The role of liquid alternatives in pension portfolios
BY Staff | October 8, 2019
Pension funds are diversifying into alternatives in an increasingly challenging environment for returns.
But many of the traditional characteristics institutional investors seek to achieve by investing in alternatives may not actually be present depending on the particular asset class, said Michael Sager, vice-president and client portfolio manager in multi-asset and currency management at CIBC Asset Management in a webinar hosted by the Association of Canadian Pension Management on Wednesday. For this reason, investors might want to seek out ways liquid alternatives could better provide those features, he noted.
When allocating to an illiquid alternative like private equity, for example, an investor is really looking to achieve three things: diversification away from equity risk, decent returns and for those returns to be risk adjusted, Sager said.
Risk within Canadian pension portfolios is heavily concentrated in equities. “When the macro environment is more malignant, when you’re heading to, or flirting with, a global recession . . . the equity performance is going to be much weaker, much lumpier, much more episodic. The traditional equity-concentrated portfolio is going to struggle. So we need to diversify away from that concentration. And that’s the first reason why alternatives have been embraced so strongly by investors.”
In addition, illiquid alternatives, like private equity, typically provide value to pension funds by artificially smoothing their own volatility, he said.
However, a move into private equity doesn’t necessarily create any real added diversity in the portfolio if the goal is to move away from the exposures contributed by the public equity component, Sager noted. “Private equity doesn’t really offer any significant diversification benefit. The very concentrated 60/40 portfolio is not much less concentrated having allocated a little but of capital away to private equity.”
As well, as evidenced by their performance during the financial crisis, illiquid alternatives don’t necessarily provide as much protection in a severe market downturn as investors might expect, he added.
Another challenge is illiquid investments often involve multi-year waits for capital calls, and it’s difficult for investors to find ways to keep the needed capital in cash or easily liquefied investments like public equities. “To have a complimentary allocation to return-enhancing liquid alternatives is a great idea,” he added.
Liquid alternatives can include an extended universe of strategies, he noted. Broadly defined, they are best-in-class hedge fund strategies that can combine a mixture of traditional and alternative assets, like equities and other derivatives being used cohesively, he said, highlighting they’re characterized by having daily liquidity, low fees and more transparency than illiquid alternatives.
From a risk perspective, liquid alternatives typically target risk that is similar to fixed income allocations in portfolios, so bond-like risk, but in the current environment they can achieve much more attractive potential returns, he said. Various hedge fund strategies also provide more diversity when compared with illiquid private equity, Sager noted.
As such, macro-fundamental multi-asset strategies using liquid alternatives could be a better way to achieve some the characteristics long-term investors want from alternatives generally, he said.
“These strategies . . . typically mix best in class hedge fund strategies, so long-short investing, as well as traditional long-only, applied to a range of traditional and alternative asset classes,” he said. “But they do something different to hedge funds . . . importantly, they give daily liquidity, low fees and much more transparency around holding and objectives and investment processes.”
That said, massive investors like the Canada Pension Plan Investment Board need to allocate to private equity since they’re too big to capture the risk factors found in the small and even mid-cap equity markets, he said. “An allocation to private equity for the mega funds makes a lot of sense. But the smaller plans, perhaps a complimentary direct allocation to small and mid cap may be more efficient, a lower fee way of harvesting the return opportunity that’s being captured by private equity.”