As yield in fixed income picks up, a regime shift may have begun – but alternatives remain fundamental for institutions, says expert
Pension funds have been steadily increasing their allocations to alternative asset classes like real estate, infrastructure, private equity, and private debt, a trend driven by the pursuit of higher returns and portfolio diversification.
However, while the alternative investment opportunity set is diverse, and plan sponsors have chosen their paths based on their unique objectives, “there seems to have been a bias among pension plans for private market versus liquid alternatives,” says Jim Cole, managing director and institutional portfolio manager at PH&N Institutional, RBC Global Asset Management Inc. He says a likely reason for this is that “the long-term cash-flow generation profile of many private market asset classes is a good fit for what pension plans are striving to accomplish.”
As for real estate, Cole says that core real estate has featured in pension plan investment programs for many years. It was the era of very low interest rates that saw a significant pick-up in demand for core infrastructure and private debt as alternatives to public market fixed-income portfolios as plans focused efforts on maintaining expected returns at levels that would continue to support the benefit objectives of pension plan sponsors.
As for liquid alternatives, various forms of alternative public market credit have also found their way into portfolios as a way to build yield and income in institutional portfolios in what had been a low interest rate environment for many years.
“So, the theme for much of the past decade has been yield enhancement and portfolio diversification,” Cole says. “However, we may be in the early stages of a regime shift as fixed-income markets are now offering materially higher yields.”
The challenge of low yields in traditional fixed-income markets has also driven demand in global multi-asset credit strategies that offer the flexibility to invest across sovereign and corporate credit and to invest in both investment-grade and high-yielding issuers, depending on market conditions. Allocations to such public market strategies have helped bolster the yield profile in public market fixed-income portfolios.
Specialized funds can play valuable role
Cole says specialized funds can also play a valuable role in an institutional investment portfolio. “Alternatives are a very diverse asset class, even within individual sectors such as real estate or infrastructure. Specialized funds can be useful to round out core alternative investment exposures by targeting specific risk premiums or sources of return.
“Specialized strategies may be used to take advantage of the unique skillsets of some specialized managers, and through this expertise offer the opportunity to improve the overall return profile of an alternatives investment program. As well, specialized funds can offer the opportunity to access tactical opportunities that are presented by a unique and potentially temporary set of market circumstances.”
Specialized investment strategies are often designed to be very concentrated on one small segment of investment markets, says Cole. “Therefore, access to several specialized funds may be needed to build the desired overall portfolio exposures. This process can be time-consuming and requires very specialized knowledge to consider such investments. Investors will want to ensure they have access to sufficient resources and investment knowledge to consider specialized strategies to any significant degree. Many institutional investors have these resources available to them, and in these instances, it’s common for specialized strategies to form a part of the investor’s overall alternatives program.
“For smaller and mid-sized institutional investors that perhaps don’t have the resources to integrate specialized strategies into their investment programs, the diversification and governance simplicity offered by alternatives funds with broader mandates can or may make them more suitable.”
Due diligence may be more extensive
While alternative investments do not necessarily present additional investment risk relative to traditional asset classes, there are important reasons why due diligence may be more extensive than for some traditional asset classes.
“Differences across strategies, and therefore potential for greater return dispersion, can exist to a greater degree with alternatives versus more traditional asset classes,” says Cole. “There are also often a number of additional operational complexities that are not necessarily presented in traditional asset classes. For example, an investor will likely want to consider factors such as liquidity, portfolio concentration, derivative usage, leverage, performance fees, etc. For these reasons, we do often see a desire for more operational and investment due diligence for alternative investment strategies.”
As an expert in the field, Cole says institutional investors should approach the decision to invest in alternative asset classes based on their unique circumstances, including considerations such as long-term return objectives, inflation protection, governance structure, and liquidity needs.
“Lower yields and the desire for return diversification have been important forces driving demand for alternative investments over the past decade,” he says. “Fundamentally, we believe we will be in a lower interest-rate world going forward, if perhaps not as low as it was immediately post-global financial crisis or post-pandemic. And the uncertain economic backdrop may result in elevated volatility in traditional asset classes. Alternative asset classes will continue to play a role in institutional portfolios for the same reasons they were sought out in the first place.
