Alternatives Continue to Win Pension Assets

Terry Flanagan

Many European pension funds are planning to change their risk profile in the coming years with investors increasingly looking at alternative asset classes to address funding issues.

Government gilts in particular, a staple for pension funds, have seen yields drop sharply since the financial crisis, making it more expensive for funds to match income to liabilities unless they add riskier, higher-yielding assets to portfolios.

In a recent survey by the Economist Intelligence Unit, a U.K.-based business research organization, which was commissioned by investment manager and custody bank State Street, 58% of European pension funds surveyed said that they expected to change their risk profile with 60% reporting that they would be increasing allocations to alternative asset classes over the next three years.

Pension funds were also increasingly looking toward strategies which offer downside protection.

“Investors are becoming more conscious of the need to diversify to avoid tail risks and are creating individual solutions to address this need,” said Niall O’Leary, head of EMEA portfolio strategy at State Street Global Advisors.

“We are seeing a growth in demand for strategies such as managed futures, or trend-following strategies, which provide the opportunity for significant positive returns in dislocated markets, but also offer the possibility of modest returns in more normal market conditions.”

Increasing exposure to emerging markets is another likely theme for pension funds.

“Most scheme sponsors are ultimately looking to manage volatility,” said Peter Griffin, director of Allied Pension Trustees, a pension and investment consultant.

“For us this would be met by a mixture of asset classes including corporate bonds, hedged global equity funds and absolute return strategies. Portfolio diversification may well reduce your exposure to immediate dips in financial markets; however, it is important not to diversify your return potential away.”

Another survey, this time from consultant Towers Watson, found that U.K. pension funds had slashed their equity allocations from 61% in 2002 to 45% last year. While exposure to alternative asset classes had jumped from just 3% to 17% in the same period.

“Jittery markets and heightened risk awareness continues to make asset allocation very challenging as companies and trustees balance such priorities as long-term de-risking, short-term market opportunities, rebalancing and maintaining a strategic asset allocation mix,” said Chris Ford, EMEA head of investment at Towers Watson.

“In terms of specific asset classes, we don’t think that bonds represent great value at the moment—but for those that think equities represent relatively better value, it is challenging to know what to do about it when the goal for many funds is to reduce risk overall.

“So many funds are buying fewer bonds than before, and those which are considering adding risk to their investment portfolios are most often diversifying into alternative assets rather than simply buying equities.”

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