While alternative assets have become something of a buzzword in institutional investment in recent years, the term has tended to apply to asset classes such as private equity, hedge funds and property.
Beyond the fringe though, a number of other alternatives have been garnering interest. Moves by Dutch superfund PGGM into commodities and allocations by US giant CalPers to timber are two high-profile allocations that have sparked a re-evaluation amongst peers.
Bill Muysken, global head of manager research at Mercer Investment Consulting, explains that standard procedure for the consultant when receiving enquiries from institutional clients about alternative assets would be to run through the main types – private equity, hedge funds, emerging markets debt – and try to explain the basics and the pros and cons before promoting a discussion on the issue.
“From then on it depends on the level of interest from the clients. It’s a matter of client preference rather than different alternatives being suitable for different plans – although we wouldn’t recommend the more illiquid types of alternative investments to plans looking for liquidity.”
Looking across the board at different alternative asset classes, Muysken explains that Mercer doesn’t classify currency overlay as an alternative asset: “We classify this as mainstream and we have a number of our clients looking at this and we would raise it separately outside the category of alternative investments.”
With regard to commodities, the consultant has yet to be convinced that this is a viable recommendation to clients: “We get a lot of research in about the case for commodities, but we also get a lot of good research in explaining that commodities might not be such a good idea. The basic theme of those is that inflation-linked bonds are a better hedge against inflation than commodities and have the added advantage that they provide a positive real return over the long term, whereas with commodities it is debatable. All the marketing material we see compares it to equities and bonds, but ignores inflation-linked bonds as an alternative.”
Forestry investment, he adds, is also producing some interesting research: “It looks interesting and worth pursuing further. It seems to make a lot of sense.”
In the past year, Muysken says the firm has seen a steady trickle of clients moving to alternatives: “Eleven clients have moved into hedge funds – two of which are European funds. At the same time, eight clients have moved into private equity, of which five have been European funds.”
Chris Mansi, senior investment consultant at Watson Wyatt, also notes that the interest from pension fund clients in less common alternatives has been scarce.
“Some clients are starting to look more widely than their bond and equity exposure, at private equity, hedge funds and property, but not really beyond that.”
However, he offers a checklist that the consultant would use when looking at new asset classes that could provide a useful template to funds considering exposure to alternatives.
“Different asset classes have different skill set and governance requirements. You need to look at the investment case and the implementation issues. There are plenty of good investment ideas out there, but can you invest in them in a straightforward manner?”
In commodities, for example, he suggests that investors might want to look at whether they provide a diversification benefit, then consider the governance requirements for the asset class before examining how easy it is to get in and out and what the fees are.
“Will the fees erode the supposed return advantage? With equities and alternative assets you’re looking for a return in excess of bonds, so you have to ask yourself this question.”

Gold
As uncertainty and volatility grip the markets, investment in gold has regained some of its former lustre. With the gold price rallying in recent years and gold funds outperforming equity markets, the place of gold in a portfolio as a safe haven from economic turbulence has been reassessed.
A recent survey of fund managers and analysts conducted by the World Gold Council found that over 70% understood gold’s role as a safe haven and even more appreciated its unique correlation with equities, bonds and currencies. Furthermore, from a selection of commonly used portfolio diversifiers, gold was found to be the one with the lowest correlation to the S&P 500 index for the decade ending in December 2001.
Experts argue that the reasons for gold’s portfolio exile lie in the phenomenal growth in equities in the last 20 years. There has been little need for a defensive diversifier like gold.
Some have pointed to gold’s supply and demand fundamentals as a reasons for avoiding the precious metal.
Supporters, however, flag up gold’s immunisation effect during inflationary times. They note that the ratio between percentage movements in the price of gold and in the consumer price index is at least five to one – enough to contribute substantially to offsetting any inflationary loss in value of other portfolio assets.
Certainly, in the current equity depression, the yellow metal’s unusual market correlation is reminding managers that in portfolio management theory the inclusion of assets that have low or negative correlation with other assets helps to reduce overall portfolio risk.

Forestry/timberland
If it’s long-term investment you’re looking for there can’t be many asset classes with the same growth characteristics as trees.
Low or even negative correlations with other asset classes and an investment duration that would appear ideal for the liability horizons of pension funds have brought forestry investment to the attention of scheme managers.
Supporters note that investment in timber is an opportunity for long-term money to be invested with risks spread in terms of geography and types of timberland. Historically, the asset class has demonstrated stable and attractive real returns with low volatility.
The message has certainly been heard in the US where the level of institutional investment in timberland has increased steadily over the past 20 years, from $4.2bn (e4.4bn) in 1981 to more than $10bn in 2001 – with CalPers taking a $1.5bn exposure.
In Europe, enthusiasm for forestry investment has been less evident, although a number of Danish, Swedish and Irish institutions have started to take a serious interest.
Furthermore, many institutional investors consider timberland to be a hedge against inflation. Unlike income from fixed-rate financial instruments, the real value of timberland does not necessarily decline during an inflationary environment. Indeed, some managers question whether ‘hedge’ is the appropriate terminology for forestry investments that simply perform independently of inflation.

