Monday, July 12, 2010

Pensions Dive Into Alternatives

ai5000 reports, Pensions Dive Into Alternatives:
Global research by Towers Watson shows that around half of all assets managed by the world’s largest alternative investment managers are managed on behalf of pension funds, with funds beginning to favor infrastructure and commodities.

According to the study, of the total allocated to alternatives, pension fund assets run by specialist infrastructure managers has risen from 9% in 2008 to 12% in 2009 while commodities managers have seen their allocation rise from 0.5% in 2008 to 2% last year.

“Infrastructure and commodities managers have significantly increased their pension fund assets under management during the past year, as investors have become more comfortable with these asset classes and while others have continued to opportunistically add to their allocations," said Carl Hess, global head of Investment at Towers Watson, in a statement. "However, investors should be very wary of the structure of some of these mandates with careful attention being paid to the ‘net of fees’ proposition, in particular for infrastructure.”

The research also revealed that alternative assets under management on behalf of pensions remained unchanged in 2009 compared to the previous year of $817 billion.

The Global Alternatives Survey spanned five alternative asset classes: real estate; private equity fund of funds (PEFoF); fund of hedge funds (FoHF); infrastructure and commodities and includes rankings of the top managers in each area. The analysis of the top 100 alternatives managers revealed the following percentages per sector:

  • Real estate managers accounted for around 52% of assets (down from 58% in 2008)
  • PEFoF on 21% (20% in 2008)
  • FoHF on 13% (13% in 2008)
  • Infrastructure on 12% (9% in 2008)
  • Commodities on 2% (0.5% in 2008)

The survey showed Macquarie Group is the largest infrastructure manager of pension fund assets, topping the ranking, with $51.6 billion ($44.4 billion in 2008). Netherlands-based ING Real Estate Investment Management, JP Morgan Asset Management, and AEW Capital Management, LP, and Morgan Stanley followed.

Towers Watson's survey included 224 investment manager entries (up from 206 in 2008) comprising: 60 in real estate, 60 in fund of hedge funds, 57 in private equity fund of funds, 22 in commodities and 25 in infrastructure.

A recent survey by Russell Investments' on alternative investing supports these findings, showing that institutional investors worldwide view alternative investments as an effective way to diversity their portfolios, with plans to boost their exposure to these investments in the years ahead. The Russell survey of 119 organizations throughout North America, Europe, Japan and Australia showed that over the next two to three years, pensions funds, endowments, foundations and insurance providers expect to increase their allocation to alternative investments by more than a third, to 19% of their total investment portfolios. While real estate, private equity and hedge funds remain the preferred alternative types, the study showed commodities and infrastructure are also expected to make meaningful gains.

You can download the Global Alternatives Survey 2010 by clicking here. Not surprisingly, the top 10 managers are mostly in real estate and infrastructure.

Pauline Skypala of the FT reports, Pensions enthusiastic but inflows are variable:

Many pension funds are keen to invest more in alternative investments. And alternative investment managers are usually keen to have such investors on board: they are seen as more long-term and knowledgeable than the wealthy investors many managers have focused on in the past. They are also less likely to panic and demand their money back when the going gets tough, which makes life easier for managers in the relatively liquid sectors such as funds of hedge funds.(PDF of top 100)

Against this background, it is perhaps surprising that alternative assets managed on behalf of pension funds globally by the top 100 managers barely registered any change in 2009, according to a survey by Towers Watson in association with FTfm. Assets rose from $817,002m (£538,477m, €649,657m) in 2008 to $817,090m for 2009. That is down from $823,118m in 2007.

There is a change in the way the assets are distributed between alternative investment sectors though. The share of real estate has fallen, from 58 per cent to 52 per cent, while that of infrastructure and commodities has grown. The former is now 12 per cent of pension fund assets under management by the top 100 managers, up from 9 per cent, while commodities have leapt to 2 per cent, from 0.4 per cent. Five commodities managers now make it into the top 100, up from one in 2008.

