MSG Team's other articles

10033 Investment Banks and Governments

Governments all over the world regularly engage in high-value financial transactions. They often need the help of experts in order to do so. Since investment banks have a lot of experience in mediating high-value transactions, they are often appointed by the governments to be their advisors on these matters. In this article, we will have […]

12390 Auto Loans and Personal Finance

Personal finance gurus seem to have differing opinions on many subjects. Some of them believe that mutual funds are good investments whereas others think the exact opposite. They seem to agree on very few things and auto loans are one of them. Almost every personal finance guru in America believes that auto loans are bad […]

9029 Dutch Auction

Book building has been one of the most widely used methods in the underwriting process. However, over the years, companies have realized that the book-building process is largely controlled by the intermediaries, i.e., the investment banks! The investment banks are the ones building the books. Hence, they can easily control who gets in and at […]

11821 What are STRIP Bonds?

STRIP is an acronym that is commonly used to denote Separate Trading of Registered Interest and Principal of securities. This is a complex-sounding term however, in reality, the meaning is quite simple. It is important to understand that when we buy a bond that pays regular coupon payments, we are actually buying the right to […]

8927 Difference between Corporate, Retail, Investment Banking, and Private Banking

The Difference between Retail, Corporate, and Investment Banking Most of us when dealing with banks usually walk into the branch and get our work done we usually do not bother whether it is retail banking branch or a corporate banking branch. The difference between retail and corporate banking is that retail banking serves individuals and […]

Search with tags

  • No tags available.

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:

  1. 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.

  2. 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.

    Pension Funds

  3. 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.

  4. 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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

The Chinese Pension System

MSG Team

Challenges of Risk-Based Supervisory System

MSG Team

Challenges Facing Pension Fund Governance

MSG Team