Pension funds across the world generally invest in traditional asset classes such as debt and equity. However, over the past few years, many experts have suggested that pension funds should branch out and invest in alternative asset classes. Theoretically, investing in alternate asset classes has many benefits. However, when the pension fund actually starts making such investments, they run into a host of issues.
Regulatory bodies which govern the investment behavior of pension funds have a duty to ensure that the risk-return profile of alternative assets has been thoroughly studied. This makes it important for investors to conduct a detailed study of alternative assets.
Some of the issues which pension funds need to take into account before including alternative assets in their portfolio have been explained below:
- No Clear Definition of Alternative Assets: The first problem with understanding the concept of alternative assets is that there is no clear definition. The concept can be considered to be ephemeral since the definition of alternative assets is constantly evolving with the innovations in the markets. However, for practical purposes, we can consider them to be investments that are different from traditional debt and equity investments. Hence assets such as securitized real estate investments, cryptocurrency, real estate, and even artwork can be categorized as alternative assets.
Alternative assets have a very different risk profile which can impact the overall risk profile of the pension fund. For example, the liquidity risk, valuation risk, and operational risk of alternative assets can be markedly different from that of the other assets held by the pension fund.
- High Risk: In order to understand the risk profile of alternate investments, one needs to look at their historical origins. Alternative investments were originally created for high-net-worth individuals. Since these individuals have a higher risk tolerance, these assets were not created for investors with a low-risk appetite. The problem with these investments is that oftentimes they use excessive leverage. Also, the underlying security may be illiquid. Hence, the returns obtained from these investments depend on the skill of the manager.
Now, pension fund investors tend to be retirees who do not have much time to cover up any losses which may happen in alternative investments. Hence, regulators have to be careful when allowing pension funds to invest money in what could be considered opaque and illiquid investments. Generally, a very small and inconsequential amount of the total funds under management can be allocated towards alternative assets.
- Controlled Allocation: Modern-day regulators do not believe that alternative assets should be completely shunned. Instead, they are of the opinion that these assets do play a vital role in the functioning of the pension fund. For instance, the risk-return profile of these assets is completely different from the ones contained in the pension fund. Hence, if alternative assets are held in small amounts, they help in diversifying the portfolio.
Also, since these investments are illiquid, they tend to provide a higher rate of return. This is because of the fact that more liquid investments charge a liquidity premium. Hence, the controlled addition of these assets to an already existing pension fund can have its benefits. This is the reason that regulators all over the world do not eliminate the use of these assets but instead restrict them. The unwanted concentration of alternative assets in a pension fund portfolio needs to be avoided.
- Higher Governance Costs: Pension funds across the world are required to have risk management mechanisms in place. They are required by law to periodically take stock of the assets and liabilities that they have in their portfolio and understand the risks which are associated with them.
If a pension fund decides to include alternative assets in its portfolio, its governance costs tend to increase. This is because of the fact that risk management procedures which need to be followed for such assets are more extensive and therefore more expensive.
It also needs to be understood that ascertaining the unbiased valuation of these alternative assets can be quite difficult and also quite expensive. For example, the value of a stock or bond can be easily ascertained from the market. However, objectively determining the value of an artwork is not an easy task. There is no standardization when it comes to the valuation methodology of such assets. Pension funds need to ensure that the valuation is independent and unbiased. They also need to ensure that the valuation can be back-tested.
Regulators expect the pension funds to show due diligence in this regard. They should explicitly recognize the risks that the pension fund faces when it invests in alternative assets of a particular kind. Procedures should be defined to measure and manage the risk. The pension fund managers should be regularly apprised of the possible adverse outcomes of such investments and the measures which are being taken to avoid such outcomes.
The fact of the matter is that financial markets are evolving at a rapid pace. As such pension funds are exposed to a wide variety of options when it comes to alternative assets. It can be tempting to include these assets in the portfolio in order to increase the overall returns. However, since pension fund investments are meant to be conservative, considerable thought should be given to the possible outcome of such investments.