July 13, 2014 2:32 am

Pension funds seek ‘sweet spot’ in alternatives

The titans of the hedge fund, private equity and real estate industries are poised for significant asset growth as money from a growing range of institutional investors pours into alternative funds.

Assets managed by the 100 biggest alternative fund groups rose by 6 per cent last year to $3.3tn, according to the latest annual survey by Towers Watson, the investment consultancy, analysing the global alternative asset management industry.

Alternative asset managers investments by region

Alternative asset managers investments by region

The sharp increase has been to the benefit of many of the largest alternative fund companies, including the likes of infrastructure house Macquarie, hedge fund giant Bridgewater and real estate specialist Blackstone.

Amin Rajan, chief executive of Create Research, the asset management consultancy, believes these alternative fund houses largely have the pension fund industry to thank for the big influx of money.

Pension funds remain the most important source of capital for alternative asset managers, accounting for $1.3tn of the money invested in the largest 100 fund houses.

The importance of pension fund money to the alternative fund industry is unlikely to subside, Mr Rajan believes.

He points out that more than a quarter of European pension schemes are currently cash flow negative, and this number is likely to double in the next five years as the largest generation of postwar baby boomers reaches retirement.

This phenomenon is pushing pension funds around the world towards alternative funds that occupy the “sweet spot” between volatile equities and overvalued bonds – equity-like returns with bond-like features, according to Mr Rajan.

He says: “Ageing demographics are driving ever more pension plans into the off phase, where their needs extend well beyond getting shoot-the-lights-out returns.

“Hedge funds and private equity are seen as providing low volatility absolute returns, and property and infrastructure are seen as delivering regular income and inflation protection.”

The rapid rise in global equity markets since the financial crisis has also pushed some investors towards alternatives as concern builds about public equity markets’ ability to continue to produce attractive returns.

“Institutions have increasingly looked for strategies that can provide some protection when markets turn – and turn they will,” says David Walker, senior analyst at Cerulli Associates, the research group.

Anthony Tutrone, global head of private equity at Neuberger Berman, adds that new investors putting money in alternatives for the first time has helped fuel asset growth. He says: “[A] very powerful source of increased investment in alternative assets is sovereign wealth funds, pensions and financial institutions from developing markets that have very little or no exposure to alternative investments and are seeking to bring their alternative allocations on par with similar institutions in the US and Europe.”

Large sovereign wealth funds in the Middle East, China, southeast Asia and Latin America are beginning to invest with alternative fund managers, while conservative institutions in some developed markets, such as Japan and South Korea, have upped their exposure to alternatives, according to Mr Tutrone.

The biggest 25 alternative fund companies participating in the Towers Watson survey, for example, have seen allocations from sovereign wealth funds rise by 10 per cent year-on-year to $143bn, with the bulk of this money going to real estate and private equity funds.

While pension funds increased their allocations to alternatives by 5 per cent last year, endowments and insurance companies raised theirs by 10-11 per cent, according to Luba Nikulina, head of private markets research at Towers Watson.

Within alternatives, real estate funds continue to command the bulk of assets, with property-focused managers accounting for more than a third of the $3.3tn of assets managed by the 100 largest alternative fund houses.

But interest in real estate funds has begun to slip, in part due to the surge of interest in hedge funds and private equity funds, which now account for $724bn and $753bn respectively of assets managed by the 100 largest alternative fund groups.

The decline of interest in real estate funds, which now account for 37 per cent of pension fund assets in the Towers Watson ranking, down from 41 per cent last year, is also to the benefit of niche but growing areas within the alternatives sector.

Illiquid credit and real assets, for example, were included as standalone asset classes in the Towers Watson survey for the first time this year in response to growing investor demand in these asset classes.

Ms Nikulina says Towers has encouraged its clients to look at funds investing in real assets such as timber and agriculture as they are “linked with the long-term theme of resource scarcity, [with] less land available for growing crops and timber”.

“There are links with inflation in these asset classes, but [they provide] a strong cash yield and have performed well with low correlation to equities and bonds,” she adds.

Although the future seems bright for alternative fund providers across most asset classes, there are risks on the horizon.

Philip Masterson, a managing director at fund house SEI, says investors and managers are “keenly monitoring” regulators’ approach to the shadow banking industry, which could impact allocations to alternative funds in areas such as direct lending.

Ms Nikulina adds that while the surge in allocations towards alternatives is good news for fund managers, “from the investment side of this equation, it may not be as good news as there is more competition”.

Neuberger’s Mr Tutrone, meanwhile, acknowledges that rapid asset growth throughout the alternatives industry could lead to bubbles forming.

He believes, however, that this risk is mitigated by the memory of the last crisis being fresh in investors’ minds, and banks being more conservative with their underwriting policies.

Credit defaults, meanwhile, are close to all-time lows: non-sponsored leveraged loans’ default rates hit a peak in 2009 at 16.3 per cent, but are currently at approximately 0.8 per cent, according to Mr Tutrone.

Many alternative fund managers, meanwhile, are confident that the big influx of money witnessed last year is part of a sustainable trend.

Andy Stewart, co-head of BlackRock Alternative Investors, predicts that global alternative assets under management will increase to $8tn by 2016, up from $6tn today.

He says: “The rise of alternatives since the financial crisis is only the beginning of a long-term shift in investor behaviour. As investors continue to expand their use of alternatives, it is our view that ‘alternatives’ will in fact become mainstream.”

A table accompanying this article is subject to a correction and has been amended.

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