There is an alternative ... or is there?
With pension fund managers worried by the prospect of diminishing returns in the new century as the equity boom runs out of steam, we found many considering alternative investments to help fill the gap. Although their responses indicate consensus that such investments can reduce volatility and increase returns, there is also a fair amount of caution, and not a little ignorance
In IPE’s millennium edition we were surprised to read how many pension funds considered the prospect of decreasing returns on their investment as the major cause for alarm at the dawn of the new century. This month we decided to give pension managers the opportunity to explain their fears. A problem shared is a problem halved, after all…
The reason for such investment worry? Simple. The majority of pension funds responding to Off The Record believe the seemingly inexorable rise of equity markets during the last decade could be about to run out of steam. Ninety four per cent of scheme managers predict that equities will show decreased returns going forward.
Opinion is divided, however, on the future prospects of fixed-income investment. The pessimists just outstrip the optimists, with 56% seeing tempered returns on the investment horizon.
Real estate and cash pose less of an issue for future fund returns, say managers, with less than a third predicting a dip in fortune for the asset classes.
As for the timing of the equity fall-out, most managers see the next three years as the greatest danger period. Just over half expect share returns to dampen in the coming year and over the subsequent two to three-year period.
Managers appear to see little reason for an extended bear market though, with two-thirds expecting equity returns to pick up again after three years.
The marginal lack of confidence in fixed-interest returns for this year rebounds more quickly than equity predictions, however.
Expectations of negative fixed-income return numbers fall back to less than a third on the two to three-year horizon. Just under a fifth of managers see red on fixed-income in the longer run.
Faith in real estate and cash prospects is solid though, with only a lone manager in each category predicting a downward trend for assets at any point after this year.
Consequently, the number of funds actively set to change their strategic allocation to respond to any market changes is relatively low at just under 40%.
Suggestions as to how this might be altered unsurprisingly involve a reduction in equity portions with a mix of complimentary strategies including the shortening of bonds, a shift to corporate debt and increased property holdings.
For the more bullish manager it’s business as usual, with one set to up equities past the 70% level in anticipation of a continuing equity gravy train. Accordingly, the projected downturn in stock performance is the precursor to 45% of managers noting they will implement or increase their use of tactical asset allocation.
Amongst respondents, the number already using alternative investments (AI) as a potential boost to returns comes out at just under half. A further 28% say they are considering alternative securities and slightly over 30% say they have ruled out AI altogether. One manager cites legal restrictions in the local market as an immediate frustration to any AI ambition.
In terms of asset type, private equity seems to be the funds’ alternative choice with 44% of respondents already invested and 22% considering it a possible route.
High yield bonds and securitised assets both attract over a third of alternative investors, with the former proving to be the most probable investment choice for funds on the AI trail in the future.
Twenty eight per cent of AI followers say they already invest in forestry/land, although less than 1% of respondents say they would consider the forest path as an AI opportunity further down the line.
And while none of the respondents currently invest in commodities, just over 10% say they are looking at the investment potential.
One certainty, though, is the consensus among scheme managers that alternative investment can reduce volatility and increase returns.
Nearly three quarters of replies concurred on this statement, with 44% proposing that to make AI a worthwhile investment strategy within a portfolio would take an allocation of between 5 and 7.5%. Just over 20% feel around 3–5% would be a sensible portion to have in AI.
And on average managers expect to collar around 200 basis points per annum from their AI allocations, although degrees of demand vary between funds.
A number are clearly focused on seriously bumping up returns, seeking “S&P plus 400 basis points” or “500bps over cash”.
Nevertheless, some funds seem happier to see what rolls in, claiming they want only 50bps on alternative securities or “minor” returns on their investment.
Whichever way funds play their AI strategy, the message is clear. In the coming years interest in alternative investment is set to boom.
When asked what proportion of their assets managers expected to have in their portfolios by the end of this year the average level comes out at 2.4% of total portfolios, with the range running from 1.5% to 10%. By 2005, however, the average weighting for AI within fund allocations is set to triple to around 6.8% with the range between 3% and 15%.
Surprisingly though, considering the above figures, when funds were asked to list in order the major concerns of scheme trustees over alternative investment, ‘lack of familiarity’ comes out on top.
Clearly there are those in the know on AI and those where investment education falls short.
The second most important concern for funds is ‘risk’, with ‘uncertain returns’ third and ‘cost’ and the ‘long-term perspective’ sharing last place – representing the least worrying aspects for plan sponsors.
Further problems put forward by managers include legal aspects, inadequate management resources for AI, as well as a lack of established benchmarks.
To resolve such issues surely scheme managers can look to the consultants for advice. Or maybe not… Over half of the respondents say their adviser does not have sufficient expertise in the AI domain to offer such support. And as one manager adds worryingly: “But then again no-one has!”
Strangely though, one manager is emphatic its consultant can offer advice for alternative investing – and that they too have the know-how: “Yes, our consultants have the expertise, but then so do we.”
Clearly there is some confusion here about what AI entails and some of the final comments made by managers encapsulate the need for fund awareness in what they are doing and seeking to achieve.
As one manager notes: “Pension funds should start with an exact definition of what AI is before they proceed.”
Another adds that care and caution should be the implementation watchwords: “Plan sponsors need to look carefully at their implementation costs, because savings there will reduce costs, even if the returns are negative.”
Looking to the future a manager points to an increase in interest for different products such as inflation linked bonds.
To end, though, a note of caution. Stark words of warning appear in bold type at the foot of one manager’s responses, as a timely reminder of just what pension fund investment should be seeking to achieve: “HEDGE FUNDS ARE NOT APPROPRIATE FOR PENSION FUNDS”
You have been warned…