Alternative options for achieving growth

Alternatives have recently dominated asset allocation
re-weightings among pension funds. So where are European pension funds now placing their bets? Lynn Strongin Dodds finds out

Although equities and bonds still rule the European investment scene, their dominance is waning as alternative asset classes become more popular. Diversification is now the mantra and fund managers are re-jigging their portfolios to make room for private equity, hedge funds and real estate. The more adventurous investors are branching out even further into sub-sectors such as infrastructure and renewable energy as well as structured products.

Alternatives may still only be a small proportion of the total asset allocation pie, but they are a growing segment. Over the past two years there have been several reports marking their progress. One of the most recent ones was Watson WyattÕs Global Pension Asset Study 2007. According to the study, at the end of 2006 pension funds had a global average of about 60% equities, 33% bonds and 7% alternative assets.

In a separate study, the UK based National Association of Pension Funds (NAPF) 2006 annual survey revealed that the proportion of defined benefit pension fund assets invested in equities slipped from 61.1% in 2005 to 59.5%, while a third raised their stakes in fixed interest investments. Alternative assets enjoyed a boost, with 18% increasing their holdings in property; 8% investing more in hedge funds and 7% more in venture capital and private equity.

The reasons for the altering patterns of investment have been well documented. The stock market collapse in 2001 prompted fund managers to take a hard look at their investment strategies,
but subsequent accounting and regulatory changes have accelerated the trend. Although investing in alternative assets is not a European- wide trend, every country is facing the same dilemma of how to fund an ageing population with a shrinking workforce.

For now, the two countries leading the charge are the Netherlands and the UK, and to a lesser extent Denmark and Sweden. The common link among the four is regulation that emphasises valuing liabilities using market rates. The Dutch, for example, have just put the final touches on the Financieel Toetsingskader (FTK), which uses a mark-to-market system whereby pension fund liabilities are calculated using variable interest rates depending on the duration of their liabilities, rather than the fixed rate.

The UK, on the other hand, took the accounting route three years ago and passed FRS 17. Companies are required to report year-by-year changes in the value of their pension funds as gains and losses, instead of smoothing out the variations over many years. Businesses have to display the shifts in value on their balance sheets, rather than using actuarial predictions of fundsÕ likely positions. The Accounting Standards Board, the UKÕs accounting regulator, recently announced that the FRS 17 standard would be brought more in line with international accounting standard IAS19.

These reforms have also triggered a trend towards liability driven investing (LDI), particularly for plans with a guaranteed element. Although LDI has become a catchy buzzword, it is not a new concept. As Robert Hayes, managing director, strategic advice and solutions team of BlackRock, points out: 'There is an increased focus on LDI but it is essentially a risk framework whereby pension funds formulate strategies in the context of their liabilities. This involves not only hedging risks but looking for diversification of returns.'

Vincent de Martel, a principal in the LDI team for Barclays Global Investors (BGI) notes: ÒDiversification is not a new concept.
Ten to 15 years ago it meant investing in US and European equities, but now those markets are highly correlated.
'Today, the focus is on alternatives. The questions that pension funds have to ask is: how do I access the asset classes and how much should I allocate? Also, is it possible to get the same returns that equity generated with less risk?'

As John Kremer, head of European institutional distribution at the asset management business of Credit Suisse, puts it: Pension funds have to be explicit in their investment objectives. 'When adding alternative assets, they need to consider how each investment will either mitigate or concentrate factor sensitivity to things like their bond or equity exposures, as well as how it will improve returns.'
Navigating a path through the various alternatives is not an easy task unless the pension fund has stature and scale. ABP, Europe's largest pension fund, was a pioneer embarking on a radical diversification strategy long before it became a trend. Alternative investments such as private equity, hedge funds and property accounted for a quarter of its 208bn euros invested assets at the end of last year, up from 11% in 2000.

According to its 2007-2009 strategic review, the Dutch-based group plans to more than double its private-equity holding to 5% of the portfolio by 2009, from 2.4% in 2005, while hedge funds should rise to 5%, from 3.2%. Innovative funds and infrastructure investments should each account for 2% of the portfolio, from nil two years ago. It also expects bond holdings to fall to 40% of the portfolio, from 44.6% in 2005, and stock holdings to 34% from 37%.

PGGM, the country's second largest pension fund also changed its internal investment process to focus on beta, enhanced beta and alpha strategies across multiple asset classes. Currently, about 13.4% of its portfolio is invested in real estate with private equity comprising 5.4% and commodities representing 5%. Stocks accounted for 44.7%.

