Pension Funds Chasing Illiquid Assets
What's driving them is a mystery for some.
May 5, 2011
Despite searing losses during the financial crisis, institutional investors are still convinced of the value of alternative investments in the investment portfolio – at least that’s what consultants think. And what’s more, the illiquid investments that proved so troublesome – at least on a mark-to-market basis – are now being eyed as inflation hedges, according to a survey by Casey Quirk and eVestment Alliance. That’s the fifth annual survey they’ve conducted among North American pension plans.
To be sure, alternative investments have regained favour in institutional circles. A March survey of public pension funds worldwide by Preqin indicated that exposure to hedge funds had doubled, but from a very low base. So current exposure is 6.1%. Nor are investment expectations very high – probably lower than what seems to be the 7.5% return assumption by many public pension plans. (CalPERS – the huge California state employee retirement fund — kept its discount rate at 7.75% in March, at least in part because a lower rate would mean more contributions from public-sector employers.) According to Preqin, they expect a rate of return of 6.1%., which these days is pretty close to a what seems to be a standard assumption among many plan sponsors: 4% over CPI.
On that score, Casey Quirk reports: “Appetite for hedge funds continues to rise. Consultants expect the most search activity to center on hedge funds during 2011, although a growing number of large investors will turn to more direct mandates, using funds of hedge funds for specialist portfolios instead of core hedge fund exposure.”
That’s part of a desire, first of all, to get excess returns from non-correlated assets. But it also reflects inflation worries. “More than one-half of consultants expect increased search activity for inflation-hedging strategies; more than a one-third anticipate boosted mandates for liability-driven portfolios in 2011.”
It changes the mix of actively managed portfolios considerably. Where once alternative investments were contained in a box that included hedge funds, real estate and private equity, that box has opened to include commodities and illiquid investments, while the equity and credit/bond boxes are including long/short investments.
Explains Casey Quirk: “These new portfolio construction strategies continue to underscore longer-term implications for fund managers servicing North American institutional investors:
• Managers offering non-correlated investments will realize the most success in winning mandates.
• Firms offering both “traditional” and “alternative” investments will stand the best chance of providing institutional clients with a total portfolio solution.
• Product development and innovation will remain critical competitive differentiators.”
Still, the illiquid investments represent a bit of a puzzle. But according to the consultants Casey Quirk surveyed, who together advise on $10 trillion in assets, there is “[m]ore demand for unlisted investments, driven by rising inflation and longevity fears among North American institutional investors. Consultants believe private equity and real estate search activity will increase substantially, particularly among corporate and public defined benefit pension plans of all sizes, many of which are struggling to ﬁnd ways to execute liability-driven investment strategies.”
The inflation fears appear to predominate. “Inﬂation risk drove increased search activity for commodities managers in 2010, as investors sought real assets. Consultants expect this trend will broaden in 2011 to embrace a wider array of illiquid,longer-dated asset classes, such as property and private equity, which are more immune to inﬂating currencies. Respondents expect search activity in private equity to focus on niche strategies rather than large buy-out funds. Such fears are particularly palpable among U.S. corporate deﬁned beneﬁt plans. Nearly all consultants focused on corporate DB plans expect a signiﬁcant focus on inﬂation-related search activity in 2011.”
Many of us are old enough to remember the inflation of the 1970s – and the high interest rates imposed by central banks not just through the 1980s, but well into the 1990s. But does looking at the rear-view mirror mitigate the risks barely visible through the windshield? What does lie below the hill ahead? A market trough? A pool of water? Or a desert of illiquidity?