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Pension funds and insurance companies have increasingly embraced riskier assets in their hunt for higher returns over the past five years.
Alternative assets such as property, infrastructure, private equity and hedge funds have been bought up by institutional investors in a world where yields on safer government bonds have hit rock bottom.
Total assets managed by the 100 largest alternative investment managers rose to $3.6tn this year, up 3 per cent on 2015, according to consultants Willis Tower Watson, as these assets have become more embedded in the portfolios of pension funds and insurance groups.
This switch into alternative products has prompted warnings that some of these institutional investors could be severely affected in the event of a financial shock or the seizing up of liquidity in the markets.
The OECD, the Paris-based group of mostly rich nations, warned last year that pension funds and insurance companies faced a growing threat of insolvency because of their increased allocations to riskier assets.
“The main concern is whether pension funds and life insurance companies have, or might, become involved in an excessive ‘search for yield’ in an attempt to match the level of returns promised earlier to beneficiaries or policyholders when financial markets were delivering higher returns. This might heighten insolvency risks,” the OECD said in its business and finance outlook for 2015.
So what are institutional investors doing to make sure they are not taking on too much risk?
Chris Hitchen, chief executive of the UK railway pension fund RPMI Railpen, says: “It is much harder to get returns today because yields are low. It takes decent returns as well as decent contributions to make decent pensions. This involves some risk.
“We have risk systems in place to try to ensure we do not get into a position where we are forced sellers. In the event of falling markets, we want to be in a position where we have enough liquid assets to pay our pensions and firepower to invest at lower prices.”
RPMI has investments in quoted shares, real estate, infrastructure, private equity and hedge funds, all considered riskier than government bonds, traditionally the safest assets.
The group has a system in place that monitors risk to its portfolios daily, while it employs experienced fund managers to ensure that its funds’ positions deliver the best returns with risks reduced to the lowest possible levels.
Other institutions such as Legal & General Investment Management carefully monitor systemic risk, or the perceived dangers to the markets of a breakdown in the financial system that would prevent investors from being able to sell assets or liquidate positions.
LGIM says that risks to the system are elevated because of rising worries over a hard landing in China, the threat of a break-up in the EU as the economies continue to struggle to grow, the potential fallout of Brexit and concerns over the impact of expected US interest rate moves.
John Roe, head of multi-asset funds at LGIM, says: “There are elevated risks in the system. As a fund manager or institutional investor, that means you have to be more vigilant and think more carefully about the weightings in your portfolio.”
Other fund managers say investors need to be more disciplined and flexible, seeking opportunities in areas of the market such as corporate high-yield bonds, subordinated bank debt, infrastructure and equities.
“Equities look good value and so does infrastructure. But you need a longer term horizon to invest in these type of securities,” says the investment director of a top UK fund manager.
“A pension fund that is still open to new members and is looking to hold an asset for a long time can be quite comfortable with equity volatility or the illiquidity in a market like infrastructure because they can hold these assets for years.
“Some pension funds refer to their quarter as 25 years, rather than three months. If you have that kind of long-term horizon, you can take quite a lot of risk and not face any threat in terms of insolvency.”
However, the reality is that it is much harder today to make decent returns.
“Going forward, if you want 8 per cent today in returns, you are going to struggle,” says Mitch Reznick, co-head of credit at Hermes Investment Management. “It is harder to hit those kind of returns with zero interest rates.”
He adds that the days when a pension fund or insurance company could rely on government bonds, typically considered close to risk-free, for returns, is in the past.
Unless a pension fund puts all its money in cash or treasury bills, which offer zero rates or in some cases negative yields, then there will always be a danger that the market could undermine its portfolio and cause losses.
As Jim Leaviss, head of retail fixed income at M&G Investments, says: “There is no such thing as a free yield. If you want yield, you have to take some risks.”