GLOBAL - Institutional investors need to further diversify their assets into areas such as reinsurance strategies by using catastrophe bonds and other insurance linked securities, according to Towers Watson.

In its latest Global Investment Matters publication, Towers Watson noted that many pension schemes mainly rely on equities to generate the majority of their returns. Yet figures from the consulting firm showed over a 10-year period the annualised index return to 31 March 2009 for developed equities was -0.6%.

This compared poorly to positive returns for seven other asset classes, including 10% for emerging market equities, 11.6% for emerging market debt, 10.1% for commodities and 7.5% for catastrophe bonds. The remaining asset classes comprised UK real estate, high yield debt and global investment grade credit that produced returns over the same period of 6.3%, 3.7% and 6.5% respectively.

In the section 'Is diversification dead?' Towers Watson stated that the investment world remains uncertain but its central view was that "developed market equities do not look particularly cheap at present". It therefore suggests three specific opportunities for diversification: insurance type strategies, emerging market wealth and alternative betas.

Within insurance-type strategies, it notes reinsurance as a good example of fundamental diversity, since the investor receives a premium for insuring against losses caused by natural disasters, such as hurricanes, yet this does not affect stock market crashes nor is it impacted by them.

Towers Watson highlighted the easiest way to access reinsurance as being through catastrophe bonds, although it also outlined the use of insurance-linked warrants, and additional insurance strategies against volatility in the equity and bond market. The firm argued that while volatility insurance is market-based, the risk does not change in the same way or at the same time as the markets themselves.

Carl Hess, global head of investment at Towers Watson, said: "Insurance strategies are fundamentally unlike the mainstream asset classes of equities, bonds and real estate, which rely to varying degrees on economic growth as the source of return and risk. Insurance strategies instead provide a risk transfer mechanism, for which there should be a premium paid that investors can take advantage of."

Towers Watson also claimed that many institutional investors still have a "very small allocation" to emerging markets, with, for example, the region accounting for around 10% of a global equity index.

The consultancy thus recommended that investors increased allocations in the region through investments such as infrastructure or domestic consumption to gain direct exposure to emerging market growth. An alternative was to exploit productivity growth by investing in a basket of emerging market currencies  - 70% of emerging market debt is denominated in local currency bonds, so the region is "much less exposed to a currency crisis making their debt more attractive".

Tower Watson also outlined to investors the potential of alternative or exotic betas for diversifying a portfolio. These can be accessed through strategies exploiting less common asset classes or by utilising strategies that exploit systemic risk premiums in conventional asset classes.

It concluded: "While the theory of diversification has been severely put to the test over the last year, we believe it is still valid, particularly over the medium term. New opportunities can help institutional funds to build a more diversified portfolio to improve investment efficiency. This leads to higher governance than for a simple equity/bond portfolio, but we think the effort is worthwhile."

If you have any comments you would like to add to this or any other story, contact Nyree Stewart on + 44 (0)20 7261 4618 or email nyree.stewart@ipe.com

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