1st November 2006

Between a rock and a hard place

Author: Amin Rajan

Inherent in alternatives is the herd mentality that thrives on new lingo, fear and greed. For investors, they offer a stark choice: follow your convictions or follow the herd. Pension funds are creating a third way by enjoining their consultants to get ever closer to strategies that have not yet been stress-tested. That is easier said than done, argue Amin Rajan and Janette Shaw of CREATE, a UK-based think tank.

Worldwide – especially in the US – pension funds have shown a keen interest in alternative investments owing to a set of mutually reinforcing factors: like the equity bear market of 2000-3, heightened investor interest in uncorrelated returns and the much publicised flow of top talent into absolute returns strategies.

Accordingly, new money has flooded into alternatives. The cash sums involved may well double the size of the three sectors that have hitherto dominated the alternatives by 2008: private equity, property and hedge funds. This much is clear from a research report published last year by CREATE and KPMG*.

Focusing on hedge funds, the report found that earlier resistance on the part of pension funds is weakening as the strategies pursued by hedge fund managers have become less opaque, while partnering with external administrators to do their independent valuation, processing and monitoring.

In part at least, this weakening is underpinned by changing attitudes of pension consultants, according to four separate sets of respondents to the study’s global survey: pension funds, hedge fund managers, mainstream fund managers and external administrators (see figure). As consultants have come to see the benefits of absolute returns, they have - and will continue to - become less risk averse over the period 2005-8.

Welcome though this development is, consultants’ interest in alternatives is a double-edged sword.

Pension funds’ disillusionment with mainstream asset classes is all too well known. Few pension funds now believe that their current funding gaps can be bridged by old style reliance on domestic equities and bonds. They have started to diversify, for sure.

In the process, pension consultants have been forced to enhance their expertise over a wide range of alternatives, by paying special attention to product characteristics such as risk, volatility, liquidity, transparency and simplicity. They are also honing their instincts on manager selection, risk management and performance monitoring. They are scouting for talent in different parts of the world. Above all, they are trying to restore their credibility after a severe reputational blow for over-exposing their clients to equities before the last bear market.

On the downside, consultants recognise that most of the strategies in the alternatives space carry two health warnings: they have yet to stand the test of time and they are of a zero sum nature.

For example, the first generation of pension fund investment in hedge funds, mainly in the US, reaped handsome returns over the period 1998-2003, only to see them fall sharply as the new wall of money swamped the available prime capacity. Similarly, few analysts believe that the current boom in private equity and property is sustainable. Pension funds are coming in at a time when most of the upsides may well have evaporated. Because of their internal governance structures, pension funds have far longer time lags when implementing their targeted allocations to alternatives than other investors.

As a result, the familiar prime mover advantage rarely accrues to them. Pension funds’ interest in hedge funds peaked in early 2005. By that time, less than 6% of hedge fund managers, out of over 8,000, were producing decent returns: the rest were ‘wannabes’ and ‘has-beens’. Notably, the successful ones ran life style businesses which were unscalable, partly because of the nature of strategies they adopted and partly because of the personal preferences of their owners.

This raises a paradox: in search of high returns, pension funds are diversifying into un-correlated asset classes; yet only a few of them are scaleable. In turn, their consultants are forced to develop expertise in areas where arbitrage opportunities disappear just as fast as they are discovered. As a result, when the next down-turn occurs, the scale of losses from alternatives could be huge, according to some observers. After all, the value of alternative assets has doubled to US$3 trillion in less than 5 years, according to the latest estimates from JPMorgan.

To their credit, consultants recognise that swimming with the tide carries enormous risks to their own businesses, at a time when their influence has been waning in many countries outside the UK. But as one of them put it to me, “going into alternatives is not our first choice; or last choice. It’s our only choice”. It is driven by three factors.

The first of these is the secular emergence of investment banks on the pension landscape. Until recently, pensions were seen as an HR issue. Thanks to regulatory and accounting changes, they have become a financial issue. With their close links with CEOs and CFOs of large companies, investment banks are well-placed to design and implement solutions that immunise some of the risks that would otherwise be carried on the balance sheets of plan sponsors. Such solutions range from providing structured products to fiduciary management that expressly elbows out the traditional consultants. Fiduciary management, pioneered in the Netherlands, is attracting interest from pension trustees across Europe. It is potentially the biggest competitive threat to established consultants.

The second threat comes from the ascendancy of multi manager arrangements worldwide, attracting medium and small pension funds. By forming alliances with the best of breed product providers, such arrangements are providing one-stop-shop solutions similar to those increasingly available from fiduciary managers.

The final threat comes from large fund managers, who are increasingly offering strategic asset allocation services, alongside their tactical asset allocation products to pension funds. In the Netherlands and Sweden, such managers are forming strategic alliances with pension funds and engaging in joint investments. In sum, the taboo that ensured an arm’s length relationship between the two parties is fading into history. New alignments are emerging, while the old ones are being re-moulded.

Thus, it is clear that the pivotal role once enjoyed by consultants is under attack, as pension funds seek out new ways of plugging their ‘black holes’.

To stay ahead of the game, consultants are developing new tools and expertise that can help them to retain their distinctiveness and add value. But their task is made all the harder by the pension fund governance practices that undermine agility and nimbleness.

After all, history tells us that, more often than not, alternatives reap returns for prime movers. Not surprisingly, it was the high net worth clients and, to a lesser extent, large foundations that benefited most from the spectacular returns from hedge funds in the last ten years. In the absence of a track record, such investors relied on their own convictions. Their less onerous fiduciary obligations were more of a help than a hindrance. Pension funds, in contrast, have far less latitude.

Hence, the biggest challenge for their consultants is to identify those investment professionals from the property, private equity and hedge funds universe who have an acceptable pedigree and sustainable capability to replicate returns that are consistent with the expectations of their conservative clients.

As if that is not challenging enough, they also have to develop the foresight to predict the success rate of new investment strategies as and when they evolve. For example, many hedge funds strategies often hit capacity ceilings or go out of fashion for a variety of reasons. Their managers therefore need to invent new strategies commensurate with the inflow of money. In turn, consultants need sound gut instincts on what works, what doesn’t and why.

These are formidable challenges. In the 1990s, when investment strategies were focused on domestic bonds and equities, consultants mainly considered macro factors such as asset allocation and economic outlook. With alternatives, consultants have entered a new world of granularity and transparency; a world in which the boundary line between judgement and luck is as clear as black and white.

*Hedge Funds: a catalyst that changed glogal investment, available from www.create-research.co.uk