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
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
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?