Monday, 20 November 2017

    Diversification is always a balancing act

    David Willers, UK alternative investments leader, Mercer, offers his thoughts on the growth of alternative investments

    In early 2003, UK pension plans had, on average, a 1% allocation to alternatives, largely real estate. In 2017 this has swollen to 22%.

    What is behind this rise? Certainly, the main answer is diversification.

    However, diversification may not be an easy win – in the global financial crisis most asset classes correlated and fell together. So a dazzling panoply of alternatives has emerged and pension schemes have invested In areas that were traditionally the domain of other investors – for example hedge funds and ground leases.

    At the time of the crisis there was a sense that diversification was essentially shutting the stable door after the horse had bolted, but in the current climate, with asset valuations at all-time highs, the case for alternatives is compelling.

    So there has been a search for asset classes that have truly uncorrelated return sources (for example, insurance-linked securities that have price exposure to natural disasters).

    Strategies that can strip out market returns and focus on insight, or take directional exposure to markets, i.e. hedge funds also have appeal.

    Pension schemes have liabilities as well as assets, and have lost some ability to ride out the storm. Diversification made less sense if you viewed equities as the asset class of most return, and had the ability to cope with the volatility over the long term.

    Now large drawdowns in equity markets can bankrupt a sponsor, and the timeline to peak cash flow (i.e. when you are busiest paying out most pensions payroll) is nearer, with 55% of plans already cashflow negative. With time pressing on, plans have also looked at asset classes that generate income to match their liabilities.

    There has been a focus on assets with more stability of income than equity dividends, and with more yield than government or investment grade corporate bonds. Plans have been open to working their assets harder, and this has led to a tolerance of some degree of illiquidity in the search for yield and income.

    We’ve seen the emergence of illiquid risky asset classes such as private debt (around 7% of UK plans now have an allocation in this area), where there is a high coupon rate, alongside a lock-in of assets, and also less risky though still illiquid asset classes, such as high-lease-to-value property.

    For a one-size-fits-all one-stop-shop many schemes have invested in multi-asset funds, predominantly diversified growth funds (22% of UK defined benefit funds now invest in this type), this is particularly relevant for smaller schemes or schemes with low governance budgets.

    There has been something of an existential crisis for these funds as they struggle to find value in traditional equity or bond markets, and so making money from rotation has been difficult. What is the future for alternative investing in the UK? Diversification remains critical, especially given that many pension schemes cannot tolerate large short-term losses, even in the pursuit of strong returns in the long term.

    We expect providers will rise to the challenge, producing products that guard against secular risks such as climate change and a shifting technological base, and also creating and structuring assets that are friendlier to end users.

    New offerings such as secured finance are coming on stream which attempt to harvest many of the positives of current credit offerings but with more diversification. This could be the first of a new wave of strategies that enhance the risk return profiles of pension schemes.

    This article first appeared in Engaged Investor’s Investment Diversification research report.  Click here to view and download the complete report

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