Nadine Wojakovski looks at pension funds’ changing attitude towards alternatives and how best to enter the different opportunities in this broad asset class

A recent survey of UK institutional investors has confirmed that liability shortfall continues to drive changes in investment strategy. The research, by Natixis Global Asset Management (NGAM), found that 83 per cent of investors advocated a need to replace traditional diversification and portfolio construction techniques with new approaches to achieve results. Playing a key role in this new approach, says NGAM, will be alternatives as 65 per cent confirmed they would be doing this in the next 12 months.

Alternatives have already come a long way, today making up an estimated 20 per cent of global pension schemes’ allocations compared to just 5 per cent 15 years ago. For many investors ‘alternatives’ is a catch-all term for investment in anything that isn’t quoted equities, bonds or cash says Aon Hewitt senior partner John Belgrove.

Actually, even equities and bonds can be considered ‘alternative’ if managed via a hedge fund structure. It’s a case of strategies becoming more sophisticated and requiring more skill, dynamism and risk management to meet the very specific demands of the pension scheme. So for example, says Belgrove, broad hedge fund of fund portfolios are evolving into more focused multi-strategy/multi-manager portfolios or managed accounts to meet specific institutional investor requirements. And property portfolios have extended to encompass infrastructure assets and particular niche segments with perhaps inflation-linked pay off profiles that suit investor requirements. Additionally, both debt and equity opportunities in these are being separated and selected.

In addition to staple alternatives like property and private equity, the past decade has seen meaningful increases to hedge fund allocations, infrastructure, commodities and currency. Some previously more esoteric opportunities like timber, farmland, social housing, ground rents, shipping and aircraft leasing have all featured in a few higher governance approaches. Says Belgrove: “The investment cases for each opportunity and their suitability to individual schemes may vary greatly but the trend is consistent - the pursuit of lower correlation return.”

The type of investment undertaken typically is dependent on client size, needs, governance and approach, observes Russell Investments regional alternative consulting director Nick Spencer. He believes alternatives fall into three broad categories: property and real assets, which includes infrastructure, farmland and timber; private market, which includes private equity and private debt; and hedge funds.

Understanding the different instruments and their complexity is a huge learning curve and depends on trustees’ knowledge and the governance structure. Spencer says the simplest way of accessing alternatives is through a fund of funds - although an exception would be core property, which can be done through a single fund manager.

Commodities, he points out, can come under real assets if it is about getting exposure to the market and inflation. However, if the focus is as a trading strategy then it may better fit alongside other hedge funds where the scheme is looking to gain access from the underlying investment skills (active management).

Private equity is at the forefront of certain alternatives that are steadily attracting interest, says private equity firm Adveq’s CEO Sven Lidén. He thinks pension fund allocations to private equity will grow, mainly because of expected portfolio diversification benefits and the attractive risk/reward profile. Also, since the nature of the investments is rather long term, it aligns well with the funding goals most pension funds have.

Private equity firm NeubergerBerman Investment Strategy & Risk Group CFA Juliana Hadas says the asset class is attractively priced. Secondly, there is significant strategic and operating control post-investment with the aim of improving top-line growth, profitability, cashflows and multiples upon exit. At times there is the ability to implement major strategic changes that, she says, “may create significant long-term value but incur near-term costs”. But she warns that the asset class is complex and therefore it is critically important that the investor fully understands the asset class and is comfortable with it.

The way an investor will access private equity will largely depend on the level of internal resource, knowledge and investment skills. For a more general and liquid exposure, says SL Capital Partners partner Mark Nicolson, investing in a listed private equity trust can be a good option with the higher-risk venture capital trusts (VCTs) offering a more speculative exposure, albeit with associated tax benefits. “Typically we see larger pension funds utilising a mix of direct investment and fund of funds, particularly when building their knowledge of the asset class or seeking exposure to specific strategies, while smaller pension funds often select the fund of funds route,” he explains.

Accessing alternatives can also be done in a cost effective manner through exchange traded products (ETPs) says iShares head of UK sales Mark Johnson. The UK ETP market has grown a lot and there are now products that offer exposure to property, commodities and more niche areas of fixed income and equities.

“For example, through an ETP, investors can gain exposure to gold and silver in a single trade, at a low cost and without the issues that come with purchasing the underlying commodity itself, such as having to take delivery of and store the metal,” offers Johnson. “ETFs have also made accessing frontier markets, such as Qatar, Jordan and Nigeria, a much easier and more cost-effective proposition. They allow you to buy the precise exposure you want, and can be used as a building block in a wider allocation to alternatives or to niche and emerging equities.”

Property investment specialists Cordea Savills has seen a strengthening of interest in property from pension funds as their bond and equity characteristics provide appealing attributes for pension schemes. The major component of property performance over the long term has been income return, and in a low growth environment, pension funds are attracted by the income stream and yield derived from investment in real estate.

With gilt yields at current low levels, property yields look attractive. Being a real asset, pension funds have the underlying security of a tangible asset coupled with the prospect of enhancing returns through active asset management. Pension funds also recognise the long-term nature of property investment, which in many cases, ties in with its own investment horizons.

Although illiquidity has been referred to as a drawback, in general pension funds can accept short-term illiquidity in return for enhanced returns and this is driving further investment, says the property investment firm.

It has seen a significant increase in interest in index-linked long-lease assets. A number of pension funds have established defined elements of their property portfolios to focus on assets where the rental growth is linked to RPI, CPI fixed rental increases for the duration of a long (15 years plus) lease or have incorporated them within their balanced portfolio. In addition, a number of pooled funds have been established purely to invest in index-linked property which is attracting pension fund investment.

The strong development of the alternatives market in the last few years means that the solutions are becoming more refined and innovative, no matter the asset class.

Investment management boutique First Quadrant director of global macro Jeppe Ladekarl believes the alternatives industry has matured from “first movers to the mainstream”. This has happened as concerns around operational and other non-investment risks have been alleviated and as pension schemes become more familiar with the alternative strategies available.

“Ultimately, alternatives means ‘other’ so there is never a clear definition,” notes Spencer. In reality there is a lot of overlap and interaction, and how they interact with the other asset classes is part of that complexity. His advice to clients is “to see alternatives not as different buckets but for the role that they will play in the overall portfolio”.

Written by Nadine Wojakovski, a freelance journalist

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