the introduction of new investment products providing a wider range of investors with direct access to alternative asset classes;

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1 BBS factsheet ALTERNATIVE ASSET CLASSES 1. INTRODUCTION Trustees of pension schemes have historically allocated the majority of their assets to equities, bonds and commercial property. However, during recent years, trustees have started to allocate an increasing proportion of their assets to alternative investments. This move towards alternative asset classes has been driven by: the introduction of new investment products providing a wider range of investors with direct access to alternative asset classes; a desire to provide better diversification within portfolios - in particular, with a view to reducing exposure to highly volatile equity markets. Alternatives include a wide range of asset classes, including private equity, infrastructure, commodities, currency management and hedge funds. This factsheet aims to provide an overview of the issues that should be considered before investing in alternatives and gives an introduction to their characteristics. 2. INVESTING IN ALTERNATIVES GENERAL ISSUES TO CONSIDER Alternatives give pension funds a wider set of investment opportunities and tools, with the potential to allow trustees to strike a better balance between risk and return. Each alternative asset class has its own distinct qualities. What they all have in common is that they are expected to respond to economic factors in a different way to equities and bonds. This potential lack of correlation with mainstream asset classes can be used by trustees to target an increased rate of investment growth for a given amount of risk. However, whilst investing across a more diversified range of asset classes might, on the face of it, appear to be a sensible investment strategy, there are a number of issues that trustees of small to medium sized schemes will need to consider if they are to invest directly in alternatives. (a) Governance Investing directly in alternatives may require an additional commitment in terms of time and expense on the part of trustees. In particular, trustees will need to regularly monitor the performance of the managers for each alternative asset class in which the scheme invests. BBS Consultants & Actuaries Ltd Canard Court, St George s Road, Bristol BS1 5UU. Telephone: Fax: info@bbs-actuaries.co.uk 1

2 (b) Manager selection Unlike traditional asset classes such as equities and bonds, where the majority of the return is dictated by market movements, the returns from alternative asset classes have a greater dependence on manager skill. As such, greater time and effort may be required in the selection process in attempting to identify the most skilful managers. (c) Access Access to funds providing direct investment in asset classes such as private equity and infrastructure will often require an initial commitment in excess of 5 million. Private equity funds may be required to hold liquid assets during periods of investment to feed the manager as they find suitable opportunities. (d) Liquidity Alternative assets such as private equity, hedge funds and infrastructure are often illiquid and require a long-term commitment. Direct investment in private equity and infrastructure may require a commitment of over 10 years. (e) Performance measurement The nature of certain alternative investments, such as private equity and hedge funds, may make an evaluation of historical and future performance problematic. For instance, historical performance assessments may be biased by only considering funds that have not been wound up. Furthermore, returns may need to be estimated for illiquid assets where there is no clear market price. (f) Fees Fee structures for direct investment in alternative assets classes are usually more complicated and may involve an annual management charge of 1.0%-2.0% as well as a performance-related fee if the managers achieve their stated objective. 2

3 3. AN EASIER ROUTE INTO ALTERNATIVES? - MULTI-ASSET FUNDS Before discussing individual alternative assets classes, we first make a quick aside. This section considers the use of investment funds that attempt to offer a relatively straightforward method for accessing a broad range of investments, including alternatives. Over the past five years, the mainstream institutional investment market has seen the introduction of new funds that may invest across a broad range of asset classes, including equities, bonds, property and alternatives. Such funds can offer a lower cost means of providing some exposure to alternatives and might generally be considered as a replacement for the equity/property part of the portfolio. Responsibility for timing investment into and out of asset classes and management of the issues discussed in Section 2 are typically delegated to the fund manager. Completion funds are a variant of this approach that only invest in alternatives and are intended to complement traditional asset class investments. Completion funds might be used where a set of trustees are happy with their existing equity manager but wish to allocate a specific proportion of their assets to alternatives. Multi-asset approaches come under a variety of names, e.g. diversified growth, multi-asset absolute return and dynamic target return. These funds have similar objectives, in the sense that they tend to target an absolute level of return, similar to that expected from equities, with a relatively low level of volatility. However, the approaches used by such managers in practice may vary significantly. For instance: Some funds may put more emphasis than others on preserving the capital value of the fund in the short term; Different levels of discretion will be permitted to change asset allocation within the fund based on the views of managers on the relative attractiveness of asset classes within the prevailing economic background; Some managers may use a fund of funds approach, whilst others will tend to invest in specific securities; The extent to which derivatives are used will vary considerably between funds. 3

