Alternatives: Investors cannot deliver on promises

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Pension plans are on the verge of a big move into riskier, illiquid investments to deliver promised returns; they might be better advised to curtail those promises.

For the past 10 years, Pyramis Global Advisors, the institutional fund management arm of Fidelity that manages money on behalf of pension funds around the world, has conducted an annual survey of its customers’ most pressing concerns. In recent years, these have been dominated by the immediate worries of how to minimize losses in crisis-stricken financial markets exhibiting extreme volatility.

The latest survey, released last month, shows these short-term worries are finally receding. The number of respondents to the Pyramis survey from outside the US has grown quickly in recent years. The latest carries opinions from senior management at 300 US pension plans, 90 from Canada, 150 from Europe and 90 from Asia, together responsible for $5 trillion in assets. Only 16% of them see risk management as their biggest concern today and only 19% cite market volatility. Most have tightened up processes, review risk measures more frequently, have embraced more tactical asset allocation and have required more transparency from managers. Let’s hope this is not a sign of complacency before markets crash once more.

And even if it is not, a much more fundamental and even more worrying concern now dominates. These pension plans have been promising returns ranging from 8% in the US, 5% in Europe and much of Asia, to 3% in Japan. These promised returns aren’t much changed from the start of the financial crisis. More and more investors are confronting the reality that they aren’t going to hit those returns over the next five years. More than half of respondents in Europe say they won’t make it, as do 40% in Canada and 30% in the US and Asia. Today, the single top concern cited by pension plan sponsors is not volatility risk but rather the low-return environment, which is partly driven by central bank policies of financial repression, offering zero returns on low-risk instruments and so daring investors to supply more risk capital.

You can see the process at work right now in the debt capital markets where managers are throwing cash at high-yield bond issuers and even subordinated bank debt.

In the longer term it seems inevitable that the largest and most conservative conventional real-money managers in the world are going to tear up the traditional asset management frameworks based on conventional equity and fixed-income allocations and chase yield. The Pyramis survey suggests that the single-biggest shift, cited by 38% of respondents, will be into illiquid alternative assets. Euromoney reported in September on the increased willingness of investors including insurance companies and pension funds to monetize their capacity to absorb illiquidity by buying the privately placed debt of unrated corporations. This trend might grow even faster than widely assumed, if companies are not going to make up expected pension fund shortfalls out of profits. Many investors will do this only for listed companies but will typically be placing trust in the proprietary internal ratings of banks arranging the placements. Caveat emptor.

Young Chin, chief investment officer of Pyramis Global Advisors, adds that investors might go into more hedge fund vehicles with longer lock-ups and less transparency and mentions a few other likely shifts, such as into real estate and more aggressive allocations within asset classes, for example reaching further into small-cap and emerging market equity. A number of survey respondents are also thinking about more concentrated equity exposures.

There is plenty here to whet the appetites of hedge fund managers and investment bankers. It might be that some of their businesses supposedly under threat will fare better than expected: derivatives trading for example. Pyramis was surprised to find that 73% of pension funds in Asia, 70% in Europe and 60% in the US already allow managers to use derivatives. And this use might increase as a means to extend duration, enhance returns and adjust beta in the traditional asset classes.

Whether many of the workers paying into those pension schemes will ever actually benefit from this embrace of more and new types of risk remains to be seen of course. It might be better, though still painful, to reduce promised returns while keeping risk under tight control. A zero return is better than a big capital loss. Expect plenty of horror stories.