What are best practices for pension funds investing in illiquid assets?

Institutional investors have been rushing into the arms of alternative, less liquid, investments over the past two decades.

But how major players approach these investments varies considerably, according to a paper by Kristy Jansen a PhD student at Tilburg University, and Patrick Tuijp, a research affiliate at the University of Amsterdam.

In examining a survey of nine Dutch and five Canadian pension funds and fiduciary managers, the paper found survey participants from both countries indicated the risk-return trade-off as the main reason for investing in illiquid assets, followed by diversification. Canadian respondents were more likely to report that steady cash flow and liability hedging were the main reasons for these investments.

Read: A look at the TTC pension plan’s move to more illiquid assets

On the other hand, Dutch respondents were more likely to say asset-liability modelling studies determined how much they allocate to illiquid asset classes. And Canadian respondents were more likely to say they deviate from target allocations depending on a specified target return for illiquid assets.

Many of the funds surveyed indicated they have explicit or implicit liquidity management policies, which include maintaining a cash buffer, using the repo market or securities lending. According to respondents, the option they least prefer is selling existing positions to generate cash.

The survey also found the maximum limits on illiquid assets are, on average, significantly lower for Dutch funds than Canadian funds.

The paper outlined four best practices for investors around illiquid assets, based on the survey results. First, an investor has to establish a clear motivation to invest in illiquid assets since those decisions may depend on what role those assets play in the overall portfolio.

Further, investors must understand what valuation methods are used for illiquid assets so they can gauge their real value in the portfolio, risk measures and solvency position. “Depending on the intended method, inadvertently using a different method could lead to volatility measures which understate the actual risk,” noted paper. “Investors should therefore understand how valuation methods affect their overall portfolio value, their risk measures and, in particular, their solvency position.”

Read: U.K. consults on incorporating illiquid assets in DC investments

As well, current and future liquidity requirements should be top of mind for investors. They should regularly evaluate whether they have sufficient liquid resources available. “Stress tests are needed to analyze the impact of an adverse shock to market conditions on the ability to satisfy immediate cash requirements since the latter may be substantial. . . . Such stress tests should take into account that the size of the cash requirements themselves may also depend on these market conditions.”

Finally, in scenarios when investors need to free up cash for immediate liquidity needs, investors need a clear policy around what methods to use and in what sequence.

This article was originally published on Benefits Canada‘s companion site, the Canadian Investment Review.