4 The variation in approaches offered has translated into a wide spread of returns from managers in practice. Chart 1 shows the accumulated returns provided by some of the long running funds of this type from 31 December 2007 to 30 September 2010, with the corresponding returns from UK equities provided for comparison (the dotted red line). CHART 1 ACCUMULATED RETURNS FROM MAINSTREAM MULTI-ASSET/DIVERSIFIED GROWTH MANAGERS FROM 2008 UK equities Source: Investment managers, FTSE. Returns are gross of fees. During this period, the majority of funds shown (with a couple of exceptions) outperformed the UK equity market, with several of the funds generating significant outperformance with much lower volatility in returns. Past data appears to suggest that multi-asset approaches can provide better risk-adjusted returns than the equity market, albeit there are increased risks around selecting managers given the potential differences in returns illustrated above. Multi-asset approaches can provide a useful tool for trustees of smaller schemes to obtain exposure to a diversified set of asset classes, including alternatives, at reasonable cost and with a reduction in the governance issues associated with direct investment. 4

5 4. ALTERNATIVE ASSETS CLASSES (A) PRIVATE EQUITY Private equity relates to investment in privately owned companies that are not publicly listed. Private equity investments are normally made in start-up or young companies, firms in financial distress and those seeking growth or additional financing. Private equity investments are usually categorised according to the company s financing stage (or stage of development) at the time the investment is made. Each stage (or strategy) has its own distinct risk and return characteristics and can therefore be utilised to diversify a portfolio of private equity investments. The following are the principal financing stages (or strategies): Venture Capital Venture capital represents the investment in new and emerging companies. These companies are often not producing positive cash flows at the time of investment and investors typically acquire a minority ownership position in the company. Expansion/Growth Expansion or growth financing occurs when companies need capital to grow and expand the business quickly. These companies tend to be generating sustainable revenues but may not yet be profitable. Buyout Buyouts occur when investors purchase all or part of an established company, which is typically cash flow positive or profitable and they believe is undervalued or can be improved. Special Situations Special Situations relate to a range of private equity investment strategies which are not covered by the above, including the provision of non-traditional finance to companies (e.g. mezzanine finance) and turnaround investments in underperforming and distressed companies. Investment in private equity will typically be achieved by an active manager investing in a range of private equity companies and projects, although fund of funds, indirect investment in publicly quoted funds and index-tracking approaches are also available. 5

6 PRIVATE EQUITY RISK AND RETURN Private equity investors might expect a minimum net return of between 3% and 5% more than publicly quoted indices over the long-term. Returns take the form of a combination of dividends, increased business value and capital gains on selling and exiting investments. As private equity stakes tend to be fairly large, investors generally have significant influence over management and access to detailed financial information on their investments. However, during the financing phase, returns from private equity investments would typically be expected to be negative, with positive outflows from the project only being distributed at a later stage. A long-term commitment is therefore generally required. A considerable risk lies in the illiquid nature of the investment. In addition, as investments are intensively researched, managed and monitored, management fees tend to be fairly high (1.5%-2.0% per annum), although performance fees often act as an incentive for the manager to achieve investment targets. Direct investment in private equity therefore tends only to be viable for larger pension funds. There is some controversy within the investment and academic community regarding the return and risk characteristics of private equity as an asset class and the impact of manager skill. Some commentators claim that the asset class is simply too immature to draw any definitive conclusions. Whilst private equity is generally considered to provide some element of diversification from publicly quoted equities, there is an argument that it provides returns similar to a geared form of equity investment (i.e. it will perform better than public equities in favourable economic conditions and less well in unfavourable conditions when corporate profits are put under pressure and borrowing costs rise). Consequently, private equity might be considered to be a more risky but potentially higher return form of equity investment that can be attractive for long-term investors. 6

