Investing in alternatives – why and how?

The aim of many pension fund trustees today is to regain fully funded status using a combination of increases in contributions and investment return.  However, most trustees and plan sponsors would like to see this done without the risk of the funding level getting worse or contributions getting any higher.  Despite recent positive returns in global equity markets, many pension funds still need to generate some form of additional return in order to achieve this fully funded status, assuming additional contributions alone are not going to suffice.

This may be achieved with a more diversified approach to investment policy. Traditionally, investment risk budgets have been biased towards equities. In order to counteract this equity bias, investors may benefit from a more diversified risk budget by introducing a greater balance between equity and alternatives.

Why use alternatives to diversify?

Diversifying risk with alternatives is particularly attractive if we cannot be sure that investing in equities is going to deliver the same level of long-term historic returns over bonds that we would like for the risk that we are taking. Alternatives can reduce the reliance on equities without having to forego return. Another attraction of alternatives used in conjunction with equities is that with corporate accounting measures placing greater focus on short term volatility, a diversified portfolio can offer smoother returns. Some alternatives (private equity for example) have the added “attraction” of not being marked to market on a daily basis, increasing the smoothing effect on returns.

How to go about allocating to alternatives?

If trustees want to diversify risk from equities with alternatives, a typical approach would be to:

• Go through an education program
  
  
• Assess each strategy on its own merits
  
  
• Assess governance and access constraints, and consider allocation via fund of funds
  

There are some potential difficulties in this approach. Due to the nature of many alternative investments most reviews would typically result in trustees only allocating a small portion of their fund (say under 3%) to any particular strategy. However, because such a small allocation does not pass the “so what” test, and may not be big enough to make an impact on performance, trustees may decide not to go ahead with the investment.

Moreover, in many cases the time it takes to go through the full process of trustee education and agreement can result in missed opportunities. The best alternative opportunities often have limited capacity. There is a danger that the strategic benefits may be diluted if increased demand leads to reduced quality of available products.

One way to overcome some of these problems is to agree on a strategic allocation of assets to an ‘alternatives bucket’, rather than trying to pick individual strategies initially. Once this is agreed, the trustees would then make their allocation within the “bucket” to core alternatives, possibly leaving some scope for individual strategies or new opportunities that arise.

This approach facilitates smaller allocations to alternatives, concentrating on the return prospects for the overall bucket, rather than any individual strategy. In any event, making small allocations to alternative investment strategies is often the best way of trustees educating themselves as to whether making a more meaningful allocation is right for them.

Trustees can also implement an efficient decision making structure by establishing a committee of a few qualified people, who would look at opportunities in the alternatives market. This committee would have previously agreed the criteria and investment hurdles for any new strategies/opportunities. This process would ensure that the trustees were able to capture the best opportunities as they arose. This may include evaluating the merits of individual strategies/ opportunities such as:

• Persistent alpha sources e.g. currency overlay
  
  
• Infrastructure and bond like property funds 

Get it right – up front!

There are however some issues that are common to most alternative investments.  The easiest way to overcome these is to get the fund’s governance process right - up front. Without an effective and efficient governance process, trustees will miss the best opportunities. These are hard to find and when you do, the ability to evaluate and implement swiftly is fundamental to success. Research and monitoring will also require greater effort on the part of the trustees and their consultants. Trustees need to be aware of the additional governance costs that an alternatives policy may bring.