As global equity markets double dip, following a succession of revelations about corporate wrongdoing in the US and elsewhere, European pension funds may be beginning to wonder where future returns are to be found.
Index-linked bonds may provide respectable returns in the medium term. But if pension funds are to achieve the equity-style growth of the past, they will need to search for something more adventurous.
It is no wonder that the mainstream alternative investments – principally hedge funds, private equity and real estate – are looking increasingly attractive to investment managers. Uncorrelated to the movement of the equity markets, these assets appear to square the circle, to offer both reduced risk and enhanced returns.
Some of the largest pension funds in the Netherlands, Scandinavia and Switzerland have already extended their investment into one or more of these asset classes. So is their example likely to be followed by medium and smaller sized fund?
In this month’s Off The Record, we ask how the typical European pension fund views alternative investments. Do they see them investments that are too far off the beaten track to be worth risking, or an undiscovered country of assets worth exploring?
The investment rules of a number of European countries restrict the use of some or all of these non-traditional assets by pension funds and foundations. Moreover, not everyone can benefit from them –alternative investments are deemed to be more suited to defined benefit (DB) schemes than defined contribution (DC) plans.
Indeed in the US, there are fears that a two tier system of pension fund investment could develop , with the investment managers of DB schemes moving into more sophisticated products and riskier asset classes while the DC contribution schemes are left to extract what returns they can from a rump of underperforming traditional assets.
But clearly the new, non-traditional asset classes have been given a boost by the collapse of the traditional markets. So are alternative assets likely to provide the answer to pension funds’ search for higher returns, or will they always be investments at the margin of the portfolio?
The broad conclusion of this month’s survey is that alternatives will always be what their name implies – alternatives. An overwhelming majority (97%) of the pension fund managers and administrators who responded to the survey expect the traditional asset classes of equities and bonds to remain the main source of returns for occupational pensions funds in the foreseeable future. One UK pension fund administrator sums up the response “Equities always go back after they come down, and you can’t have hedge funds unless you have a healthy equity market.”
At the same time, there is a strong conviction that European pension funds are likely to make far more use of alternative investments as marginal plays in future. Again a substantial majority, 94%, say that the use of alternative investments by pension funds is likely to grow.
There is a considerable division of opinion, however, about where that growth is likely to occur. The survey offered a choice of three asset classes which could be termed mainstream alternatives – hedge funds, private equity and real estate - and asked which was likely to be the fastest growing.
The largest single percentage of votes, 42%, backed real estate. However, there is a caveat. Many pension fund managers regard real estate as a traditional rather than an alternative asset class. One UK manager says that “real estate as a mainstream asset class will grow fastest”. Another UK pension fund administrator points out that “real estate has always been an appropriate investment for pension funds and should be used more”.
The other two asset classes get less support. Slightly more than a third of the respondents (35%) suggest that hedge funds are likely to be the fastest growing alternative asset class while less than a quarter (23%) back private equity.
Again, there was a caveat. One pension fund manager comments: “I would not make a distinction between real estate and private equity. I would place both in the same category and call it private equities.”
In spite of the current hedge funds hype, a large majority of pension fund managers (89%) believe that hedge funds and private equity are likely to remain a relatively small percentage of institutional investors’ portfolios.
The actual percentage is likely to be higher than 5% but lower than 15%. The survey posed three options – less than 5% of the portfolio, between 5% and 15%, and above 15%. Most pension fund managers (70%) chose the middle option. None of the respondents expect these two asset classes to comprise more than 15% of a typical pension fund portfolio. However, almost a third (30%) suggest that the allocation will be less than 5%.
Pension funds and foundations are often restricted by their investments rules to quoted domestic equities. This prevents the kind of support for new ventures that many governments are looking for. It also limits the choice for the investment manager. So pension fund managers might be expected to agree with the proposition that investment rules governing pension funds should be relaxed to allow some or more investment in alternatives. A surprisingly large percentage 21% think that the rules should not be relaxed. This squares with the strong feeling among some southern European countries that there should be prohibitions on asset classes such as private equity and commodity futures. However, the remaining 79% believe that pension funds should be allowed to either invest in alternatives or increase their allocation.
Attitudes to alternative investments vary. The popular perception of them is as risky asset classes. However, alternatives are sold to institutional investors as diversifiers of risk. So our survey asked what pension fund managers themselves see as the primary role of alternatives – to enhance returns, to diversify risk, or both.
Here there is some difference of opinion, The largest group of respondents (45%) leans towards reducing risk rather than generating returns, 28% believe enhanced returns is the primary purpose and 23% back both objectives.
One of the worries that has been expressed – particularly in the US – about the increasing use of alternative investments by pension funds to enhance returns, is that the managers of DC schemes cannot invest in these asset classes with the same freedom as the managers of DB schemes.
However, most of our respondents (92%) do not believe that alternatives discriminate in this way against DC schemes and in favour of DB schemes. The small minority who think that DC schemes cannot benefit from alternative investments say there are plenty of alternatives to alternatives. There are also alternatives within alternatives. One manager of Belgian pension fund manager suggests that although DC schemes may not be able to plug into hedge funds they can still invest in private equity, real estate and commodities.
Finally, since most of the survey was confined, for simplicity’s sake, to three main alternative asset classes, we wanted to know what other non-traditional asset classes pension fund managers think are likely to increase in importance in the future.
There are plenty of suggestions, including managed futures, currency overlay programmes, tactical asset allocation, capital protected products, inflation hedge contracts, high yield bonds and enhanced indexed products
The top choice of asset class, chosen by more than half of the respondents, is commodities and commodities futures. Promising commodities include sub-sets such as timber, metals and energy. But the most heartening choice of an alternative investment is wine. Clearly, some pension fund managers feel that although an investment in wine may not diversify it is guaranteed to enhance.