Why low-risk asset managers are increasing allocation in investments previously perceived as ‘high risk’

Pension funds are increasing their alternative assets allocation. A recent article published in the Financial Times quoted survey results gathered by data and research firm eVestment, which suggest that pension fund asset managers’ present planning means that their allocation of funds to alternatives will grow from 15% to 19% over the next 3 years. Peter Laurelli, Head of Research at eVestment explained the trend as a “desire to be out of public equity markets”. One case study presented was that of the City of Philadelphia Pension Fund, a fund managing the retirement savings of around 64,000 former and current city employees. The fund reportedly plans to increase its allocation to alternatives by almost 2%, up to 9% of its total invested capital.

Another story to make the news recently has been the $1.2 billion recently raised by Park Square Capital to capitalise a ‘debt fund’ intended to finance leveraged buyouts. One of Europe’s biggest lenders to private equity, pension funds are reported to be amongst Park Capital’s biggest investors. The fund has been created to take advantage of the fact that banking sector lenders have stepped back from this area as a result of tight lending restrictions, leaving the door open to alternative financing providers.

What are alternative asset classes?

Alternative asset classes are those which would not be considered as ‘normal’ constituents of an investment portfolio. Traditional asset classes would be largely considered as equities, government or corporation-backed bonds, real estate and cash equivalents.

While collectibles such as wine and art are often classified as ‘alternative’ investments, what we are really talking about here are more ‘traditional’ alternative asset classes such as private equity, hedge funds, infrastructure projects and concessions and alternative financing. These are the kinds of investments that pension funds are increasing their allocations in.

Why were they considered ‘high risk’?

Alternative asset classes have traditionally been labelled as ‘medium to high risk’, investments. The reasoning behind this classification is that they are often more complex and difficult to understand than traditional asset classes. As a result of more specific expertise and a management-intensive nature, charges are also often higher. Returns are also highly dependent on the increase or decrease in the value of the underlying asset. In the case of private equity, for example, this would mean the future success of the business invested in. This means that investors in alternative asset classes are very much reliant on the ability of the managers to pick ‘winners’.

Why traditional ‘low risk’ pension funds are investing in alternatives

If the above description of the underlying logic for the risk categorization of alternatives sounds remarkably like the nature of equities, it seems that pension fund managers have come to the same conclusion. eVestment’s research indicates that the increased capital allocation to alternatives by pension funds comes directly at the expense of allocation to equities, rather than from any of the other traditional asset classes that make up their portfolios.

The value of equities is also, in theory, reliant upon the performance of the companies an investor holds shares in. The problem is that equities are part of a much broader stock market and their value, at least in the shorter term, can bear little correlation to how a company is actually performing. When market sentiment turns negative investors tend to sell off equities across the board, meaning that companies whose performance, asset value and profitability have not in any way deteriorated still lose value. Pension fund managers find this volatility hard to predict and manage. Market slumps can easily wipe significant value from a fund’s invested capital over a matter of days, weeks or months.

Conversely, equity investment in non-listed companies and other alternative assets show little correlation to stock markets. If the asset is performing well it will hold or increase its value as a result. Changes in performance and value do not happen quickly as a result of the vagaries of wider market sentiment. As a result, alternatives are now being viewed as holding less risk of short-term volatility compared to equities. Pension funds and other investors are looking to these asset classes as both a hedge against stock market exposure and as also offering potentially more attractive long term returns.

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