Edmund Tirbutt examines the various ways pension funds can invest in alternatives

It seems fair to say that the argument about whether pension funds should hold alternative investments has already been won. According to Towers Watson’s Global Alternatives Survey published in July 2012, allocations to alternative investments now account for around 20% of all pension fund assets globally – up from 5% 15 years ago.

The survey shows that during 2011 pension fund alternative assets totalled $1.2 trillion and represented over half of all assets managed by the top 100 alternative managers. Property had the largest share of this with 40%, followed by private equity fund-of-funds (18%), private equity (14%), hedge funds (10%), infrastructure (9%), fund-of-hedge funds (8%) and commodities (2%).

However, debate remains fierce as to how UK pension funds can most effectively access such assets, and the considerations involved inevitably differ significantly between defined contribution and defined benefit schemes. Whilst the bulk of interest in alternatives to date has come from defined benefit schemes, the sheer volumes of money now flowing towards defined contribution schemes in the era of auto-enrolment makes it inevitable that the gap will gradually close.

Defined contribution schemes

Nevertheless, defined contribution schemes always have to be wary of the less liquid asset classes and they must also ensure that they offer fund choices that can be easily communicated to scheme members with little understanding of financial matters.

Consequently, although Mercer has come across a fund-of-hedge funds being offered as an option to employees of a sophisticated financial institution, virtually all alternative investing is done via the more general managed funds of the type commonly used as default options.

Asset allocations in this context can vary markedly. For example Scottish Life holds no alternatives other than property in its governed range of default funds but, at the other end of the scale, some diversified growth funds can invest over 50% in alternatives, with property – because of its illiquidity – accounting for no more than a fifth of this.

The diversified growth funds, which can be used in the growth phase of a default lifestyle programme, are more liquid and have lower fees than hedge funds and can contain everything from commodities and insurance-linked catastrophe bonds to global macro and hedge-fund style credit strategies.

Defined benefit schemes

Diversified growth funds are also very much in demand from defined benefit schemes because of considerations towards fees, liquidity and governance issues. Some schemes use them exclusively for accessing alternatives whereas others combine them with more direct forms of investment.

Mercer head of alternatives research Robert Howie says: “Medium-sized defined benefit schemes of a few hundred million pounds quite like the idea of a one-stop-shop, so more sophisticated diversified growth funds and multi-alternative funds have been proving popular, especially those including illiquid strategies.”

Defined benefit schemes that invest more directly in alternatives also tend to have more room than defined contribution schemes for the less liquid asset classes like private equity, infrastructure and hedge funds. A tiny minority even holds collectibles like fine art and wine, but this tends to be driven more by client interest than by intermediary recommendation.

Aon Hewitt reports that some defined benefit scheme clients have nothing at all in alternatives whilst others can be invested over 40% there. Indeed, its own target portfolio for the return funds of clients who also have separate liability driven investment (LDI) strategies is 44% invested in alternatives – 27% in hedge funds and 17% in even more illiquid assets like property, infrastructure and private equity.

Aon Hewitt UK head of liquid alternatives Guy Saintfiet says: “The alternative component has gradually been increasing in both private and public sector pension funds as more and more clients are starting to use separate LDIs to dampen volatility.

We see alternatives as less risky than equities as they act as a diversification and offer more predictable and steady returns and, because of the complexity of the solutions available, the influence of consultants on pension funds has massively increased.”

Such direct investment can be made either via a pure alternative fund or a fund-of-funds or, far less commonly, by actually holding physical assets. Some defined benefit schemes with overall assets of several billion pounds make direct physical investment in property and infrastructure projects and, although there has so far been little action, there is increasing talk of investing in precious metals held in vaults.

ETF Securities head of UK and Ireland sales a Neil Jamieson says: “Early last year I spoke to a local authority pension fund manager who said he was beginning to think that it made quite a lot of sense to hold metals directly rather than invest in mining companies, as it strips away the geo-political, company specific and equity-specific risks. This line of thinking certainly gained credibility later in the year, when a range of strikes in South Africa affected platinum mining equities, and physical platinum holdings did well in comparison.”

Funds v fund-of-funds

The only alternative asset classes that defined benefit pension schemes tend to access via fund-of-funds – either in addition to or instead of pure investment funds – are hedge funds, private equity and, to a much more limited extent, property. But, although many smaller schemes still value the greater diversity offered by fund-of-hedge funds and lack sufficient in-house resources to make their own individual fund selections, there has been a discernible trend away from them since 2008 as a result of disappointing performance making it hard to justify the additional layer of fees involved.

LCP partner Clay Lambiotte says: “As far as it’s possible to make any generalisations, pure hedge funds have on average outperformed fund-of-hedge-funds over the last few years. Also, when fund-of-hedge funds are being used they are often being used differently because defined benefit schemes are now using fund-of-hedge fund managers a bit more as advisory partners and asking them to bespoke their own portfolios.”

But this advisory trend is to a certain extent being countered by a trend for pure hedge funds to also start offering advice in terms of tailoring investment solutions in niche areas or correcting imbalances between assets and liabilities.

With private equity, on the other hand, demand for fund-of-funds has remained steadier as there have not been the same issues with performance, yet the ability to obtain diversity is just as strong a selling point.

For example, Adveq currently offers eight different fund-of-funds and has around 15 different private equity funds in each. Although it can mix the two, most clients prefer a mix of either buy-out or venture capital funds. If, for example, they want a spread of the latter it can mix different stages of the investment process together with focuses on different geographical areas and a combination of Silicon Valley IT-type ventures and medical ventures.

Adveq CEO Sven Liden says: “The main thing about private equity is that it has been the best performing asset class over the past few years and it is essentially a less liquid form of equities.

If a pension fund has up to £100 or £150 million in private equity it will probably go the fund-of-funds route but if it has more it might just go direct to buy a selection of private equity funds itself.”

Neuberger Berman head of investment strategy and risk Alan Dorsey points to a couple of trends that are making fund-of-funds more attractive for private equity regardless of the size of the investment: declining fees and an increasing ability to offer access to specific types of strategies as opposed to including every type in one pooled vehicle.

For both hedge funds and private equity, Dorsey also emphasises that the decision to go direct as opposed to the fund-of-funds route can depend on a pension fund’s ability to have a number of staff responsible for making investment decisions as well as its mere size.

Edmund Tirbutt is a freelance journalist

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