Can alternatives transform retirement fund returns?
Azola Zuma, Chief Executive for Sanlam Investment Management, debates with us the environment of ‘lower returns for longer’ that investment managers and retirement fund trustees have to face. In this context, she shares some of the thought-provoking insights offered by a panel of prominent professional trustees, CIOs and asset owners at the Sanlam Investments Institutional Insights conference in September. The panel were discussing their experiences of investing in alternative asset classes. TV anchor, Iman Rappetti, MC’d the event and set the tone for the discussion by asking the panel, including Mabatho Seeiso (Professional Trustee), Shainal Sukha (Investment Professional and Asset Consultant), Ndabe Mkhize (Chief Investment Officer of the EPPF) and Themba Mfeka (Principal Officer for the MWRF), “In the context of this low-return environment, surely it makes sense to add alternative investments to portfolios as a powerful diversification tool and source of alpha?”
Alternatives can be broadly defined as non-traditional ways of investing and include private equity (buy-outs and venture capital), private debt (loans), infrastructure-funding debt vehicles, hedge funds, unlisted credit and derivatives. And these all hold the potential for providing higher than average returns. And the reality is that they have a place in nearly every portfolio: they could be a potentially powerful lever for retirement funds to diversify, spread their risk and enhance returns, as a trustee in the conference audience confirmed.
Interestingly – as the panel and members of the audience revealed – the South African institutional investment community has by and large resisted using the full mandate of Regulation 28, which allows up to 15% of assets under management to be allocated to unlisted “alternative” vehicles. There is certainly far more capacity available for fiduciaries to adjust their portfolios to take greater advantage of the attractive potential returns on offer, but most funds are not biting.
Demystifying the negative perceptions
Clarifies panellist Mabatho Seeiso, “From my perspective as a professional trustee, from early on we were taught not to invest in something you don’t understand. So many of us have had an ‘arm’s length’ relationship with alternatives as a result. Also, for the longest time, pension funds had done extremely well just by investing in traditional asset classes, so there was no compelling reason to look further afield at alternatives. It has only been in recent times that these asset classes are no longer yielding attractive real returns, and therefore preventing us from meeting our fiduciary obligations…”
But there has also been a negative perception of alternatives as “high risk’, said Seeiso, and that hasn’t helped matters either; in fact it’s kept alternatives even more at ‘arm’s length’. And the problem with keeping things at ‘arm’s length’ is that, by implication, you’re not engaging properly with them or quantifying the risks accurately, nor fully grasping whether alternatives are feasible or not in members’ retirement portfolios”.
“In South Africa, we have tended not to engage comprehensively with the full, investable universe available to trustees. Whereas overseas, people have been exploring investing in timber and farmlands – not to mention public-private infrastructure projects involving roads, hospitals, and schools – as ways to provide fruitful returns over the long term”, continued Seeiso.
What has led trustees to looking at alternative forms of alpha, more recently?
Investment Consultant Shainal Sukha reported: “For us as investment consultants, it was very much about quantifying the risks, rather than just looking at returns. What led us to consider alternative investments goes back as far as 2012, where people were talking about the US Fed’s quantitative easing programme. At the time we asked ourselves “What are the risks associated with QE and what are the unintended consequences?”
“With the fed pumping liquidity into the markets, asset prices were all going up, so we were concerned about whether it was appropriate to have 100% of our clients’ funds in public markets. Were there not other avenues to explore to help diversify away that risk?”
“Admittedly, investing in private markets doesn’t reduce all your risk”, cautions Sukha. “What you’re essentially doing is dialling down your market risk exposure in favour of something like credit illiquidity. But the major risk was that no-one knew how the QE programme would unwind, or how liquidity would be pulled back. And so planning for that risky outcome [QE tapering] drove us to the search for alternative asset classes”.
