Edition: August/October 2018
Good reasons why this under-invested asset class rapidly comes into its own, says Pawan Singh. He’s the Head: Alternative Investments / Multi Strategy at Sanlam Investments.
As fiduciaries we constantly ponder the environment of ‘lower returns for longer’ that currently face investment managers and retirement-fund trustees. A popular and recurring solution is to look further afield at what the rest of the investments universe has to offer; in other words, to seek out alternative investment options.
Alternatives include private equity (buy-outs and venture capital), private debt (loans), infrastructure-funding debt vehicles, hedge funds, unlisted credit and derivatives. These all have the potential to provide higher-than-average risk-adjusted real returns.
Moreover, alternatives do not only yield financial returns but social returns as well. By investing in alternatives you can play an active role in uplifting the economy and, in turn, benefit your future members.
Debunking the myths
As children we were taught by our parents not to trust things we don’t understand. We often carry this philosophy with us well into adulthood. By the time we are approached with new information about a subject, we have often allowed many misinformed myths to feed our hesitation, even though technological advances have made sharing information on such subjects easier and more accessible.
Similarly for trustees, many misperceptions may have kept us from allocating towards alternatives, as on average alternatives only receive a 2% allocation from pension funds (noted recently by the Southern African Venture Capital & Private Equity Association). This may have made sense during a time when Regulation 28 only allowed for a 5% allocation to alternatives (meaning that by allocating 2% you were in fact making use of just under half of the available allocation).
But since 2011, Reg 28 has been amended to allow for a threetimes higher allocation at 15%! And yet, many SA retirement portfolios remain reluctantly behind the trend, clinging onto the wisps and slivers of myths surrounding alternatives.
A pioneer for use of alternatives in the international space is Yale University. It has an endowment fund, similar to a pension fund, which manages money with a long-term investment horizon. In 1985 David Swensen became its chief investment officer. The first question he rightfully asked himself was: “With a multi-generational investment horizon, why should I not increase alternatives in my portfolio?”
He then introduced alternatives to the endowment fund at about 10%. In 2017 this allocation to alternatives is sitting at a striking 70%, with only 30% in liquid assets.
This hypothesis was further supported by Harvard University which follows a similar policy with its endowment fund. There is also evidence of an increasingly higher allocation to alternatives in emerging markets, especially by sovereign wealth funds, where the average exposure to alternatives is close to 23%.
Why has this thinking not been adopted sooner in SA?
For many decades SA pension funds did extremely well by simply investing into traditional asset classes, so there was no compelling reason to look any further. However, over the past five years these traditional (listed) asset classes have no longer been yielding real returns that are as attractive. Trustees therefore been forced to look deeper and explore alternative investment options.
But a negative perception of alternatives as “high risk” hasn’t helped. If anything, it has shrouded alternatives further in mystery. When trustees start looking at investment decisions, we generally have a mindset of measuring risk as volatility: if my investment horizon is long-term then I put more money into equities, or if I have income needs, more must go into fixed interest and bonds.
However, when it comes to alternatives, conversations usually start with the topic of liquidity, or the lack of liquidity. The irony is that the most illiquid asset classes happen to be the most stable because of their contractual-return nature.
A simple example is infrastructure assets. They typically have a term of 15 to 20 years with offtake agreements that are contractual in nature and have little market risk. So in this case a high level of illiquidity does not mean a high level of risk. If anything, it means low risk. For portfolio construction, such assets are a highly stable component that can be used to match long-term liabilities.
A general lack of knowledge also appears to be a common reason for resistance to alternatives. This was further enhanced by the difficulty in scheduled robust reporting on alternatives. The performance of more traditional assets such as stocks is easy to track; just log onto Bloomberg.
But alternatives are subject to what is known as ‘stale pricing’ (a time-lag in pricing due to quarterly, less frequent reporting and subjectivity in valuation for asset classes such as private equity). This time lag creates a degree of ambiguity as returns and volatility are not as easy to quantify. Fortunately, we’ve developed robust approaches to deal with this problem. They combine real-world and academic research to accurately evaluate alternatives to approximate ‘real time’ pricing.
Instead of shying away from the world of alternatives, trustees should be encouraged to request more information from their industry partners.
Longer term, less liquid alternatives provide significant returns
The long investment horizons of alternatives actually align better with pension funds (which also have longer investment horizons) than several of the more traditional assets. And given that the average retirement fund has a long-term investment horizon, the need for high liquidity (or access to cash) should not be a discouragement at all.
Further, in the current low-return environment we can all benefit from the significant ‘illiquidity premium’ that you get as added compensation when you invest in an asset class that cannot as quickly be converted into cash.
Shake off the myths!
It is essential that as an industry we actively move to demystify the perception that alternatives are high risk when in fact they could provide fruitful returns over the long term as a stable counterpart to more traditional assets. We must upskill ourselves to realise that alternatives operate in the real economy. Alternative investments can go a fair way in helping to create jobs, resolve infrastructure bottlenecks and promote financial inclusion.
It is time to get rid of the myths, and move to benefit our retirement-fund members, by offering more diversified portfolios that provide incremental risk-adjusted returns that blend alternatives into traditional portfolios.