Are alternatives proving their worth in volatile markets?

Most schemes hold a variety of alternative assets – such as hedge funds, property or farmland – alongside growth and matching assets in their portfolios to make them more resilient in the face of market upsets.

John Walbaum, head of investment consulting at Hymans Robertson, says: “The principle of this is that it’s not so much trying to seek return – it’s trying to make them more stable.”

Walbaum says that at times correlation between alternatives and more traditional assets have been quite high, but maintains a well-diversified portfolio is still worth the effort.

He adds that even with seemingly improving economic conditions, diversification is still worth pursuing.

“If you look over the credit crunch, equity markets have pretty much gone straight up – with a few blips,” he says. “There are concerns over whether the price of equity markets are high compared to fundamentals, and how that might unwind.”

Varying degrees of correlation combined with limited investment opportunities in many of the most attractive assets have sparked a lot of debate around where schemes should look for value.

Reputational damage

Alongside this, asset classes such as hedge funds have suffered reputational damage. Investors are less willing to tolerate the lack of transparency following the credit crunch.

This, coupled with lacklustre performances, has led a string of high-profile pension schemes to reduce their allocations or disinvest entirely.

Phil Edwards, European director of strategic research at consultancy Mercer, says the Vix volatility index has been low in the recent past, potentially damaging returns.

“The one area where it is a bit more of an issue is hedge funds – some have highlighted the low-volatility environment as being challenging to their strategy,” he says.

These challenges have led to a number of providers developing novel ways of accessing hedge funds. Olivier Cassin, head of UK institutional sales for Lyxor Asset Management, says: “Hedge funds are an ugly word for many pension funds because of travel [offshore assets], illiquidity and opacity.”

He adds that use of platforms that followed and imitated trades made by hedge funds could offer similar returns but with better transparency and liquidity for investors.

“The alternatives industry has structurally changed,” he says. “Large alternative managers have negotiated discounts – advisory fees are dramatically lower.”

Alongside this, Walbaum says many of the larger schemes would look to build their in-house capability, giving greater control and complete transparency while still allowing them to capitalise on the illiquidity benefit.

“A lot of these strategies rely on skill,” says Walbaum. “In terms of pension funds the very big funds will look to build their own exposures. They can do it in quite an illiquid way.”

Another side effect of the credit crunch, says Walbaum, has been the reduction in lending by banks, creating opportunities for pension funds to take advantage of demand.

“Pension funds can take that on and create lending for business,” he says.

“The reason this is attractive is investments tend to be floating rate subject to defaults – they give predictable cash flows.”

Despite the changing appetite and appeal of different asset classes, Edwards says schemes should avoid changing their overall strategy with regard to diversification.

Edwards says: “The arguments remain the same as they have done for a long time: diversify by strategy and philosophy… the age-old principles remain sensible guidance for pension schemes.”