach places the emphasis upon the trustees or consultants to allocate and independently weight the separate segments of the alternatives markets as they believe it will best benefit the fund, in accordance with their attitude to risk and their funding levels.
Under this approach, however, there are two key issues that trustees need to address. First, they must fully grasp whether allocating to alternatives is prudent for the fund. Second, trustees must feel comfortable that the flow of information from each manager within their alternatives allocation is sufficient enough to make informed investment decisions in the face of challenging market conditions. Will a commodities, private equity or hedge fund specialist manager ever advise clients not to make further allocations, for example?
The response from asset managers to these two considerations has come in the form of the diversified alternatives (DA) manager. The role of the DA manager is to address these issues, while also being mindful of the ‘dual mandate’ that all trustees face - namely, looking to improve the long-term funding position of the plan, while at the same time seeking to maximise the worst case funding/minimise long-term contribution levels. This aspect of DA sets the approach apart from the earlier models that espoused a more simple allocation to individual managers, who themselves would be oblivious to funding concerns.
The decision in 2009 by the London Borough of Newham Pension Fund to commence a search for an overall alternatives strategy was indicative of this newly evolved approach. While Newham recognised the individual and collective contribution of alternative investments in the pension fund and had made a number of previous allocations with individual managers over the years, there was an understanding of the need for a more comprehensive appreciation of how, on a combined basis, each of the investments were working for the pension fund.
To this end, Newham’s trustees decided that the concept of a diversified alternatives manager was a good option. The chosen manager would build a robust ‘completion’ portfolio (a comprehensive portfolio of alternatives), which, taken together with existing allocations, would see 15-plus diversified strategies employed. In addition, it was felt that the DA manager must collaborate with the fund on an ongoing basis and fully understand the key objectives of the fund and its broader asset allocation.
One of Newham’s desired objectives was to optimise the alternative allocation to take into account future changes in funding positions. While some alternative investments are more geared towards providing performance in order to improve long-term funding levels, others are more effective in managing downside risk.
For example, illiquid strategies such as private equity and private real estate may have higher volatility/uncertainty, but can help contribute to an improvement in a pension plan’s long-term funding positions. By contrast, strategies such as hedge funds and specifically, macro investment strategies, have been better at mitigating funding downside risk.
After an extensive search, Newham selected Morgan Stanley Alternative Investment Partners (AIP). The team manages a diversified alternatives portfolio for the SAUL - University of London pension scheme, and coined the concept of diversified alternatives in the UK. The group can also trace its roots back to the Weyerhaeuser pension scheme in the US and the trustee decision there in the 1980s to make a 100% allocation to alternatives.
AIP does not view alternatives as a ‘satellite’ allocation, and believes that the construction of a diversified alternatives portfolio starts with a detailed understanding of client objectives, among them risk tolerance, return expectations, current and target funding levels.
AIP bases its DA approach on fulfilling the ‘dual mandate’ of improving the long-term funding position of the plan, while at the same time seeking to minimise long-term contribution levels upon the application of the dynamic risk budget. In this approach the asset allocation weights shift between a performance seeking portfolio (PSP) and a risk management portfolio (RMP). At lower funding levels the PSP dominates and as funding improves the proportion invested in the RMP increases. The pension fund’s diversified alternatives portfolio is adjusted according to funding levels.
The lessons of the financial crisis have been harsh for many pension funds, which had thought that a well-diversified portfolio spread across traditional asset classes would mitigate the risk of sharp falls in any single asset class. While allocating to alternative assets could have helped preserve value, the actual approaches used by many schemes to manage their allocations were sub-optimal.
The diversified alternatives approach to alternatives asset allocation aims to target the specific needs of the portfolio far more closely, while also providing the ability to adapt to a growing and changing universe of alternative investments.
John Turnbull, is divisional director of finance of the London Borough of Newham pension fund