Once a pension fund has decided to add alternative, non-traditional assets to its portfolio, how should it allocate these assets? One option is to use the basket approach, and throw in a wide selection of different types of asset. This is the standard method of diversifying the risk of traditional investments such as equities and bonds. Since alternative investments are riskier than traditional assets, there would appear to be an even stronger case for using this method for their allocation.
However, if the basket approach is pushed too far, and too many asset classes are included, there is a danger that the assets will cancel each other out. The alternative is to pick one or two key asset classes, such as private equity, that are guaranteed to make a noticeable contribution to the portfolio, either by enhancing returns or reducing risk. Dutch pension fund giant PGGM has done this with a bet on the commodities market of 5% of its E50bn portfolio.
Jerome Booth, head of research at Ashmore Investment Management, broadly approves of the basket approach to alternative investments. But he warns that funds should diversify discriminately, choosing asset classes that are liquid and uncorrelated to traditional assets. “Certainly, the more different stories you put in your portfolio the better. But you also need to consider things like liquidity when you are thinking about diversification. A lot of alternative asset classes are not liquid and you have to bear that in mind in terms of how you manage them.”
One example is distressed debt in the US. “It’s very much a cyclical asset class where there is a window of opportunity once every few years to get in and then that’s it. You’ve then made your bet and you have to sit and wait,” Booth says.
Funds also need to choose assets which do not move in tandem with the business cycle. “Most alternative asset classes with exposure to corporate risk are positively correlated to the business cycle. Some aren’t and emerging debt is heavily uncorrelated. It’s one of the few asset cases that, when there’s a recession in the US the impact of low interest rates globally is much more powerful and positive for our market than the negative impact of the recession.”
Emerging market debt can even be counter-cyclical since it will include oil producing countries. “So if a global recession is a product of high oil prices you also benefit. Having Russia in a portfolio, for example, will help you against the possible negative scenario of a problem developing in the Middle East in the next few months.
“This is not just diversification. It’s actually thinking through various scenarios. And the business cycle is the most obvious, because a lot of credit markets are driven by the business cycle risk.”
Philip Menco, consultant with Amsterdam-based Fortunis Investment Consultancy, which advises leading Dutch pension funds on restructuring their portfolios, says funds should avoid the basket approach. “You should keep it simple and not diversify into 20 different new asset classes and lose the charm of real diversification.
“My suggestion for a pension fund at this moment would be, first to limit yourself to not too many plays. Do not go into too many alternatives since they may level each other out. Secondly, look for both – alternatives to increase your return and to reduce your risk.
“Now that markets are no longer going up in a straight line, there’s more reason than just risk diversification to look for the investment alternatives. If you invest in US value stocks the main reason is to increase your total return. Commodities, on the other hand, don’t generate a very high return over a long period of time. But they have a negative correlation with bonds, for example. So there you are investing in something with a pure risk reduction strategy.”
Pension funds should measure the impact of alternatives on other assets in the portfolio, both traditional and non-traditional, Menco suggests. “At least you should provide a risk matrix to see what the total effect is on your portfolio. The more sophisticated pension funds and investors will have a risk budget and diversify that over their assets, and will have all the correlation coefficients included.”
Scott Donald, director of marketing and product development at Frank Russell, agrees that simply lumping alternative assets together in a portfolio is risky. “It’s very dangerous to treat alternative assets as if they were a homogeneous class. In terms of the strategies you might employ, hedge funds could be quite different from real estate or private equity.
“The classification of alternative investment misleads people into thinking that they have got to allocate a certain percentage to alternatives. This is dangerous, because there’s lots of different things in there. Some are liquid, some aren’t.”
The primary objective of an alternative investment strategy is to enhance returns rather than reduce risk, Donald says. “You certainly want to manage risk along the way. But if an investment proposition doesn’t have a very solid foundation, it doesn’t matter how much you diversify, you just don’t want it in your portfolio.”
Most investors diversify their alternative investments chiefly because they do not know how they are going to perform, he suggests. “Diversifying is a non-heroic way to invest. Some people would like to be heroes and pick the best hedge fund or whatever and go after it. Experience shows that the heroic approach to alternatives mostly ends in tears, and that you are better off with a diversified portfolio containing a range of different types of hedge fund strategies.”
Diversification brings it own problems, however. For example, pension funds cannot always be sure that the alternative assets they select will be truly uncorrelated to other assets in their portfolios – traditional and non-traditional. “One of the problems of private equity, directly held real estate and some hedge funds is that the valuation process distorts the apparent volatility of the investment, which also affects the correlation. You need to be very careful of that because over a long term you need make sure that you still have a risk-averse set of assets.”
A pension fund’s choice of alternative investments will be dictated to some extent by how much time it can devote to tracking their progress, he says. “There’s obviously no point in spraying your money around everywhere if you don’t have time to monitor the positions that you have and make the choices effectively,” he says.
Oliver Bolitho, head of UK and Irish business development at Goldman Sachs Asset Management, points out that the newness of alternative asset classes has created two sensitivities among pension fund trustees: “Will this asset class work and how much of my time and nervous energy will it take to keep track of whether it’s working or not.
“Governance is the crucial part of the alternative investment area. People haven’t been able to road test them. Therefore to have the confidence that they can delegate it to a manager with the right skills is most important. The best in class fund of funds manager should be able to track investments closely and give trustees the comfort that diversification is happening.”
A fund of funds approach is the most effective way of gaining diversification within the private equity and hedge fund asset classes, he says. “Within the asset classes we firmly believe that you will benefit from having a broadly diversified exposure. This is arguably the best way of achieving your objective as a trustee. If you go for extreme concentrations you are betting that a particular strategy will work better than others – the greater fool theory.”
The clearest example of this is hedge funds. “Two years ago you might have chosen exposure to merger arbitrage and made good money. As the deals have dried up so investors are exposed to the risk of too much money chasing too few deals.”
However, gaining exposure to an entire asset class by buying an index is not the answer, he suggests. “If you were to buy index-like exposure in private equity your performance would be no better than if you had bought an equities index.”
It is also almost impossible to buy a broad index exposure in hedge funds because so many of them are closed to new investors.
The exception is commodities. “In commodities there are strong reasons why you should consider buying into an index because what you are looking for is primarily the diversification of the asset class rather than manager outperformance. If you buy anything other than an index, like gold or timber, you risk losing the benefits of the broad diversification.”