7 (B) INFRASTRUCTURE Infrastructure assets provide essential services to communities. Examples include: Transportation assets such as toll roads and airports; Utility and energy assets such as water, power generation, renewable energy, electricity and gas networks and fuel storage facilities; Communications infrastructure such as transmission towers; and Social infrastructure such as education, recreation and healthcare facilities. Investment in infrastructure can be achieved via funds that provide finance to companies that manage, own or operate infrastructure and utility assets. An active infrastructure manager will seek to add value by assisting management with strategic decisions, investment opportunities, risk management and optimising financial arrangements. Index-tracking approaches are also available for indirect exposure to infrastructure companies. INFRASTRUCTURE - RISK AND RETURN Infrastructure returns will be linked to the performance of the relevant infrastructure companies undertaking such projects. Returns might be expected to be relatively volatile in the short-term and, as an asset class, infrastructure is subject to macroeconomic and political risks which could lead to significant step changes in market conditions. In addition, direct investment may require lengthy tie-in periods. This may however suit long-term investors such as pension funds, as well as helping them to match their liability profile with a predictable and partly inflation-linked distribution stream. However, over the longer term, direct infrastructure investments are generally considered low risk, given the stable and growing demand for essential services, the fact that relevant businesses are highly regulated and the long-term nature of the contracts protects revenues. However, risks do exist in relation to the financing costs, building costs and eventual usage of infrastructure projects. Longer term returns would be expected to have a positive but reasonably low correlation with equity markets. Specialist infrastructure funds including direct and indirect exposure have management charges of 1.0% to 2.0% per annum, with significant bid-offer spreads. Indirect exposure via index-tracking funds can be obtained based on annual management charges of around 0.3% per annum. Direct infrastructure funds may be structured so that the income and capital gains will be free of tax to qualifying investors such as UK occupational pension schemes. However, indirect exposure via company shares may be subject to tax on dividends (e.g. in the UK) or withholding taxes (overseas). 7

8 (C) COMMODITIES Commodities are physical substances that are used in the creation of other products or by commerce generally. Examples include oil, natural gas, agricultural products and precious and base metals including gold. Investment in commodities is usually made via commodity funds or the commodity derivatives markets, which removes the need to trade or deliver the physical asset. It is also possible to gain indirect exposure to commodity markets by investing in companies whose profits are linked to commodity prices, such as mining, energy or agricultural shares. Commodities can be used in diversifying a portfolio and in particular, are seen as a hedge against increases in future price inflation (commodity prices being one of the key drivers of inflation in the wider economy), and although they do not provide direct income, they are liquid assets. GOLD Gold has been used as store of value for over 5,000 years and is therefore one of the oldest forms of investment. The gold market is highly liquid in nature and tends to show negative or low correlation with the major equity markets. This is primarily explained by its status as a port in a storm during difficult economic conditions. Gold often performs best in times of political instability, financial turmoil or high inflation. Investment is achieved most obviously through the purchase of physical gold, but can also be through the purchase of shares in gold mining companies or by investing in gold-based pooled funds. Gold exchange traded funds are becoming increasingly popular, which take the form of securities traded on the stock exchange, backed by physical gold with the aim of tracking the current market price. Investment banks also offer gold-related products and derivatives. COMMODITIES - RISK AND RETURN Returns from individual commodities can be very volatile and managers therefore promote active, skill-based approaches in an attempt to identify and take advantage of changing market circumstances. A diversified, actively managed, commodity portfolio might be expected to generate a long-term return in excess of price inflation, albeit still with significant volatility. For pension schemes, commodities might be expected to provide a tool for protection or speculation within a wider multi-asset portfolio. 8

9 (D) CURRENCY MANAGEMENT As anyone who goes abroad for their holidays knows, the value of Sterling relative to other currencies changes over time. Relative currency values can be very volatile. The extent of the volatility exhibited between Sterling and other major currencies that can occur during a single year is illustrated in Chart 2. CHART 2 MOVEMENT IN STERLING RELATIVE TO THE US DOLLAR AND YEN IN 2010 Source: Financial Times market data. The change in value of currencies is primarily a matter of supply and demand. If demand increases for a currency because overseas consumers wish to buy the country s goods or if overseas investors want to buy assets in that country, its value will rise and vice versa. Volatility in currency prices presents both a headache and an opportunity to investors. First of all, investors with overseas investments might see the returns on those investment substantially altered by movements in the relative value of Sterling and the overseas currency. Currency movements may potentially detract (or enhance) the returns from the underlying overseas assets. Whilst over the long-term the effects of currency volatility might be expected to cancel out, this can be a source of short-term frustration. In practice, such currency risk can be significantly reduced using derivatives. Certain investment managers offer overseas equity funds, for example, with currency risks hedged as standard for relatively little in the way of additional charges. In terms of opportunity, currency risk can be considered as an investment opportunity in its own right. A manager may be able to successfully take views on the relative prices of currency and 9

