Alternatives make gradual headway

Last July, the Woolworths Group Pension Scheme became the latest high profile name to set up an alternatives strategy, when it announced that 10% of its €450m portfolio would be placed in non-traditional asset classes.

This might reinforce the general perception that UK pension funds are ahead of the game in terms of using alternative investments.

But according to industry observers, the reality is somewhat different.

"I wouldn't say that UK pension funds are well advanced in this area," says Mike O'Brien, head of risk management, Barclays Global Investors. "There has been a lot of media coverage, but to say the industry at large has embraced alternatives is a bit wide of the mark."

Indeed, recent figures show that UK pension funds are no further forward than their European counterparts in terms of alternative assets as a whole.

The latest European survey of pension fund asset allocation carried out by Mercer Investment Consulting shows that it is indeed the case that UK funds are more at home with private equity: 22% of UK pension schemes with assets over €750m invest in this asset, compared with 12% in continental Europe and Ireland.

However, for hedge funds, the situation is reversed, with 13% of pension funds in continental Europe and Ireland investing in this asset class, compared with only 7% of UK funds.

The main reason behind pension fund reluctance in this area is corporate governance, says O'Brien, and the question of whether trustees have enough time to research all the available options.

"Against a background of regulation in terms of pension fund risk management, and an environment of European directives, trustees have to make decisions as prudent investors," he says. "This means there has to be an audit trail in terms of openness and understanding. So there is a natural headwind against trustees in terms of making fast, aggressive decisions."

However, O'Brien also points to two main areas of concern for UK pension funds: equity concentration, and interest rate volatility in the liability valuation.

"This has led to pension funds having to work out how they can hedge the interest rate risk," he says. "So there is an appetite to invest in bonds and swaps."

John Gillies, director, investment advice, Russell, agrees that the current level of interest in alternatives is very low; he reckons the average allocation is 4 - 8% of the typical pension fund portfolio.

"This reflects the fact that the progress of new ideas happens at a glacial rate," he says. "This is partly a result of the trustee process, but also the fact that trustees are apprehensive about being the first into anything new."

While UK pension funds may not be as far down the alternatives route as is generally thought, most commentators see a noticeable increase in their use.

Neil Walton, head of strategic solutions, Schroders, sees alternatives being considered as part of a wider diversification process.

"There is quite a big appetite for people to spread their portfolios more widely," he says. "Behind that is a recognition that pension schemes hold a lot of equities, and want a more diversified portfolio without giving up the return from equities. The routes we are seeing for this are property, private equity, high yielding bonds, hedge fund strategies, and some active currency management."

According to Walton, it is better to look at diversification in its entirety, rather than pick assets piecemeal.

"The addition of a small percentage of alternatives to a portfolio makes little difference, compared with a large slug of different ones," he says. "The biggest trend we've seen is a jump from a model looking at each asset class in isolation, to a model where people are looking at the use of alternative assets as a basket, where their analysis picks them all up together."

Walton says the bigger pension funds build their own alternative portfolios, while the medium and smaller ones look to a single manager to bundle everything together.

Another way of investing is to use two managers, both running multi-asset portfolios.

"With a couple of managers, you could get two different views on the overall picture, which means better questioning by the client," he says. "If the managers agree with each other, the client has more confidence in them. If they disagree, both portfolios can be left to run, to see how they develop. That then forces the managers to explain why their portfolio is positioned in a certain way, rather than simply use a numbers-driven strategy, which can be very short-termist."

Walton says the one exception to the growing popularity of alternatives is commodities: "A lot of noise is being made, but not much is happening."

Richard Cooper, senior investment consultant, Mercers, agrees, and sees two main reasons for this.

"Pension funds typically invest in commodity futures, usually via an index such as the Goldman Sachs Commodity Index (GSCI) or Dow Jones AIG Index," he says. "Historically, returns on commodity futures have been pretty high, akin to equities. But the issue we've been raising is whether the past is a good guide to the future. Most commodities including oil have seen dramatic price increases, but you wouldn't expect prices to carry on increasing in real terms."

The second reason is more technical, involving the "roll yield".

Cooper says that in the past, the commodity futures curve has been downward sloping, so futures prices for a date several months down the line have been lower than today's price. This is because producers are prepared to pay for price certainty.

An investor buying futures could therefore expect to make money simply by waiting, and selling on the spot market. This is known as the roll yield.

But Cooper says that for the past 12 months, the futures curve has been sloping upwards, because of a huge increase in speculative activity. "So we are cautious as to whether to expect a positive return from the roll yield in future," he says. "It is possible that investors will not get a meaningful positive return above cash from commodities."

"There's a steady trickle into hedge funds from UK pension funds, and we expect this to continue," says Cooper's colleague, Robert Howie, principal and head of hedge fund research in Europe, Mercers. "Many of our mandates are for cash plus 3 - 5%. In sterling terms, the annual results for hedge funds to 30 June 2006 were 10% or more. This was a lot less than for some of the equity markets, but a good return in relation to cash, which gave 4.5%."

Meanwhile, in terms of hedge funds, Russell has advised its pension fund clients to consider those with the more non-directional strategies.

"It is very difficult for pension funds to access hedge funds directly in a single strategy fund as the risk is very high," says Gillies. "And we want clients to pay fees for skill-based returns, not market-based returns."

Gillies says that for hedge funds with non-directional strategies, the expected return is probably Libor plus five or six - "Which is not quite in the equity range, but a bit higher than for bonds."

He says that in terms of private equity, most UK pension funds invest in a broad geographical spread of funds.

"However, these are dominated by the US because that is where most of the major private equity managers focus," he says. "Pension funds also concentrate on buyout funds, because the availability of venture is fairly low." There does, however, appear to be a mini-boom in currency management.

This trend is underlined by another Mercer survey which shows the use of active management or so-called ‘alpha' strategies is increasing among UK pension funds. According to the survey, 7% of schemes now employ an active currency manager. For larger schemes, this figure is 15%.

AXA Investment Managers have recently set up a currency management team because of this growing interest, and are currently developing a new product.

Alastair Cuming, head of UK institutional business, AXA Investment Managers, says: "Clients are saying to us, ‘Can you invest in bonds to beat a domestic benchmark, but feel free to invest anywhere in the world and make money.' So we might look at the yield on, say, BP bonds, buy them denominated in dollars, then sell the dollars but hold on to the credit."

And looking to the future, he sees continued growth in the use of alternatives.

Cuming says: "There is a long-term trend towards liability benchmarks, and another towards the search for returns from markets and managers. This means the percentage allocated to alternatives should rise from its present level."

Gillies says: "In three years' time, I'd expect to see higher allocations in all these assets. Commodities are tricky because the recent rise in prices has made them attractive in hindsight but less attractive looking ahead, but we still think there is a good long-term argument for investing in collateralised commodity futures."