What lies beneath?

24 Jun 2019

Many of the first investments made by pension funds through history were likely to have been in real assets.

Romans, who first issued annuities to retiring centurions, are likely to have used the returns or profits on their investments in roads, viaducts and the range of other infrastructure for which they are famous, to meet their liabilities.

For today’s pension funds, the story is coming full circle. After a century or so of dabbling in the stock markets, with varying degrees of success, investors have returned to real assets with gusto.

BlackRock’s institutional investor survey, published in February, showed a significant portion of institutions controlling around $7trn in assets intend to increase their exposure to real assets (+54%) and real estate (+40%). This, the world’s largest asset manager said, “continues a multi-year structural trend of clients re-allocating risk in search of uncorrelated sources of return”.

Aside from public pension funds, which are mostly still open to new members and future accrual, more mature corporate schemes around the globe also planned to increase illiquid investments, BlackRock said. Some 47% reported wanting to increase real asset holdings and 35% sought to boost real estate exposure “to bolster their growth portfolios”.

Defined contribution (DC) savers, too, are being enticed towards these asset classes that historically have been seen as unsuitable, as the UK government – among others – have noted how useful this “patient capital” can be.

Illiquidity, once something feared by institutional investors, has become something increasingly looked upon favourably for the premium it can offer.

But while there is an undeniable shift, unlike our ancestral investors, pension funds today have a good deal more to mull over before diving into an illiquid investment.


Bob Collie, head of research at Wills Towers Watson’s (WTW) Thinking Ahead Group, has been advising pension investors since the mid-1980s on how to grow their capital to meet liabilities. He has seen investors buying into various types of infrastructure assets over the past 10 years and testing how they work on a buy/sell/operate basis. He has seen the asset class grow from a niche area to “an increasing part of the
opportunity set for large investors”.

“Infrastructure is one way of doing it as there is a huge infrastructure need in Europe, the US, emerging and other developed markets,” Collie adds.

The array of assets on the market is considerable and governments around the world, who might usually have been liable for funding their construction and maintenance, are increasingly at ease with letting someone else foot the bill.

“However, these assets need to be considered using a different scale,” Collie says. “Investors need to look beyond just the return profile and break out from the two dimensional mindset many have been trained to take.”

Rather than just plotting out the potential purchase and selling price, and how long a security might take to sell, investors need to take a more holistic view.

“There are political risks to consider around governments, for example,” Collie says. “These assets are multi-dimensional. They are still attractive, but require proper and skilled analysis, taking in a wide range of factors before committing.”

Kevin Wade, chief investment officer at SAUL Trustee, has seen more investors – and those offering them products and funds – moving into infrastructure and other real assets over the past 10 years.

The SAUL scheme, which has more than £3.3bn in assets and is still open to new members, had just over £100m in pooled vehicles that invested in infrastructure as of March 2018, with a further £114m in real estate, according to its annual report.

Wade and his team are well aware of the wide range of risks associated with real assets that may not come into play with listed instruments.

“We stick to developed markets, partially due to political and government risk,” Wade says. “But we are also aware of the risks closer to home, due to the announcements by the Labour party about renationalisation of key national infrastructure.”

For Collie, the institutional investors that made up the first wave of allocations were typically very large and well resourced. “There is a danger that the second wave may see their success and jump in without the same recognition of the uncertainty and demands,” he says.


For Richard J Tomlinson, deputy chief investment officer of Local Pension Partnership (LPP), there is an additional risk many investors are not appreciating, and one that has been exacerbated by the shift in institutional portfolios to illiquid assets and the fall out of the financial crisis.

His concern is about liquidity risk and the multiple layers of this liquidity in financial markets that are going to be important over the next few years.

“Public markets have evolved, and the provision of liquidity has changed in the short term,” Tomlinson says. “Now the banks, which used to be the primary suppliers of market making capital, because of the regulation after the crisis have largely gone.” Under the Volker Rules, implemented after the financial crisis with the intention to make markets safer, banks were made to close down proprietary trading desks.

These desks, along with carrying out other functions, would provide underlying liquidity in markets and often trade securities other participants would not touch.

Add this to a decade of quantitative easing from the world’s central banks using up most of their firepower to keep markets and economies afloat, and Tomlinson fears markets may be entering a new liquidity crisis. Above all, he is concerned those running risk management programmes are failing to address the issue.

