Investors wearied by low bond yields and flat, overly volatile equity markets do—literally—have alternatives. Asset classes including real estate, infrastructure, hedge funds and even timberland can be profitable options—provided investors take the time to allocate intelligently to these alternatives.
According to data from the Pension Investment Association of Canada (PIAC), the average Canadian pension plan’s allocation to alternatives in the last decade has increased from less than 10% to more than 25% today (the data include PIAC members only, which represent the larger Canadian pension plans).
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This trend is expected to continue. In its 2011 survey of Canadian institutional investors, Greenwich Associates asked plan sponsors what changes they expected to make to asset allocations over the next three years. The asset classes with the largest percentage of sponsors expecting to increase allocations were infrastructure (32%), real estate (30%), Canadian bonds (21%) and private equity (20%).
The process
Due to potential challenges—including increased complexity and due diligence—investing in alternatives requires a long, carefully planned implementation process. Implementing new investment in private equity, for example, could take a board up to two years. The board should complete the following.
- Educate board members on the reasons for investing in alternatives and on the pros and cons of various asset classes.
- Select the short list of alternatives. Pension funds with less than $200 million in assets have practical constraints on the number and type of alternative investments they can consider.
- Model the risk/return impact of various asset allocations (including short-listed alternatives) as the modeling could incorporate currency hedging strategies and geographic diversification.
- Set the policy asset mix weight in alternatives as a percentage of the total portfolio.
- Investigate alternative vehicles (including direct investments, segregated funds, pooled funds and fund of funds), as the types of vehicles available to a particular plan depend on fund size.
- Decide on the implementation schedule to achieve full allocation.
- Select the fund manager and negotiate the contract and fee.
- Select the investment performance benchmarks.
- Update the investment policy document.
- Fund the initial investment.
Once the initial investment is made, plan sponsors must commit significant time to their alternative investments to manage ongoing cash flows and capital calls, monitor investment performance and fund manager developments and review the portfolio’s asset mix against the target asset mix. Fund rebalancing procedures require careful planning, since some alternatives are not sufficiently liquid to allow for regular rebalancing.
It takes time, expertise and patience to intelligently allocate to alternatives. Considering the poor returns from the traditional 60/40 stock/bond asset mix over the past decade (for the 10-year period ending June 30, 2012, average passive return is about 5.2%—based on 40% DEX Universe, 30% S&P TSX and 30% MSCI World indexes), however, the alternatives may be well worth the effort.