The benefits and challenges of using Diversified Alternatives

by Brendan McLean   •  
Blog

Traditional asset classes, such as equities and bonds, currently look expensive. As more investors search for diversification, income and returns, alternative asset classes, which are becoming increasingly accessible to investors, are being used more.

‘Alternatives’ is an umbrella term for many different asset classes that are not traditional equities and bonds; for UK pension schemes it tends to mean infrastructure, private equity, hedge funds, various types of real estate (e.g., long lease property built to rent) and private credit.

Diversified Alternatives are strategies that comprise of various individual alternative asset assets within a single fund. They are an efficient way to access various return drivers and diversification benefits. They are particularly useful for smaller pension schemes, which might struggle to meet alternative asset classes minimum investment size and/or liquidity terms, and generally have a lower governance budget.

Alternatives can offer a wide range of benefits, but trustees must also pay attention to the risks and challenges they bring.

Benefits

  • Performance – can be higher due to the:
    • “illiquidity premium”, which is the additional expected return from locking away capital for the medium to long term (e.g., private equity), and/or
    • “complexity premium”, which is the additional expected return from the fund manager having unique skills and experience to value complex assets (e.g., distressed debt).
  • Inflation linked – returns are often inflation linked as the underlying assets have payments linked to inflation (e.g., long lease property). which also helps pension schemes hedge their liabilities.
  • Cash flow/income – many have contractual income (e.g., private credit) which helps meet pension schemes cash flow needs and reduce performance volatility, as returns are less driven by capital gains.
  • Diversification – many are uncorrelated to traditional asset classes as they are more driven by manager skill/alpha (e.g., hedge funds), which improves the risk adjusted returns of the scheme.

Risks and Challenges

  • Manager fees – due to the complexity of the asset class, investment managers fees are significantly higher than traditional markets and most include a performance fee. While performance should be strong enough to justify the high fees, it is not guaranteed.
  • Liquidity – many are illiquid with long lock up periods (e.g., 5 to 10 years), which makes them less suitable for some pension schemes as it may impact the ability to transfer to the Pension Protection Fund, or target an insurance buyout. If trustees need to exit/sell before the end of the investment term, they will need to sell their holding on the secondary market, but it would likely be at a significant discount, often ranging from 0% to -35% to the net asset value (NAV).
  • Governance – there is increased operational complexity as the assets are generally less regulated than a traditional fund structure, with fewer safeguards to protect investors. This will mean the trustees will need to spend extra time and resources conducting diligence and monitoring the investment.
  • Performance – many take additional risk to achieve higher returns. In addition, as returns are often derived from appraisal-based valuations on a time lag, it creates a smoothing effect, making risk adjusted returns and diversification appear greater than it actually is.
  • Transparency - due to the private nature of the asset class, many managers are not forthcoming with information.
  • Dry powder – there are record high levels of uninvested cash as Fund managers are struggling to find attractive opportunities. This creates competition for assets, reducing future returns, and may result in managers taking additional risks to hit their performance targets.
  • Capital deployment – often, managers will not find enough attractive opportunities to deploy all committed capital. This may impact pension schemes meeting their target alternative strategic asset allocation. In addition, managers may return capital quicker than expected, meaning it will need to be reinvested.
  • High initial investment/High minimum investment – results in difficulty creating a diversified portfolio, and if capital is returned sooner than expected it can be hard to reinvest into another fund, due to the high minimum investment.
  • J-curve – many funds suffer from an immediate capital loss due to various investment costs, management fees and no positive performance. It can take years for the performance of the underlying assets to exceed all the costs.
  • Manager dispersion – due to the reliance on manager skill to find alpha opportunities, there can be a significant range of fund performance compared to traditional markets. This means manager selection is important.
  • Currency risk - most are valued in US Dollars (USD), and as UK trustees generally invest in sterling (GBP), the changes in the price of USD/GBP can significantly impact the returns in addition to the performance of the underlying holdings. Trustees can hedge this currency exposure separately, but will incur additional costs and complexity.
  • Trapped capital – sometimes, holdings within the alternative funds can default, which can take many years to resolve. This can result in significantly longer investment period than initially intended.

Summary

Alternative asset classes can provide pension schemes with additional returns, income and diversification, but trustees need to be aware of the challenges.

There has been a growing range of open-ended/evergreen alternative funds which can remove some of the difficulties, such as liquidity, J-curve and capital reinvestment. However, these have their own challenges such as:

  • A queue (e.g., 6 to 12 months) where investors will need to wait for their capital to be invested.
  • Lock-up periods, where investors would get charged for withdrawing their money before a certain period of time (e.g., 4 years).
  • Gating provisions, where the fund reserves the right to limit the amount of money that can be withdrawn at any one time to not more than a stated percentage of the fund’s net assets – to slow a potential run on the fund as it will typically keep only a small portion of its overall value in cash.

If you would like to learn more about how your pension scheme might benefit from diversified alternatives, please speak to your investment consultant.

Further reading

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