Since the onset of the bear market in 2000, investment intentions surveys reveal a paradox: world-wide, pension funds want to invest in hedge funds, private equity and real estate as a part of holistic solutions to achieve absolute returns; yet their cash allocations to such investments remain small at around 3% currently.

There is a yawning gap between aspirations and outcomes, according to recent surveys carried out by CREATE-Research.*

When markets tumbled, interest in these newly discovered alternatives accelerated: they were initially perceived as uncorrelated low-volatility options that complemented, not competed, with other asset classes. Since then, however, a number of factors have dictated an incremental approach that is at odds with media headlines which continue to convey the image of pension funds flocking en masse to alternatives.

Such headlines fail to take account of the fact that most pension funds outside the top 50 do not as yet have governance structures and investment expertise to achieve a radical diversification. Nor do they recognise that the worst funding crisis in living memory is re-shaping pension funds' investment approach.

Together, they are ensuring that radical diversification is a matter of more haste, less speed. Incrementalism is the name of the game.

The bear market savagely exposed the scale of the funding crisis and damaged many reputations. In retrospect, some of the things pension funds did in the 1990s - like being overweight in equities, relying on their risk premium to take care of long term liabilities, declaring ‘pensions holidays' when numbers were good, awarding mandates on the basis of immediate past performance or star culture, and having total faith in their consultants - seem reckless,.

Now they are understandably cautious; all the more so since the crisis has weakened the strength of the covenant between pension trustees and their plan sponsors. As a quid pro quo for extra contributions towards the persisting deficits, plan sponsors are demanding that further diversification should be targeted at strategies that have been stress tested as well as road tested.

Regulators too are demanding a more risk-controlled approach to underfunding. The new mark-to-market accounting rules being implemented on both sides of the Atlantic will inject extra volatility into the balance sheets of plan sponsors that their shareholders find unpalatable.

And another aspect relates to the funding level. Even in the Netherlands, one of the most sophisticated and successful pension market in the world, the new FTK accounting rules are requiring pension funds to match their liabilities to the market rate, thereby forcing a more conservative approach to asset allocation. The new rules demand 105% funding. The capital and income protection strategies they favour do not necessarily leave enough assets in the classes in which they are invested, since hedging instruments are expensive.

Other factors inherent in alternative strategies and the ways in which they are delivered also promote caution. These are exemplified by hedge funds that now account for 50% of the total value of assets in the alternatives universe now estimated at $3trn (€2.2trn).

Most pension funds have four concerns about hedge funds: high charges, shortage of prime capacity, opaque strategies and absence of governance structures. Such concerns have not deterred ultra high net worth clients and family offices, which have largely fuelled the extraordinary growth of hedge funds in the past 10 years.

Accordingly, before making large allocations to alternatives, pension funds want to see step improvements in different aspects of alternatives, as covered by hedge funds, private equity and, to a lesser extent, property and commodity funds.

Not surprisingly, therefore, delegates at a recent conference of top European pension funds could scarcely contain their current indifference. Specifically, they want to see improvements that:

❏ Clarify risk-adjusted returns so that they can clearly assess the opportunity cost of going into or not going into alternatives;

❏ Reduce the opacity of strategies used in alternatives to make them more comprehensible to trustees; so that they can address valuation, governance and expertise issues;

❏ Make certain asset classes with long time horizons (eg, private equity and real estate) more transparent; so that they can be considered as credible sources of alpha;

❏ Have a value-for-money fee structure that clearly separates alpha and beta returns on the back of sound business basics; so that they can deliver superior value.

In the meantime, these requirements are ensuring that ‘sticking to the knitting' is the new mantra for pension funds. That does not mean business as usual. It means product deepening rather than widening: that is, straying further a field in the familiar territory rather than discovering new ones.

Four points are worthy of note, in this context.

First, pension funds worldwide need average annual returns of around 8% to meet their future liabilities from the existing levels of funding. A majority is sourcing them cost effectively from the best-of-breed mainstream asset managers without recourse to extra risk and high charges. The long-only sector is developing a good track record of delivering alpha. Furthermore, last year, an average hedge fund gained 12.9% after fees, according to Hedge Fund Research Inc. The Vanguard 500 mutual fund, which tracks S&P's 500 stock index and charges investors a slim 0.18% of assets, jumped 15.1%.

In any event, a combination of stock market recovery and the rise in the discount rates used to measure plan liabilities has notably moderated the annual increase in pension liabilities. For example, they increased by 1.9% in 2006 in the US, the lowest increase since 1999, according to Milliman's annual study on 100 large plan sponsors.

Second, pension funds' pursuit of high returns is no longer couched only in terms of product alpha: defined here as excess returns over a pre-defined benchmark (x% over LIBOR). Increasingly, solutions alpha is also being sought, too. It involves producing targeted returns at lower risk, lower volatility and lower charges year on year.

Looking at alpha in this two-dimensional way, in turn, reflects the widespread view that beta will remain the overwhelming source of wealth creation until product alpha - as we know it - has undergone extensive innovation, as described earlier.

Third, the growing correlation between major asset classes is forcing pension funds to look further field by exploiting the advantage inherent in their status as long-term investors and exploit the associated illiquidity premium via so-called exotic beta strategies. For example, in Denmark the emphasis has been on infrastructure, in France commodities, in the Netherlands forestry.

In these and other cases, pension funds are diversifying into asset classes that they understand, using strategies which are not capacity constrained and adopting a fee structure based on an ever closer alignment of interests between investors and their fund managers.

Not surprisingly, therefore, the long-only world is evolving. In the process, it is deploying the tools that are stock in trade for hedge fund managers - eg leverage, derivatives and shorting - within a far more competitive pricing model. Growth in unconstrained mandates, GTAA strategies and 130/30 type mixes is indicative of long-only managers' response to the growth of hedge funds and private equity.

Thus, old asset classes are becoming the new alternatives, as they seek to combine the best of old and new. They are re-asserting the point that, on the one hand, markets are adaptive, strategies move with fashion and risk-return relationships change over time, and on the other fund managers' ability to deliver consistent high risk-adjusted returns is far more limited than is known.

Amin Rajan is CEO of the consultancy CREATE
*Hedge Funds: a Catalyst Reshaping Global Investment (2005), Tomorrow's Products for Tomorrow's Clients (2006), Pension funds: Why diversification is such a hard thing to do (2007) are available free from amin.rajan@create-research.co.uk

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