Alternatively speaking

Written By: Matthew Craig LAPF Investments

Matthew Craig looks at the use of alternative assets by LGPS funds and shows how they have become an essential component of the funds’ investment strategies

Alternative assets are becoming more central to the asset allocation plans of many long-term investors, including many funds within the Local Government Pension Scheme (LGPS).

While some think of hedge funds and private equity as being the main alternative assets, property and infrastructure are increasingly part of a strategic allocation to alternatives. Alongside these assets, private debt and loans, and assets such as timber, farmland, insurance-linked securities, aircraft leasing and other niche areas are also used within the alternative assets space. Assets like this can also offer an attractive blend of alpha (return from manager skill) and beta (market return). While alternative assets may be based on activities and industries that are quite different to the main markets for investors, there are managers of alternatives who will have the necessary skills and expertise.

A look at some statistics from LGPS members show how alternatives are now becoming a significant factor for UK local authority pension funds. The North Yorkshire County Council Pension Fund, part of the Border to Coast asset pool, has a benchmark allocation to equities of 62% and 18% to fixed income. For alternative assets, it has a benchmark allocation of 20%. In recent times, it has added property, diversified growth funds (DGFs) and private debt as its alternative assets.

Looking at North Yorkshire’s results for the year to the end of March 2018, it saw a mixed performance from its alternative assets. Two two diversified growth funds gave returns of 0.9% and -2.2% for the period – well below North Yorkshire’s overall return of 8.4% for the year. On the other hand, private debt allocations generated annual returns of 13.3% and 7.3%, while a property allocation saw a return of 11.5%. These results show how performance within different alternative asset classes can vary, based as they are on a wide range of underlying assets.

The pension fund at Worcester County Council has a high 75% weighting to equities, with a target allocation to alternatives of 15%. In its case, infrastructure and property and the main components of its alternative allocation. Another example is Buckinghamshire County Council, which has a 26% allocation to alternatives, split between diversified growth, hedge funds, property and private equity. This compares to a 49% allocation to equities and a 25% allocation to bonds. In its latest annual report for the year to March 31, 2018, Buckinghamshire made an overall return of 3.6% over one year and 7.4% over three years. Leaving aside private equity, which the fund reports separately, there was a 9.2% annual report from a property mandate, a 4% annual return from a DGF, and a 4.4% annual return from a hedge fund allocation.

For an insight into recent private equity performance, the published results for Strathclyde Pension Fund, for the year to June 30, 2018, show that two of its private equity managers reported one year returns of 14.1% and 12.3% respectively, ahead of benchmark in both cases. In theory, private equity should outperform public equities, as there should be a premium to investors for committing their assets for longer periods. Private equity managers also aim to add value by choosing under-valued assets and making them operate more efficiently, with a hands-on approach and tighter financial controls.

These LGPS fund statistics show how assets such as property, DGFs and private market assets (such as private debt and private equity) are now being held alongside equities and fixed income. Listed equities and public fixed income are highly liquid assets, and can provide growth and diversification, but they can also be volatile. A long period of low interest rates, together with quantitative easing, has raised valuations in both the two main asset classes, leaving investors wary of a market correction when both equities and fixed income fall in tandem. So alternative assets can help pension funds create a more balanced portfolio, with growth from a wider range of assets. In addition, after the global financial crisis of 2008, when equity markets in particular slumped dramatically, many investors decided that they wanted to increase exposure to tangible assets based in the real economy.

A recent survey of 500 institutional investors around the world by Natixis Investment Managers found widespread evidence of support for alternative assets. “A combination of uncertain returns and a rising rate environment has forced institutions to look further afield to generate returns and respondents have signaled a preference for alternatives and private market assets,” Natixis commented. The survey found that among UK institutions, 40% planned to increase allocations to private debt, with 37% looking to increase their infrastructure allocation, 33% increasing real estate and 26% increasing private equity. Research such as this shows how the old 60:40 portfolio split between equities and bonds is being replaced by a much greater use of alternatives.

While alternative assets as a whole are gaining in popularity, many investors, including LGPS members, are sceptical about the benefits of hedge funds. This is because hedge fund performance can be variable and charges can be very high, even if the “2 and 20” fee model is under pressure¹. As evidence for the former, early 2018 saw the conclusion of a 10-year bet by investment guru Warren Buffet, who, in 2007, wagered $1 million that an index fund would beat a collection of hedge funds. In January 2018, Buffet won this bet, as the S&P 500 index of US equities returned 7.1% on an annualised basis, while a basket of hedge funds returned 2.2% a year. These results show how hard it can be for any professional investor, including the best hedge fund managers, to consistently beat the market. Protection against falling markets is one key attribute for hedge funds, but many have failed to do this in the past, adding to investor disenchantment. At the same time, with markets driven by central bank policy and political decisions, conditions have been difficult for many hedge funds. If quantitative easing ends and we return to markets driven by fundamentals, then overall hedge fund performance could improve in future.

Gaining access to the best opportunities is vital for investors in alternative assets, as performance can vary widely between the top quartile and the average performer. One way to find the best opportunities is to develop good relationships and networks in areas such as private debt or private equity. Another important attribute is size; larger pension funds tend to be more proficient and extensive investors in alternatives than smaller funds. For the LGPS funds, this means that asset pooling could help increase the ability of funds to invest in assets such as infrastructure.

A bigger asset pool should be able to get better terms from external managers. LGPS asset pools with £20 billion plus in assets should be able to obtain the lowest fees offered to institutional investors for many investments. Moreover, as the asset pools grow in size, it is possible that they could work together to invest directly in alternative asset classes, so avoiding manager fees entirely. This is already happening with the GLIL Infrastructure LLP, which was set up by the Greater Manchester Pension Fund and the London Pensions Fund Authority to invest directly in infrastructure, mainly in the UK. Other LGPS funds, including Merseyside, West Yorkshire and Lancashire County Council have also committed funds to GLIL, bringing total commitments made to it to £1.3 billion. So far, GLIL has taken stakes in Anglian Water, the Clyde wind farm, and is investing in bioenergy plants and new rail vehicles for the UK’s railways. The Northern Pool as a whole has prioritised alternative assets as an area where its constituent members can achieve economies of scale and other benefits by collaborating on infrastructure investment.

Asset pooling, on the scale seen in the LGPS, is a time-consuming operation and setting up new asset pools will incur extra costs. However, once the new asset pools have the tools to invest in alternatives, they should provide much more cost-efficient and effective access to the asset class, giving LGPS funds much more scope to utilise a wider range of assets. Bigger funds have the investment expertise to also invest in externally managed funds in niche areas within alternatives. As the latest annual results for LGPS funds such as North Yorkshire and Buckinghamshire show, investors can see very good results from their external managers in alternatives, making them an extremely useful part of the investment tool kit.

So in the future, we can expect to see LGPS funds hold around 20% to 30% of their assets in alternatives, including assets such as property and infrastructure, as well as private market assets, DGFs and other alternatives. These assets will be held through a mix of direct investment by asset pools and investment vehicles set up by them, as well as through specialist external managers. From an initial consideration as alternatives to other assets, the alternative assets have themselves become an essential component of LGPS investment strategies.

1. “2 and 20” is a hedge fund compensation structure where hedge funds are paid a 2% management fee and a 20% performance fee.