10 exploit these to generate a positive return. For instance, if a manager thinks that the US Dollar is likely to increase in value against Sterling, the manager could use Sterling to purchase Dollars and, if their view is correct, buy Sterling back at a later date at a more favourable rate and thereby make a profit. Furthermore, managers claim that currency markets are inefficient in the sense that changes in the value of currencies are driven by the practicalities of central bank activities, international trade and holidaymaking, rather than investors speculating on currency prices. As a result, currency valuations do not reflect underlying economic fundamentals and mispricing occurs within these markets which, in theory, can be exploited by a skilful manager. Active management of currencies is normally undertaken using derivatives contracts that are backed by the Scheme s existing assets (known as an overlay ). CURRENCY - RISK AND RETURN Active currency management is normally expected to add a relatively small addition to portfolio returns, in the order of 1%-2% per annum. However, there is scope for additional returns from overlay approaches to be zero or negative, with significant potential volatility. Returns are considered to show a lack of correlation with those from other asset classes, as they are thought to be solely the result of manager skill, rather than deriving from the wider economic sources of return for other asset classes. (E) HEDGE FUNDS Hedge funds are investment vehicles that use a comprehensive range of investment tools and techniques to generate returns for investors. They encompass a wide range of different trading strategies and investment objectives. Hedge funds have historically been unregulated vehicles and are generally structured as limited liability partnerships. They commonly make use of derivatives and can explicitly borrow or otherwise take leveraged positions (gaining greater market exposure than the value of their underlying assets). The investment objectives are normally of an absolute return form, aiming to target a return in excess of that available from cash. As they tend to be unregulated, investors will not receive the same protections as they might if they were to invest in an FSA regulated fund, for instance. Fees tend to be relatively high, often with a substantial performance related element. Whilst hedge funds are normally priced monthly, they may be illiquid, with tie-in periods and pricing issues resulting from holdings of illiquid assets (such as the shares of small companies). Fund of hedge funds approaches offer a means to diversify exposure to different hedge funds and transfer the responsibility for governance issues (e.g. making sure a hedge fund manager has appropriate operational procedures) to a third party. The principal downside is the additional layer of fees that such approaches attract. 10

11 Examples of common hedge fund strategies are: Equity hedged Historically, this is the most prevalent hedge fund strategy, in which the manager holds equities whose price is expected to rise, whilst also short selling stocks whose price is expected to fall (short selling is essentially a mechanism for betting on the price of stocks to fall). The hedge fund manager can therefore express a wide range of views within the equity market, providing the possibility of generating positive returns in all market conditions. This strategy can be categorised by market exposure, sector, capitalisation, geography, etc. Event-driven These funds invest in companies to take advantage of performance opportunities where significant corporate events are taking place, for instance mergers, restructurings or bankruptcies. Relative value These are funds which pursue arbitrage opportunities. Arbitrage relates to the difference in prices of assets with similar characteristics. On the assumption that the assets with similar investment characteristics must have the same price, any differences in prices represent investment opportunities. Trading These funds use a range of trading techniques to generate returns, for instance, by expressing views on global macroeconomic changes. HEDGE FUNDS - RISK AND RETURN The level of risk associated with a particular hedge fund will vary depending on the strategy being utilised. Diversification can be achieved by opting for a fund of hedge funds, whereby underlying investments are in several hedge funds covering different strategies and geographical areas. Whilst hedge funds, and in particular funds of hedge funds, have an established track record of being able to deliver steady levels of absolute return for relatively low levels of volatility, investors should bear in mind the lower transparency and liquidity, together with the higher complexity involved in such investments. Fee levels for such products may be prohibitive compared with alternative vehicles, e.g. the multiasset funds discussed in Section 3, which have similar objectives. 11