Alternatives: Losing their shine?

3 Apr 2018

Has the rising popularity of alternative assets damaged the investment case? Charlotte Moore takes a look.

“There are measurement issues surrounding some alternative assets.”

Tapan Datta, Aon

The popularity of alternative investments shows no sign of abating. Seven out 10 investors told a recent survey that it is essential to invest in these assets to diversify portfolio risk, while more than half of those questioned (57%) believe they are necessary to outperform the broader market.

The appeal of these assets is being driven by a number of trends. The survey indicates that some want to diversify their portfolios to better manage risk. Others are looking for assets which could provide income-like returns so they can move away from a portfolio segregated between liability-matching and growth assets. And some are simply looking for assets which provide superior returns than equities or bonds.

But the popularity of alternatives among institutional investors is altering the investment characteristics of these assets. There is already evidence this is becoming a sellers’ market: yields on infrastructure debt look lacklustre and loan covenants have been weakened.

The distortions of the private debt market are particularly important because this has been such a popular asset class. Aon global head of asset allocation Tapan Datta says: “Not only have returns been weakened but the risk characteristics of this investment have also changed.” A pension scheme financing loans today needs to be much more careful than one allocating to these markets five years ago, he adds.

A sovereign market

Rising prices also mean investors need to pay more attention to valuations. The cardinal rule still applies: no matter how attractive an opportunity appears, if the price isn’t right, it will not be a good investment. It appears occupational pension funds are in danger of making this mistake, especially when compared with sovereign wealth funds’ (SWF) activity in this sector.

State Street Global Advisors head of policy & research Elliot Hentov says: “SWFs have allocated to these assets on a fairly consistent and rapid basis over the past decade.”

Hentov and his team estimate they have invested around $1.6trn in alternatives and the total market is around $10trn. In other words, SWFs hold around 15% of the global market.

“We do not expect to see significant additional in-flows of capital from these investors: allocation has now peaked.” The average SWF has an asset allocation of 30% to alternatives, he adds.

The investment activity of SWFs is significant because these large institutional investors are often trend-setters. Hentov says: “These funds can be more nimble because they have fewer governance and balance sheet restraints than pension funds.”

As first movers, a halt in significant SWF allocations to a particular asset class is an important message for other institutional investors: it signals that these investors have reached their allocation peaks.

But it might still be worthwhile for pension schemes to allocate to alternatives. For example, a pension scheme might want to match a 20 or 30-year liability with a real asset. “This is still an appropriate investment even if valuations are somewhat excessive because it would at least provide a predictable income stream,” Hentov says.

He adds that valuations may not be the primary concern for a pension fund. “Depending on the scheme’s strategic goals, different asset classes in different proportions can play a valuable role in a portfolio.” Alternatives might, for example, mitigate the risks in a fund through diversification.

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