Thursday, September 6, 2012

A New Asset Allocation Tipping Point?

Caroline Henshaw of the WSJ reports, Pension Funds Shift Gear, Go an Alternative Route:
Alternative assets classes aren’t looking so alternative these days.

J.P. Morgan expects pension funds will raise their allocation to investments such as infrastructure, property, private equity and natural resources to 25% over the next decade. Currently, just over third of international funds asked by the investment bank allocate 5%-15% to the asset class now.

In Australia’s superannuation industry, which is expected to grow to 2.8 trillion Australian dollars (US$2.85 trillion) by 2020, that would equate to more than A$700 billion.

“Low bond yields along with outsized equity market volatility and modest equity returns have brought us to a new asset allocation tipping point,” said New York-based Head of J.P. Morgan Asset Management Global Real Assets Joe Azelby.

“For Australia, this is particularly pertinent given the concentration of the local equities market and the shallow fixed income market,” added Mr. Azelby, who oversees more-than US$60 billion in real assets across the US, Europe, Asia and Australia.

To be sure, Australia is already leading the way in alternative investments with peers in Canada and Holland, particularly when it comes to local property.

As an example, Australia’s A$73 billion Future Fund made a A$2 billion bid for all of the assets of listed investment firm Australian Infrastructure Fund Ltd, which includes minority interests in airports around the country and in Europe.

A J.P. Morgan survey of 125 Australia funds representing more than A$404 billion in assets found that almost half already allocate 15%-25% of their assets to the alternative class, compared to around 5% of global funds.

Mr. Azelby said he expects an increasing amount of this to be invested offshore as the size of Australia’s pension pool grows and the strength of the Australian currency makes overseas assets – especially in Europe – comparatively cheaper.

One challenge, however, could be the introduction of more stringent rules requiring lower fees, transparency and the need for more liquid assets under the government’s MySuper legislation.

This could make it more difficult for investors away from investing in infrastructure – ironically undermining one of the government’s key aims for the industry under the reforms, said Dragana Timotijevic, Mercer’s Global Investment Leader for Alternative Beta Investments.

“If you’re thinking about plain vanilla MySuper there’s not really a lot of room to accommodate much exposure to” alternative assets, she said.

Nothing new here, faced with low bond yields and volatile public equities, Australian funds have decided to shift a substantial portion of their assets into illiquid alternatives.

But is this really "a new asset allocation tipping point"? I take a much more tempered view knowing full well there are limits to what all these alternative investments can offer and there are important risks too, many of which pension funds completely ignore.

Moreover, the approach into alternatives matters. In the US, state pension plans have been doling out huge fees, getting low profits in return. There too, they're running out of alternatives, piling into alternatives, desperately trying to meet their ridiculously high actuarial return targets.

In Canada, Denmark and the Netherlands, they're taking a much more sensible approach, lowering external manager fees by bringing assets internally and only investing or co-investing with top managers when alignment of interests are there and performance targets will be achieved at a reasonable cost. They can do this because their governance model is superior to the one most US state plans follow.

Importantly, in Canada, we pay our public pension fund managers top dollar to deliver performance. They are supervised by an independent investment board which operates at arms-length from the government.

And even here, things are far from perfect, but there is a better understanding of what works and what doesn't when it comes to alternative investments. When I read studies from JP Morgan or others claiming pension funds should allocate 25% in alternatives, I cringe in horror.

Is this a new asset allocation tipping point? We shall see, I remain cautious and think investors would be wise to do so too.

Finally, speaking of tipping points, think President Clinton secured a second term for President Obama last night as he systematically and brilliantly dismantled every 'Mitt Ryan' talking point. It was devastating. Watch his powerful endorsement below.

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