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

    Ros is a leading authority on both private and state pensions,annuities and
    retirement policy. Numerous major awards have recognised her work to
    demystify finance and make pensions work better for people.

  • Ros Altmann

    Ros Altmann

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

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

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

    by Dr. Ros Altmann

    (All material on this page is subject to copyright and must not be reproduced without the author’s permission.)

    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

    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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