“It changes the liquidity profile of markets (and investors’ portfolios) dramatically,” Tomlinson says. “As liquidity dries up, at a portfolio level, will institutional investors get caught? There are different risks that come into play by investing in illiquid assets rather than just in public markets – and one is what happens to public markets as a result.”

For Tomlinson, institutional investors need to understand – or at least address – where the “crash barriers” in financial markets are in 2019 and how they are functioning.

There is some evidence for this concern. In December, on the back of some painful, if not unreasonable, economic data from the US, global stock markets crashed, wiping out much of their gains for the year.

With fewer players in the game, and those players being less willing to take market risk or get involved on a day-to-day or even moment-to-moment basis, it makes sense that liquidity has dried up somewhat.

World Federation of Exchanges’ (WFE) figures show that the number of stocks traded in the US, which is a proxy for global liquidity, fell 30% in the decade to the end of 2018. This figure is reflected globally, too, and may give evidence of fewer people operating in the market.

“Now, in a systemic dislocation, where does the stabilisation capital come from?” Tomlinson asks. “Bank prop desks are largely gone, hedge funds, which have around $2tn, may be able to play, but what about institutional investors? Might they be willing to deploy capital in scale and at interesting pricing?”

But if their assets are already allocated to the billions in illiquid assets, it might not be possible.

Collie at WTW says that institutional investors had not traditionally been cast in this “buyer of last resort” role, but as other sources of liquidity leave, some have considered asking them to step in to provide it. “It is happening as asset owners are more willing, but it is slow. It has been able to happen as investors have become more dynamic in how they allocate assets. No longer is it a stationary 60/40 split.”

However, Collie highlights another question around whether these investors would be the right choice at all.

“Using Richard Bookstaber’s analogy that a shopkeeper would not reduce the price of a loaf of bread if it does not sell within 20 seconds of going on sale, when markets crash, it takes time for all investors to come in to buy,” Collie says.

Institutional, long-term investors may wait for a better price, which may make the situation worse and “act as a deterrent from them stepping in to provide liquidity”, Collie says, adding that for the moment, there are still plenty of liquid assets available. But the main limiting factor is more about whether they have governance structures that allow and enable them to step in to provide liquidity, Collie says.

There are different risks that come into play by investing in illiquid assets rather than just in public markets – and one is what happens to public markets as a result.

Richard J Tomlinson, Local Pension Partnership

This is something that Tomlinson and Wade have addressed.

As LPP builds out an internal team, it is targeting people with the skill set and experience of working in multiple complex environments who would be able to deal with and potentially exploit a sudden downturn. Wade, too, says that SAUL would be equipped dive in if there was a crash and put capital to work from the side-lines. He says that several market participants had warned that liquidity levels were not at the same levels as they were a decade ago.

With a 50% allocation to liability-driven investments, SAUL also has to manage its liquidity to ensure its collateral can back this complex mechanism. Being nimble in the event of market shocks is key. “If a crash looked likely, we would swap out of our active equity programmes and into futures and total return swaps,” Wade says.

“This way, we would not lose exposure, but have more available for collateral purposes.” Governance structures as developed as those run by LPP and SAUL may be vital in the near-term, as investors become forced to think further about non-listed assets. “If the number of listed companies keeps coming down – as it is in the UK and the US – investors will have to find new ways of accessing the economy and private markets are one way to do it,” Collie says.

In the 16 months to the end of April 2019, the number of companies listed on the London Stock Exchange dropped 3%, according to official figures. Since the start of 2008, the number has dropped almost 36%, a figure echoed around the globe, according to WFE.

Whether this move by companies has been the chicken or the egg for investors moving out of public market and taking some liquidity with them is almost a moot point – the shift is happening and investors must be ready as the waves of volatility have returned to a much shallower pool of capital. And as these waves return, just having an immovable object or real asset might no longer be enough.

“We are planning for a rainy day, so we can try and avoid being forced into any kind of fire sale,” Tomlinson says. “We want to be a provider of liquidity, not a demander of it. We want to be able to use our edge as a sophisticated long-term investor and our large, stable balance sheet in the event of something significant.”

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