Commodities
With gold and oil prices in the ascent in recent times, much industry talk has focused on the possible benefits of institutional exposure to commodities. Experts believe it is a strategy that needs to be seriously considered.
As a sector, commodities are renowned for rising during crisis periods, but falling after a short peak. Consequently pension funds with a significant exposure to commodities were somewhat shielded from the aftermath of the events of 11 September.
As well as the benefit of diversification and solid potential growth, the inclusion of commodities in a portfolio can limit both specific and inflation risks. Returns on a commodity portfolio are to some extent positively related to unexpected inflation.
The reason is that commodity prices are primarily based on current supply and demand pictures, whereas the values of other asset classes are based on expectations about the future. When approaching the top of an economic cycle, equity prices decrease. However, at the same time commodity price levels are at a maximum because of high demand resulting from high economic activity. These high commodity prices in turn slow down the economy, putting pressure on equity prices.
For pension funds with obligations indexed to wage levels the positive correlation with inflation can be very interesting.
With relatively new commodity indices such as the S&P joining more established ones such as the Goldman Sachs Commodity Index, a reevaluation of commodities by pension funds has been in evidence.
One significant example was the investment last year by Dutch superfund, PGGM, of around e2bn in commodities.

Real estate
Institutions are back in the real estate market. With diversification again the order of the day, pension funds have seen sound property returns over the past few years and noted the low correlation with all the other main asset classes.
Property’s most important benefit in the multi-asset portfolio is diversification. As a result, institutions with high relative property weights have seen significant benefits at the portfolio level.
Real estate typically tends to have a six- to nine-month lag over general economic conditions, and has certainly held up well in difficult trading conditions. And predictions are that property could well outperform other asset classes over the next five years.
As a result, pension fund allocation to real estate is very much on the agenda at the moment, although experts warn that investors should be wary of liquidity issues. Real estate is not an asset class that can be piled out of easily.
Nonetheless, some institutional investors have found it hard to access direct real estate investments due to the size of investment needed.
In recent years, however, manager of managers approaches (sometimes known as fund of funds), where investment is made in two or more pooled vehicles, have gained in popularity.

Currency
The emergence of several significant trends in pension fund investing – such as the shift towards holding a greater proportion of foreign equities, the move towards multi-manager structures, the search for alternative sources of excess return and the growing use of risk budgeting – have all put currency implications on the agenda for pension funds.
Proponents of currency trading programmes argue that a good strategy should have a positive expected return with little or no correlation to other asset classes. As such, currency overlay strategies represent a highly attractive addition to portfolios heavily weighted towards equities or bonds with a need for diversification.
The returns overlay managers have produced are impressive. Watson Wyatt has measured the results of more than 200 currency overlay accounts from 20 leading overlay firms and found that across all accounts the average cumulative gain since inception was 1.5% (per annum). The consultant concluded: “active currency management can increase portfolio returns”.
Although overlay managers have different decision styles and disagree on whether the currency market is efficient or inefficient, most agree that investors should appoint more than one manager with different approaches to protect them against adverse currency movements and spread the risk.
A report by research outfit InterSec forecasts that the world’s pension funds will control cross-border assets totaling well over $3trn by 2005. In other terms, one in five dollars in pension assets will be subject to currency risk. The figures suggest that it will be imperative that investors address how that risk is managed.

Fine art
With investment in art there are no guaranteed percentage returns, but time has proven that the returns can nevertheless be huge.
Art has not received greater recognition up to now in the investment world because it is viewed, in comparison with stocks and bonds as a long term, illiquid investment with limited opportunities for income. It is also subject to high maintenance and transaction costs.
Furthermore, few in the markets have had the relevant expertise to make art pay.
Nonetheless, over the years increasing levels of capital and competition have energised the international art market, with the introduction of art swaps and options. An art swap allows an investor to participate in the art market without the negative costs and risks of ownership. The Art Securities Index comprises the share prices of four major auction houses and dealers listed on the London and New York stock exchanges and enables options to be used to hedge art works in more liquid markets. Hedges can be constructed for art portfolio insurance or speculation based on the high correlation in prices between assets.
Through derivatives, art funds and portfolios, today art can be made part of the pension fund asset allocation process.

Derivatives
European pension funds are not the most prolific users of derivatives, although many argue that these instruments can be employed to improve the management of a pension fund.
One example, say supporters is the use of futures for tactical asset allocation (TAA) – short-horizon changes in the broad asset allocation – to add value over the strategic benchmark or for equitising cash.
Regulators in some markets do not allow pension funds to take derivatives positions directly. However, in countries such as the UK, Netherlands, Sweden and Denmark the use of derivatives by pension funds is largely unrestricted and a number of funds use futures and options to obtain exposure to commodities and to manage the duration and credit exposure of their bond portfolios.
It is often easier and more cost efficient to obtain investment exposure through derivative markets than trading in the underlying securities. For example, it is easier to reduce equity exposure through the futures or swap market, rather than selling individual equities. Other derivatives, such as options, mean funds are protected against the negative impact of downturns in the equity markets, but can still take the upside gains.
For pension funds then, the use of derivatives can reduce risk and ‘shape’ investment exposure, without taking speculative market bets.

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