While these behemoth funds have their own in-house resources to explore the alternatives space, smaller and medium-sized pension funds tend to turn to consultants and larger fund management groups for guidance. Currently real estate is one of the most popular avenues as it is the most established and well understood. As Hayes notes: 'Real estate offers a certain comfort level and we are seeing many funds increasing their allocation. We have just gone through a period of strong returns and although there is a concern about performance going forward, investors are willing to look outside their domestic markets for opportunities.'

Private equity has also become a firm favourite as it is one of the best performing asset classes in the past few years, with average returns of between 10% to 15%. In the last few months alone, PKA, the admini-stration company for occupational pension funds in Denmark, said it intends to raise its exposure to private equity from 2% to 5%. In Germany, BVV, the pension fund for the financial industry, is poised to boost its holdings through a private equity fund of funds, which is the most common way to invest.

This is because investing directly into a private equity fund is a labour intensive exercise, according to
John Gripton, head of investment management Europe of Capital Dynamics: 'Only the large funds have the resources to do this. The benefits of a fund of funds approach is that it offers diversification across the spectrum from buyouts to venture capital in different geographical locations. However, investors have to be aware that these are long-term investments and they are not very liquid.'
Hedge funds, which have a variety of alpha generating strategies, are also increasingly becoming a must-have asset in a portfolio. Again, fund of funds is the most preferred route. As Jamie Murray, head of business development and distribution at HBSC Alternative Investments Limited, explains: 'Two to three years ago, institutional investors' eyes mostly glazed over when talking about hedge funds. Today, investors have a much better understanding of what they are and how they can offer better risk adjusted returns than equities and bonds.'

While real estate and private equity are becoming firm fixtures in portfolios, investors are also looking farther afield. For example, recent figures from Standard & Poor's reveal that banks and pension funds are expecting to invest between $100bn and $150bn in infrastructure assets in the coming months. Paul Bourdon, managing director and head of the European pension solutions group of Credit Suisse, explains: 'Once investors have become more comfortable with life beyond equities and bonds, they are looking at new ways to diversify their portfolio with less correlated assets. We are seeing more interest in asset classes such as infrastructure as well as energy funds which invest in timber, mining and bio fuels.'

Collaterised debt obligations are also on the radar screen although few European pension funds have taken the plunge. This is because they are a more complicated investment than other asset classes. Ray O'Leary, partner of Solent Capital, explains: 'CDO structures can fit with an LDI strategy because of their longer maturities and yield pickup. We have not seen that many direct investments yet but there has been some interest via asset managers.'

Seeing the forest for the trees:
the future of timberland investing

Forests, and the products that are derived from their resources, are one of the oldest sources of income and most traditional drivers of economic value. Used for construction, furniture, paper, heat, and other uses, wood from timberlands continues to be an essential commodity.

Timberlands investments have, however, only entered into sophisticated institutional portfolios over the last 20 years. Lead by large US pension funds and university endowments, this novel investment area now has an estimated $30bn of institutional investment.

Historical evidence over this period has shown that timberland is an excellent diversifier, offering non-correlated returns driven by the biological growth of the trees as well as a low volatility and long-term inflation hedge.

All good news for institutional portfolios. So why has this asset class remained almost exclusively the territory of US institutions and is this changing?

The issues that have discouraged European institutions from investing in timberland are driven by the fact that most timber investment vehicles to date have been designed for US tax-exempt investors. These vehicles are private equity-like structures (generally with lock-ups of 10-16 years), tend to focus on US timberland, and do not provide tax structuring.

In addition, returns on US timberland have been coming down as the market matures. Data from NCREIF shows historical returns on US institutional timberland averaging 15% over the last 20 years, but only 8% over the last ten years.

Wrong asset class, wrong time?
Quite the opposite. European institutions are perfectly positioned to move into the next generation of timberland investing.

The future of timberland is global. Mature markets offer stability in a timberland portfolio, but the addition of developing markets in regions such as Latin America and Eastern Europe can offer substantial returns by bringing value added experience from more mature markets.

The future of timberland is also green. The ethical/sustainable side of timberland has been focused to date on responsible management, which has now reached high standards across the industry. But good ethics are also good business. Carbon credits, sustainable forestry, and local economic infrastructure may be the future of timberland investing.

Evidenced by several recent high profile announcements from European pension funds of allocations to the next generation of timberland products, European institutions which are unburdened by the traditional US investment models and sensitive to environmental management issues are poised to capture this emerging opportunity.

The global timberland market is estimated at $300bn, with only approximately 10% in institutional hands and more than $100bn outside of the US. An excellent, ethical diversifier with an outstanding risk/return profile Ð we are going to be hearing a lot more about timberland in Europe.

Written by Kimberley Tara,
CEO, FourWinds Capital Management