Blog

News & Updates

Alternative Assets for Pension Funds

February 14, 2017

For large institutional investors, understanding the risks and potential benefits of alternative assets is key for portfolio expansion and diversification. This is especially important for public pension funds, as these hold assets for police officers, teachers, firefighters, and other state and local government employees. Despite various risks, many public pension funds are increasing their investment allocations for alternative assets. The following are key factors contributing to this trend.

Pension Fund Motivations for Selecting Alternative Assets

One of the main factors driving the spike in pension fund interest in non-traditional investments is the desire to capture higher returns. Recent portfolio strategies emphasize a return to diversification and alternative assets do present additional opportunities for generating alpha (returns) for portfolios. Other advantages associated with alternative assets include:

  • Balancing of portfolios with assets that are non-cyclical
  • Alternative assets often do not correlate with shifts in the economy, thus providing insulation against instability and unpredictable conditions
  • Typically less buyer competition for alternative assets; this can contribute to higher cap rates and better yields
  • Tax benefits may be connected with some alternative assets
  • Exposure to new talent pools of managers that are outside of normal institutional networks

Alternative assets can provide greater opportunities for returns and can open up new investment options for growing pension funds. Also, many investors become aware of alternative assets through word of mouth and through information shared by associates. Thus, alternative investments can also expand the networking capabilities of organizations.

Types of Alternative Assets

Another appealing factor of alternative assets is that the list of available assets in this category is broadening. The term “alternative assets” has now expanded to include:

  • Hedge funds
  • Private equity funds
  • Foreign currencies
  • Derivatives

Additionally, investment in alternative real estate assets is expanding for public pension funds. Investment in real estate now frequently includes alternative assets such as:

  • Hospitality
  • Senior housing
  • Student housing
  • Single family rentals
  • Data centers
  • Workforce housing
  • Timber
  • Golf courses

Overall, there are far more ways to diversify a portfolio now than, say, 10 years ago. Also, there is a shift occurring in the broad investment community. Assets that were once considered to be “alternative” are now moving more and more into the mainstream as accepted assets for institutional investors. 

Risks Associated with Alternative Assets

The main drawback of alternative investments is the high amount of risk associated with such products. There are many reasons for these risks:

  • Some alternatives may be associated with a lack of data, especially with regards to cyclical performance
  • Many public funds are still on the learning curve when it comes to exploring new investment options, and must therefore proceed with caution
  • Alternative investments may be newer and lack significant history and background for analysis and study of performance
  • With regard to risks, many alternative investments have significantly higher standard deviations compared to other investment options
  • Regulation of alternative assets is rapidly changing

Lastly, alternative investments can involve complex strategies that are difficult to understand; representatives can sometimes encounter difficulties in explaining how an alternative investment works to customers. This in turn can lead to legal liability in areas such as fiduciary duties, transparency, and even fraud. This is especially the case with hedge funds, which can have some issues with disclosure. 

Approaches for Dealing with Risks

Firms and organizations seeking to explore alternative investments should consider the various risks as well as regulatory hurdles that are associated with such assets. In particular, pension funds should: 

  • Ensure that thorough committee review and due diligence procedures are in place in order to select the optimal alternative investments
  • Consider potential policy and operation risks that such investments pose
  • Implement suitability requirements to address factors which would determine whether a particular investment is an ideal “fit” for the pension’s aims and goals
  • Search for experts, teams, and all relevant data and track records surrounding an investment

Pension funds should also be up to date on the regulatory and enforcement schemes that affect alternative assets. These can sometimes be limited and “spotty,” and are also subject to adaptation as alternative assets continue to evolve. 

Pension Funds in the News

In Ireland, several pension funds such as the Construction Workers Pension Scheme (CWPS) are increasing allocation to alternatives as ways to generate additional returns in a particularly low-return space. 

For instance, at the end of September 2016, alternatives constituted 30% of CWPS’ total portfolio. This was followed by 27% in bonds, 24% in equities, 14% in case, and 5% in property. 

Also in Ireland, new risk-reserve requirements for defined benefit schemes took effect in January 2017. Pension funds must now build a buffer equal to 10% of liabilities, minus any liability-matching bond and cash assets. Funds must also have an additional margin which would reflect the impact of up to a 0.5% decline in bond yields on assets. 

California
A new law in California (AB 28331) will require each California public pension and retirement system to provide certain information regarding any alternative investments they have made. This includes any information regarding any fees or expenses borne by the fund (either directly or indirectly), as well as investment performance. The information must be disclosed at least annually in a public meeting. 

Under the California law, “alternative investment” is defined as an investment in:

  • Private equity funds
  • Venture funds
  • Hedge funds
  • Absolute return funds

The disclosure requirements apply to all contracts that California public pension funds enter into on or after Jan. 1, 2017, as well as any existing contracts to which a fund makes a new capital commitment on or after that date. Various other provisions apply to different situations, such as grandfathered contracts. 

Summary

The consensus across the board is that public pension funds should exercise thorough due diligence in selecting and monitoring alternative assets. These types of investments do present opportunities for diversification and strong returns, but the associated risks are great enough to warrant comprehensive review and analysis of the data available. In doing so, large pension funds can minimize losses and can possibly avoid issues with fraud and other legal violations in the future. 

The definition of “alternative assets” will likely continue to evolve as the palate of mainstream and accepted assets broadens. Regulations and enforcement remain complex, especially when considering differences across the globe in various jurisdictions. If you have any questions or inquiries regarding investment strategies and portfolio monitoring for large pension funds and other institutional investors, contact us at Kessler Topaz. We understand the nuances of monitoring a diverse institutional portfolio, and are committed to creating and implementing workable engagement strategies.