Private equity fund of funds are up slightly, from 20 to 21 per cent, but funds of hedge funds remained steady at 13 per cent.

Carl Hess, global head of investment consulting at Towers Watson, says in the less liquid alternative assets there has been a catch-up in valuations. However, the rise in commodity assets is real: “There have been substantial inflows into the asset class,” says Mr Hess. It has the advantage of being relatively liquid at a time when investors remain concerned about liquidity. Provided US regulators, concerned about the link between commodity price rises and speculative flows, do not make it difficult for institutional investors to put money into commodities, he expects to see pension funds allocate more to the sector.

He attributes the decline of the share of real estate to falling valuations and unwillingness on the part of investors to devote more money to illiquid strategies. “Flows into core strategies slowed down, although there is still interest in opportunistic strategies,” although the latter depends on the availability of cheap leverage.

Infrastructure, while as illiquid as real estate, is a less mature sector, says Mr Hess. The possibility of more public spending on infrastructure is an attraction for investors, although the fiscal austerity now being imposed across much of the world may prove a dampener. However, Mr Hess expects the sector to continue to attract flows, especially if the fee structure improves.

On the private equity front, Mark Calnan, global head of private equity at Towers Watson, believes the fund of funds model is “challenged” due to the fee structure and disappointing returns. He expects investors increasingly to cut out the fund of funds managers and go direct.

The same goes for funds of hedge funds. “The model will come under pressure,” says Mr Hess. “The larger pension funds should be able to build their own funds of funds.”

Craig Baker, global head of manager research at Towers Watson, reports a 10 per cent growth in the number of direct hedge fund mandates awarded by the consultant’s clients in 2009, and a fall in demand for fund of hedge fund mandates. Mandates for direct hedge funds now account for 85 per cent of all the consultant’s hedge fund searches, compared with just over half in 2008.

Similarly, direct allocations to private equity managers accounted for 80 per cent of private equity mandates awarded in 2009, of which there were far fewer than in recent years, with numbers down by 80 per cent, reflecting the fact that far fewer funds came to market last year.

Funds of hedge funds are the least oriented to institutional investors of the five alternative investment sectors included in the survey. Slightly more than a third (36 per cent) of the $355,435m assets under management of the top 50 funds are accounted for by pension funds. Private equity funds of funds are much more reliant on this source of funding – with pension funds representing more than half (55 per cent) of the $340,121 the top 50 funds have under management.

Infrastructure claims the highest proportion of institutional investors, with 61 per cent of the top 20 funds’ assets of $179.198 coming from this source.

The overall proportion of pension fund money for the top 100 alternative investment managers is 48 per cent.

The future of alternative investments with regard to pension funds will centre on the question of the alignment of interests, says Mr Hess. “[Pension funds] are not yet throwing their weight around on fees as much as they could do.

“You can look at how much of the returns from funds of hedge funds, for example, were due to skill rather than to market returns and make sure you only pay for skill.”

The evidence shows skill exists, he adds, but that investors have overpaid for it.

The majority of investors have overpaid for the "skill" alternatives managers claim to be delivering. I am also very nervous about billions flowing into commodities.

So why are pensions diving back into alternatives and more importantly, is it the right thing to do? From one perspective, this is the right thing to do, especially if you think the US economic recovery will proceed, even if it's at a muted pace. Illiquid asset classes like Real Estate and Private Equity tend to outperform once the economic recovery is well underway.

There is a lot of money on the sidelines waiting to be deployed, but don't be fooled, the same structural issues impeding these asset classes remain. For one, banks aren't willing to finance mega buyout funds. Also, as one senior pension officer told me today: "I believe in the governance model of private equity but it will take years for the industry to work through its problems."

Maybe, but watching pensions flooding alternatives with billions again, I think we're back to the good old days where everyone is looking to these investments to get them out of their pension jam. But alternatives are a double-edged sword. If everyone is piling into them again, you can bet those pension dollars that returns will be diluted. In effect, alternatives are drowning in a sea of liquidity, so don't expect much from them over the next decade.

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