Matthew Botein asks how pension funds can protect against alternative investment risk

Alternative investments are assuming increasing impor-tance in the portfolios of European pension fund managers. There are numerous reasons for this, not least inflation, which is a clear and present danger for European investors at present. However, fund managers considering allocating to alternatives face a number of difficult decisions, such as which asset classes to buy into and how much weight to allocate to them.

In the wake of the financial crisis, the challenges facing investors in alternatives have become even more complex. The post-crisis world is considerably more risk-aware than the one which preceded it, leading to the emergence of new approaches to risk management that insist on the consideration of a greater number of risk factors than ever before. In such a complex environment, how can European pension funds ensure that their mechanisms for assessing and managing risk are robust and embedded within the entire investment process – not merely a monitoring or compliance function?

Four of the broadest alternative asset strategies available to institutional investors are hedge funds, private equity, real estate and commodities. These can provide two key benefits for investors: diversification through exposure to non-traditional beta or risk premia that are unavailable via traditional products; and alpha, or excess returns derived from manager skill.

However, during the recent global financial crisis, diversification offered limited protection as correlations between many ordinarily unrelated asset classes increased sharply. Furthermore, many investors simply did not fully understand the under-lying return drivers of alternative asset classes and their changing patterns over the economic cycle.

There are four broad categories of risk facing investors in alternative assets: investment risk, liquidity risk, operational risk and organisation risk. Let's take each of these in turn.

Investment risk can be sub-divided into three further categories: primary risk, secondary risk and idiosyncratic risk. Primary risks are overarching market risks and include movements in interest rates, equity markets, foreign currencies and commodity prices. Secondary risks are more nuanced as they result from exposures that a portfolio may exhibit to sub-segments of a particular asset class. For hedge funds, these risks may emerge from exposure to equity market volatility or credit spreads. Secondary risks relevant to private equity include exposures to a particular industry or vintage year, whereas real estate may include geography as well as economic and demographic trends. Idiosyncratic risks are specific to certain investments, such as the approval of a merger or acquisition or change in company management, which may be unrelated to primary or secondary risks. It is the role of alternatives managers to skilfully avoid unintended invest-ment risks and demonstrate that portfolio exposures are deliberate, diversified and appropriately scaled.

Liquidity risk affects the ability to meet liabilities using immediately available funds in an asset portfolio or when the selling of liquid assets results in a portfolio that is mis-aligned with its strategic target.

With respect to alternative investments, liquidity risk management should include initial due diligence and monitoring to ensure that a fund has the appropriate liquidity for the investment strategy employed and the manager has a history of adhering to withdrawal requests. It should also include consideration of sources of contingent liquidity risk, such as the nature of co-investors within a given fund, which may affect the demands on the fund's resources.

Operational risk is the risk of loss resulting from inadequate controls, people or systems, or from external events. Poor operational practices increase the risk of fraud occurring and not being detected. The shocking scope and scale of Bernard Madoff's fraud raised serious questions about the ability of regulators to limit operational risk and sharpened investors' focus on the paramount importance of operational due diligence.

A vital aspect of operational risk is the soundness of the operating and internal control environments. Standard practices such as the segregation of duties, requiring two signatures on key documents, reconciling key financial balances and statements, and the use of independent auditors, custodians and administrators, are all part of this.

The financial crisis also pushed counterparty and collateral risks up the agenda for investors, particularly within the hedge fund space, as previously impregnable financial institutions suddenly looked vulner-able. Consequently, investors in hedge funds need to consider not only the hedge fund itself, but the organisations around it, such as its prime brokers, administrators and other providers, as part of their due diligence. Investors should identify hedge fund managers that are able to negotiate competitive terms of trade with counterparties and are able to maintain strategic relationships with them in times of market stress.

Organisational risk can relate to the ability of an organisation to withstand a significant economic or market downturn. The financial crisis demonstrated the importance of partnering with a large institutional alternative solutions provider that can cope effectively with periods of major market disruption. Organisational risk can also relate to key man risk, or the overreliance on one or two key individuals. Another important factor to consider is the potential lack of clear alignment between the manager and investor's interests.

The regulatory environment in which alternatives managers operate globally is evolving and this has some clear ramifications for the industry. In Europe, for example, the Alternative Investment Fund Managers (AIFM) Directive will impose registration, reporting and initial capital requirements on alternatives managers.

Increased regulation and changes in investor demands following the financial crisis have also raised the barriers for entering (or staying) for many historically less regulated firms like hedge funds. Many organisations may find themselves unable to cope with the operational and organisational complexities imposed on them. However, these developments – and the market stresses that preceded them – have not diminished the case for alternatives. Rather, they have created significant opportunity for talented alternative investment managers due to less competition and highlighted the need for more dynamic and comprehensive risk management processes that truly reflect these underlying drivers.

For those investors who are able to identify a partner with these attributes, the new financial land-scape looks favourable for many alternative assets. Hedge funds, for example, are finding that the uncertain economic and market environment is creating some compelling opportunities for managers with the requisite skill and insight at a time when proprietary trading desks have been decapitalised as competitors. In private equity, corporate spin-offs and deleveraging are increasing, while the changing regulatory environment with respect to healthcare, financials and energy also presents attractive investment potential. Opportunities in real estate are appealing in the current low-yielding environment, while commodities remain useful as an inflation hedge.

In order to maximise the potential of a strategic allocation to alternatives, it is vital that pension funds seek out managers with a strong risk management culture and sophisticated systems to analyse and control investment risks on
a continuous and dynamic basis. Managers should demonstrate strong compliance procedures, transparency and expertise in a wide range of asset classes - a partner that can be trusted to identify the right solutions for a client and manage them appropriately within a diversified portfolio.

Written by Matthew Botein, Head of BlackRock Alternative Investors

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