FTfm opinion piece on need for including
alternative assets to diversify pension fund investments

by Dr. Ros Altmann

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UK pension funds are struggling with large deficits and at least part of the blame lies with trustees' traditional over-reliance on equity investments, which have not delivered consistent superior returns. Trustees and their advisers thought asset allocation was easy. Just rely on higher 'expected' equity returns to meet pension liabilities over the long-term.

This approach was far too simplistic. Firstly, it ignored downside risk. Insufficient attention was paid to the effect of severe or prolonged bear markets on maturing schemes which have to pay out pensions, or schemes of weak companies which wind-up in deficit and leave insufficient money to pay the promised pensions. Secondly, it relied solely on the beta of the equity market to generate strong returns and the alpha of active long-only managers to outperform the equity indices. (In many cases, neither of these bets paid off). Thirdly, there was no clear focus on how equities would actually match the liability profile of pension obligations. There was an implicit assumption that equity returns would keep up with longevity and inflation, but they did not.

Whilst it was clearly a mistake to rely too much on long-only equities, I am concerned that the frequently recommended response of simply switching from equities to bonds, is misguided. Yes, it reduces portfolio risk (as measured by volatility) but it also significantly reduces expected return. Surely, if investors wish to reduce the risk entailed in an over-reliance on equities, they should do so in the most efficient way - i.e. for the lowest reduction in expected return, not the highest. By simply switching a large proportion of the portfolio into bonds, any deficit which exists will be locked in, removing the potential for asset growth to help reduce the deficit over time.

A superior response is to switch into a diversified range of assets, which are lowly correlated with equities and bonds, but which also have higher expected returns than fixed income assets. This should allow investors to capture the many different sources of alpha and beta which are available in modern markets.

Furthermore, it is important to appreciate that bond investing is not risk-free. Especially if focussing on corporate bonds, in search of a yield pick-up over gilts, there remains a non-negligible risk of significant capital losses. Thus, selling equities and buying corporate bonds removes the upside potential of equity returns, but retains some of the downside risk of corporate default and widening spreads (especially from today's levels).

Whilst the appeal of a simple switch to bonds is understandable, the asset allocation task for pension trustees is more complex and those who want to find easy solutions will be disappointed.

The finance and operational divisions of large companies fully understand risk control, swaps, derivatives, hedging, and so on, but pension fund trustees are not used to these more modern investment banking concepts. A more sophisticated approach, with a broader range of asset classes can provide more efficient portfolios. If alternative assets are combined with traditional investments, portfolio risk can be reduced and potential returns enhanced.

Investing in a diversified portfolio of hedge funds, commodities, currencies, real estate, venture capital and even infrastructure projects should ensure a higher-return, lower-risk asset allocation than just using equities and bonds. Hedge funds, in particular, offer a wide array of risk-reducing and return enhancing strategies. Emphasising absolute return investments and uncorrelated, hedge fund products, can generate superior risk-adjusted returns. Successful absolute return investing should outperform long-only, benchmark constrained management over time and historic returns bear this out. Diversification into alternative assets allows investors to capture more than one source of alpha and achieve more varied beta exposure, with better downside protection.

In addition to a wider spread of investments, judicious use of swaps and derivatives can help pension funds match their liability profile. There are no assets (yet) which perfectly match the inflation, duration and longevity risks of defined benefit pensions in the UK, but swaps can help to minimise some of these risks.

This all makes the task of trustees and their investment advisers far more difficult. The due diligence required for alternative asset investing can be expensive and time-consuming, but that should not be an insurmountable problem.

The days of simplistic investment approaches are over. The pension fund industry needs to move away from the asset allocation notions of the past. Just relying on bonds (instead of over-emphasising equities) is not optimal. There are tremendous opportunities for enhanced returns from a broader, more modern spread of asset classes and investment products, emphasising absolute returns. Indeed, the institutional investment industry sometimes seems to be living in a different era from the investment banking world and pension fund thinking urgently needs updating, to help corporate UK fund its pension deficits. Optimisation models are available to assist the portfolio construction process, but too little use is being made of them. Perhaps commingled products could be designed by investment banks to help pension fund trustees with their asset allocation decisions.

In summary, there are no easy answers, but more diversified approaches can deliver superior performance over time. Are trustees and their advisers ready for this challenge?


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