4 not-so alternative investments

Today, alternative investments aren’t as “alternative” as they once were. Data from the Pension Investment Association of Canada (PIAC) show nearly 26% of total pension plan assets were in alternative investments at the end of 2014. Ten years earlier, it was 10.5%—and just 4% in 1999.

The move into alternatives has come at the expense of stocks and bonds. Per PIAC, the total allocation to equities has dropped from 57.7% to 38.1% in the past 15 years, while the allocation to bonds has dipped from 31.2% to 27.8% over the same time frame.

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“Investors have experienced some very significant declines in equity markets that have hurt them, so they’re looking to avoid that,” says David Zanutto, a partner and Canadian director of strategic research with Mercer. “To diversify risk—especially equity risk—alternatives is the key approach.”

Equity markets have recovered significantly over the last five years, to a point where they may be fully valued or overvalued. And, with bond returns expected to be low in the near term, it may be time to look at other asset classes. But where should you look?

1. Real Estate

When pension plans decide to move into alternatives as part of a diversification strategy, they typically add the ones they feel most comfortable with and that are easiest to implement. So they tend to move into real estate first. It was the most popular alternative at the end of 2014, with 10.6% of total assets allocated to the asset class, PIAC says.

Real estate provides a long-term revenue stream that typically rises with inflation. “That helps match some of the key risks pensions have, which are inflation risk and matching their long-term liability flows,” says Andrew Smith, managing executive with Northern Trust Asset Management in Canada.

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It also offers a degree of diversification from stocks and bonds, and returns are less susceptible to business cycles, explains Benjamin Abramov, associate partner and Canadian head of private markets research with Aon Hewitt. “Pension plans that are heavily weighted toward fixed income—and the low returns it’s expected to offer in the future—are looking for ways to generate more attractive returns,” he adds.

Medium-size and smaller plans tend to use external expertise, investing in the asset class through either an open-end or a closed-end pooled vehicle. A closed pension plan that needs greater liquidity might even invest in real estate investment trusts, Smith adds.

Buying the farm

Timberland and farmland can be good options for pension plans. However, they’re very illiquid and have long investment horizons.

Timber is a renewable resource, and its value increases as the trees get older. The trees don’t need to be harvested right away and can be sold when timber prices are high. Land can be in Canada or abroad, and pension plans can access this investment through pooled funds. Larger plans can invest directly.

“Investors in this category tend to buy and hold for a long time,” says David Zanutto, a partner and Canadian director of strategic research with Mercer. “The supply that’s out there doesn’t turn over very much. There’s more demand than there is supply.”

Farmland is another attractive investment because of global population growth. In 2009, The Food and Agriculture Organization of the United Nations estimated global food production would have to grow by 70% to feed an additional 2.3 billion people when the world population reaches 9.1 billion in 2050.

But it might get harder to buy farmland in some parts of the world, including Canada. In April, Saskatchewan prohibited institutional investors, including pension plans, from making any additional purchases while it undertook a review of farmland ownership rules under The Saskatchewan Farm Security Act.

While the large public plans are the most active investors in farmland and timberland, “it’s something an open plan might consider as a diversifying source of return,” says Andrew Smith, managing executive with Northern Trust Asset Management in Canada. “If you’re a closed fund and you have a relatively short time horizon, the illiquidity of those investments won’t be attractive to you.”

2. Private Equity

Private equity (PE) and venture capital are the second-most popular alternatives, with 8.3% combined in total pension assets, says PIAC. However, private equity is the more popular of the two. Venture capital comes with a higher risk but also a higher expected return (see “No Venture Capital for Me!” below).

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“The plans interested in private equity tend to be ones with very long time horizons and fairly limited liquidity needs,” such as large open DB plans, says Zanutto. And, as with real estate, it’s a long-term investment.

For global private equity buyouts exited last year, a Bain & Company report finds the median holding period has increased to a record 5.7 years, compared with 3.4 years in 2008.

“As PE funds continued to harvest the unrealized value in their portfolios, the average holding period has lengthened—and will continue to stretch because so many holdings acquired during the boom years have yet to be fully exited,” states the report.

