Are alternatives for everyone?

Written By: Andrew McCaffery Global Head of Alternatives Aberdeen Asset Management

New research by Aberdeen Asset Management confirms that pension schemes are investing in an increasingly wide range of asset classes and strategies in their drive to manage risk and achieve returns. Andrew McCaffery, Aberdeen’s Global Head of Alternatives, summarises the research findings

Our study among more than 100 senior investment professionals, including those within the LGPS, focused on allocations to hedge funds, private equity, property and infrastructure. Globally, investment in alternatives by pension funds has increased to 18% (15 years ago it was 5%1) and the long-term outlook for alternatives is one of further growth with predictions2 that by 2020, the adoption of alternative strategies will represent 35% of assets managed by the industry.

For local authority pension schemes, the key drivers for allocating to alternatives were inflation protection, their high return potential and access to an illiquidity premium. While the definition of alternatives may differ from one investor to another, common to the use of such strategies is the recognition that they have different characteristics from more traditional options and consequently offer strong diversification possibilities. Pension investment managers are seeking cash flow generation to pay benefits over the long term – diversification of risk in their search for equity-like, but less volatile, returns. Managing deficits also remains a challenge, and 33% of schemes surveyed see a role for alternatives in liability management, with investment in property in particular, viewed as an alternative to investing in index-linked Gilts.

Property and infrastructure
Among the LGPS funds surveyed, 89% had exposure to property and the remainder expected to introduce this asset class within the next two to three years. In addition to the diversification benefits, which are well established, the long-term nature of lease contract structures implicit in property investments make them attractive for their predictable, stable returns. Consistency of yields was cited as a prime driver for investing in property.

The fastest growing asset class is infrastructure, where 67% of the LGPS funds surveyed have allocations to infrastructure, and the remainder expect to make some investment in this asset class over the next two to three years. Average yields have been substantially above comparable rated public corporate bonds and, while corporate bonds are likely to be in short supply, the potential amount of infrastructure debt is enormous. Among our respondents, exposure to infrastructure was most commonly through a pooled fund. Funds within the LGPS had a minimal weighting and were wary of the costs and time horizons.

Hedge funds
Hedge funds were widely regarded as a good way of diversifying equity risk, but a concern among some schemes regarding fees and performance is causing them to look elsewhere or differently at this asset class. Hedge funds were used by 33% of LGPS funds in our survey. As one respondent put it: “Financial alternatives, such as hedge funds and private equity, do provide useful diversification within the portfolio and you can reduce the degree of correlation to some extent through that. You can also improve risk-weighted returns through sensible use of alternatives.”

At Aberdeen, we are seeing increased investor sophistication in how hedge funds and other liquid alternative strategies are being used in portfolios and how customisation is becoming more important. By introducing these strategies into portfolios, it is possible to improve compounding, reduce volatility and improve overall risk-adjusted returns. In our view, it is worth considering these more liquid alternative strategies as tools to build bespoke or customised portfolios that are complementary to a client’s wider portfolio. Return profiles and drivers can vary considerably across different strategies, which means that active monitoring and management of an allocation is important. Increased focus on liquidity, transparency and fees is forcing providers to up their game, and we believe that this will lead to better outcomes for investors over time.

Private equity
In our survey, 89% of LGPS funds had an allocation to private equity. The majority reported that these investments had met or exceeded expectations, and the weighting to private equity is likely to increase further over the next few years. Pension managers we talked to were investing in private equity in order to meet their growth and diversification goals.

LGPS attitudes to single platforms and CIVs
In May this year, the government consulted on two common investment vehicles (CIVs) across England and Wales: one for listed assets and another for alternative assets, which they suggested could save £660 million a year in investment costs. We asked local authority funds how attractive they considered this proposition to be for their pension fund. Of those asked, 33% said it was not attractive and the remainder were divided in their opinion, which appears to support the wider market view. Those who expressed a negative view had concerns regarding loss of control and diversification (“it would be putting all your eggs in one basket”), and a need to retain accountability: “Our view is that we achieve economies of scale through our investment structure. We like local ownership of that and a collective investment would have to show that it preserves local decision-making, and the value that we can achieve in comparison to what we have currently got in place. The pension panel is very much against being forced down the passive route.”

Concerns were not limited to the potential loss of control; the burden of increased governance was a factor too. Laura Goodchild, North East Scotland Pension Fund, commented: “Would I want to commit to putting investments into a collective investment vehicle and having to manage additional committees? An extra custodian, an extra investment consultant, an extra performance measurement position? Probably not. I think there is an underestimation of the resources and the costs involved in trying to manage those additional relationships.”

Views were mixed on the appeal of pooling funds to achieve greater cost efficiencies but respondents indicated that niche alternative funds could present a shared opportunity for LGPS with a view that economies of scale in the more niche areas might be achieved by smaller asset allocations working with other authorities. Geoff Reader, Head of Pensions, Bedfordshire Pension Fund, said: “With infrastructure, we think the best way to get a good deal would be to invest side-by-side with others – that is where a CIV could really help. If CIVs come in through the route that they seem to be, then I think there will be pressure on us to get involved and that is certainly one way that I would see we could invest in new options and make asset allocations decisions quicker.”

Looking ahead, we asked how the weighting of alternatives might change among LGPS funds. The majority of respondents expected their allocation to alternatives to at least remain the same and in most cases, to increase, with managers citing their key challenge as the search for uncorrelated returns that would reduce the overall risk of the portfolio.

There is no question that the traditional relationship between asset classes has changed, and that the introduction of alternatives into pension portfolios represents an inevitable evolution. Aberdeen has a significant commitment to alternative investment and believes it is important to help make this evolution as simple and straightforward as possible. Our dedicated alternatives business manages £11.1 billion (30 June 2014) in alternatives across multi-manager portfolios of hedge funds, private equity funds and property funds, plus direct investments in infrastructure. In a persistently low-yield environment, investors are casting their nets far and wide in search of returns and in order to manage risk. Our research showed that whichever tools and techniques are selected, staying focused on investment objectives and goals was universally agreed as being most important.

1. Towers Watson: Global Alternatives Survey 2014
2. PwC, Asset Management 2020: A Brave New World