Investing in alternatives: Opportunities and obstacles

Many have some exposure to alternative investments, either directly through dedicated allocations or indirectly through investments in diversified growth funds.

While certain alternative asset classes are reasonably simple to understand, many are complex and require a much deeper comprehension before investors commit capital

Property, commodities and hedge funds were popular pension scheme investments, but over recent years we have seen the emergence of other alternative asset classes gaining traction among pension scheme investors. Examples include infrastructure, private debt, timberland, farmland and insurance-linked securities.

Attractive returns

While returns vary across alternative asset classes, a key reason for investing in alternatives is the potential for high risk-adjusted returns.

Return expectations will vary according to the riskiness of the underlying investments but in the main, alternative asset classes can provide attractive levels of return, both on a standalone basis and relative to transitional asset classes.

There are risk premia available in many alternative asset classes that are typically unavailable in most traditional asset classes, namely illiquidity and complexity premia.

The income that many alternative asset classes generate is often more attractive than the income available in public markets, so can help pension schemes meet their cashflow obligations.

Alternative investments are complementary in nature to traditional asset classes, and the returns on offer often display little or low correlation to these asset classes, particularly equities.

A key benefit of investing in alternatives is the diversification that allocations can bring to an overall pension scheme portfolio, which can help reduce overall portfolio volatility and make funding levels more stable.

Furthermore, certain parts of the alternatives market are more aligned with responsible investing, an area that is growing in importance to pension schemes.

It is easier to assess the benefits that investing in property, infrastructure and other real assets bring relative to less tangible asset classes.

Illiquidity and complexity can prove problematic

Investing in alternative asset classes can be hugely beneficial to pension scheme portfolios. However, there are also obstacles that need to be considered.

Choosing what alternatives to invest in is tricky due to many asset classes lacking a long history of performance, particularly over multiple market cycles, while traditional performance analysis techniques cannot be applied to many alternatives.

This means that narrowing down what alternatives to allocate to can be challenging.

Furthermore, alternatives are typically less liquid than traditional investments, so careful consideration should be made on the size of the investment and the liquidity that the pension scheme will require in the future.

It can take years to receive your money back from some illiquid alternatives. Truly long-term investors, ie those that can tolerate this illiquidity, usually benefit most from the illiquidity premium available.

Complexity is also an issue. While certain alternative asset classes are reasonably simple to understand, many are complex and require a much deeper comprehension before investors commit capital.

This may put many off venturing into these types of investments and prevent them harnessing the complexity premium available from many alternatives.

Manager selection crucial

We are seeing more investment managers providing alternative asset class solutions, but this increased supply does not equate to increased quality, so manager selection is key.

Investors can be put off by the fund structures available, particularly closed-ended fund structures where capital may not be invested for years after the initial commitment.

In addition, some alternatives can be assessed using listed equity markets, although this can reduce the diversification benefits over the short and medium term.

These implementation considerations, coupled with the illiquidity of alternatives, make it very difficult for some investors, particularly defined contribution pension schemes, to make significant allocations to alternatives.

Alternative asset classes are generally expensive to access, despite downward fee pressure over recent years.

Many funds also charge performance fees on top of management fees, so investors with greater fee sensitivity are often discouraged from investing in such structures or forced into cheaper (and sometimes inferior) alternatives.

We see the popularity of alternatives continuing to grow significantly over the next few years, and expect the range of solutions available to soar.

Adam Porter is an associate investment research consultant at Hymans Robertson