Farrakh Ashraf has kindly agreed to contribute the following blog to the Dalriada Trustees’ website. Farrakh is an Investment Consultant with KPMG. He has over 5 years’ investment consulting experience. Farrakh has an MSc in Finance from the University of Strathclyde and a MA in Economics with Business Economics from the University of Glasgow. He is also a Chartered Alternative Investment Analyst.
The significant majority of UK pension schemes have increased the diversification within their ‘growth’ portfolios, to varying degrees, over the last decade. Despite this, a number of schemes still have a high reliance on equity markets to drive investment returns.
This strategy has been rewarding over recent periods, with global equity markets returning 16.0%p.a. over the past 3 years. However, arguably, this strong equity performance has not been primarily due to material improvements in market or company fundamentals. Rather, performance has largely been driven by a supportive environment being created by central banks engaging in quantitative easing and loose monetary policy, with an aim of aiding an economic recovery following the global financial crisis.
There is debate on whether equities can continue to increase in value over the medium term, as factors such as central banks (especially the US Federal Reserve) revaluating their economic policies and equity markets looking at least ‘fully valued’ on a number of metrics used by financial market analysts, are lowering expectations on whether investors can continue to gain similar returns going forward.
My view is that returns are unlikely to be as strong as they have been as we move to a less accommodative environment, where exceptionally low volatility in equities compared to historic levels, is unlikely to persist. I therefore believe there is a strong argument for reducing reliance on equities to drive growth at the current time.
Hence consideration should be given to making equity focused investment strategies more robust to withstand a wider range of future scenarios (such as a fall in equity markets) and limit downside risk.
One way of reducing this downside risk; without damaging expected return of a portfolio (and indeed potentially enhancing it) is by substituting some of the equity exposure into ‘Alternative’ investments.
What are alternative investments?
Alternatives is a general term used to bundle a range of asset classes that do not fall under the traditional equity, bond or cash category. These assets can be very different in terms of underlying investment rationale and return profile due to this wide definition.
For example, some asset classes are utilised primarily for their return generation abilities; whilst others are included in portfolios because they provide superior diversification benefits, which reduce overall risk.
Alternative asset class strategies are also based on extensive ‘active management’ (i.e. manager skill is key in producing returns, as opposed to strategies which are passive and rely on market returns for the majority of performance).
Some of the mainstream asset classes that fall under the alternatives umbrella include: Private Equity, Private Debt, Infrastructure, Commodities, Hedge Funds and Insurance-Linked Securities.
One of the key distinctions between traditional asset classes and alternatives, such as the asset classes mentioned above, is that the latter are illiquid in nature i.e. investor capital is locked up for a period of time (depending on the asset class) before it can be accessed (unlike liquid asset classes, such as equites and bonds where investors can invest/disinvest on a daily or weekly basis). This ‘lock up’ period can be seen as a major drawback of these markets for some investors.
However investors are compensated for the risk of taking on this longer holding period by being offered an expected premium over traditional asset classes, referred to as the ‘illiquidity premium’.
Importantly, as long term investors, pension schemes have the ability to exploit this illiquidity premium to its full extent.
In my view, despite having the advantage of a long term investment horizon, a significant number of pension schemes have not utilised this position to an optimal degree (with most behaving like short term investors that can liquidate the majority of their holdings within a week) and continue to have ample scope to access attractive opportunities in these markets, in order to improve the risk and return position of their portfolios.
In sum, I believe that those pension schemes that have not allocated (or made material allocations) to alternative assets should seriously think about diversifying some of their exposure away from equity risk, as these asset classes allow investors to:
- Increase diversification;
- Help achieve fund return objectives through a high degree of active management from investment managers;
- Reduce the overall volatility of portfolios in current market conditions.
(Please note, the views expressed above are my own and do not constitute formal advice.)