Large plans, such as Ontario Teachers’ Pension Plan, have their own private capital divisions. At the end of 2014, Teachers’ had $21 billion worth of private investments. Smaller plans without that kind of scale usually access private equity through funds of funds.

No venture capital for me!

The venture capital industry has been on a tear recently. The value of deal activity in Canada jumped 23% to $939 million in the first half of the year, says the Canadian Venture Capital & Private Equity Association.

However, it isn’t where most Canadian pension plans are actively investing.

One of the challenges is, there aren’t a lot of Canadian venture capital managers with a long and successful track record, explains Benjamin Abramov, associate partner and Canadian head of private markets research with Aon Hewitt.

The Government of Canada has tried to spark interest in the sector: in 2013, it said it would allocate $400 million to venture capital over the next seven to 10 years.

But plans are more likely to look at private equity instead because it has a more defined outcome, says Ian Struthers, a partner and national investment consulting practice leader with Aon Hewitt. “You only get into venture capital if you have a really large plan and you can put aside that risk-seeking capital.”

3. Infrastructure

Pension plans dedicated nearly 5% of their total assets to infrastructure at the end of 2014, notes PIAC.

Infrastructure was the first alternative the Colleges of Applied Arts and Technology (CAAT) Pension Plan got into, says the plan’s chief investment officer, Julie Cays. The allocation was approved in 2005, and investments began the following year.

The CAAT Pension Plan, which has $8 billion in assets to date, primarily invests in infrastructure funds. It’s also begun to do some co-investing along with some of its fund managers and other partners in both infrastructure and private equity.

There are a number of ways plans can invest in infrastructure. Open plans usually invest in private infrastructure, while closed ones tend to choose listed infrastructure because they have a shorter time horizon and need more liquidity, says Smith.

In 2014, Canadian pension plans allocated the following amounts to alternative assets:

Real estate: $152.2 billion
Private equity/venture capital: $119.4 billion
Infrastructure: $71.9 billion
Hedge funds: $29.4 billion

Medium-size plans usually do co-investments or invest in closed-end infrastructure funds. “The behaviour is typically dictated by the plan size and status,” he adds.

Infrastructure isn’t as risky as private equity and typically comes with inflation protection, so it’s a good match to liabilities, says Zanutto. But while it can earn returns well in excess of bonds, it’s illiquid. “Some plans are viewing this as a bond substitute. You have to be a little careful there,” he cautions.

4. Hedge Funds

Of all alternatives, hedge funds have the smallest total allocation, at about 2%, sometimes as part of a portable alpha strategy (transferring alpha from one portfolio to another), PIAC finds.

Hedge funds are attractive because they’re uncorrelated with other asset classes and can help reduce volatility. “Even though the returns are not expected to be as high as equities, they’re a very diversified source of returns,” Abramov explains.

There are a variety of hedge fund strategies to choose from, but macro, global macro (making bets on events that could affect entire economies) and long-short equity have attracted the most interest recently, says Smith. “That’s because they invest in familiar market risks—like equities, commodities or currencies—and they’re easier to understand and integrate within an existing portfolio.”

The vast majority of smaller plans invest in hedge funds through funds of funds. Medium plans often choose a few multi-strategy hedge fund managers, and larger plans will put together a portfolio of various sub-strategies, says Abramov.

Globally, the popularity of hedge funds is expected to grow. A Credit Suisse survey finds 93% of global institutional investors intend to keep or increase their allocations to hedge funds in the second half of 2015.

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Pension plans have also been globalizing their alternatives allocations, which brings diversification benefits. “What we’re seeing is investors gradually drawing down their Canadian equity exposure and picking up a global alternatives exposure,” Smith explains.

The CAAT Pension Plan’s infrastructure and private equity investments have global developed market mandates, while its real estate investments are mostly Canadian. But the plan is starting to diversify and has invested in real estate funds in the U.S. and the U.K. While there’s a compelling case to invest in alternatives, it’s important for boards of trustees to understand their complexities and lack of liquidity. Before investing, Cays says, pension plans need to understand what they want out of them. She also believes a smaller plan shouldn’t exclude alternatives because of how much it has to invest. “There’s a lot of discussion these days about size and how you have to be very, very big to play in these markets—and you don’t necessarily have to be.”

Craig Sebastiano is associate editor of BenefitsCanada.com.

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