The other risk was that markets had become increasingly ‘short-termist’ in their behaviour, and reacted to every single bit of news from Ben Bernanke, which created volatility in the markets and discomfort, continued Sukha. And this is when a long-term view becomes the safer option, where your capital is locked safely away, and then you can’t take short-term action and erode the value of your funds through constant switching and bad judgement, spurred on by excess noise in the markets.
Diversification is the new ‘free lunch’
CIO of EPPF Ndabe Mkhize added by saying: “In public markets, diversification is just about the only ‘free lunch’ you can ever hope to get in the markets. And sadly most pension funds are not nearly diversified enough. Even ten years ago, people had minimal exposure to global emerging markets and listed property, and those asset classes have done exceptionally well in the past ten years. But now even these have been adversely affected by the actions of the central banks, so it really makes sense in this low-return environment to be pivoting to private markets. This could include private equity, real assets or infrastructure assets, direct property and timberland and farm lands. These assets are all long-dated and inflation sensitive and will match the liabilities of many pension funds or other long-term investors.
Why have we not seen a bigger take-up, despite the potential of real alpha?
A general lack of education appears to be the most common reason, answers Ndabe. There was even a time when equities were considered to be ‘alternative’, so people would frequently put all their money in bonds. It’s only as people begin to understand the different asset classes and their pitfalls, their risk and return profiles, that they can choose the right investments, avoid the bad ones, get a good return and enjoy the diversification benefits. Dispersion between the high performers and the laggards can be huge, so you need to be able to ‘do your homework’ properly and discern accurately.
Says Themba Mfeka, “For me, it depends on how you classify alternatives. We prefer to look at alternatives in their individual categories, rather than as a whole. For example, with something like hedge funds, trustees have always been allowed to get away with pleading ignorance or a lack of knowledge about the subject matter, but this won’t continue going forward. As a collective we have to take more accountability for the decisions made. Therefore education is key”.
The other drawback appears to be the liquidity risk and risk of capital losses, continues Mfeka. But the time is ripe for a more innovative approach to determine how your fund can be diversified, and at the same time, ignite the economy.
Picking up the thread, Seeiso concurs that infrastructure is a good investment opportunity. “It is a good diversifier, returns are fairly stable and they are also inflation protected. But here you have to realise that you are in for the long-haul, so you must have a long-term investment horizon for this asset class”.
As a fund trustee, you have to understand exactly where you want to play in this field, says Seeiso.
“For instance, you may want a high-impact fund that will also benefit fund members directly. In my capacity as Independent Trustee of the Road Freight Provident Fund, we considered ‘truck stops’, which are integrated one-stop shops for truck drivers, including nursing facilities. In the early considerations, fear of getting it wrong was a big inhibitor. We needed to go through the right education channels and understand the processes involved, the benefits, the risks and the return profiles”.
“With hindsight”, Seeiso reports, “the truck-stops were a really good investment. We’ve had them in place for 18 months now and they have already returned 19%. But to get there, we needed to understand and quantify the risks, and importantly, find the right investment partners to make sure the investment worked”.
So a key question is: do you have the right asset manager who understands both your needs and the investable universe to select from, making it a robust and workable partnership that can yield real fruits?
We need to think out of the box…
Says Sukha, the world is changing and we need to think differently. “We are overly obsessed with daily liquidity and daily pricing, and in our industry this has become a big disservice”.
Given that the average retirement fund has a long-term investment horizon, the need for high liquidity (or access to cash) should not be a factor at all. And in a low-return environment, we could all benefit from the significant ‘illiquidity premium’ or compensation that you get when you invest in a share that cannot easily be converted into cash.
For instance, says Sukha, “We should also be investing for life expectancy, instead of retirement – because longevity is another major risk we underestimate. Life expectancy is improving globally and we are all living for longer. So we cannot de-risk members too soon as we are currently doing; just before retirement, and then put them straight back into growth assets soon after”.
Coming back to fiduciary duty, continues Sukha, “It is our duty to exploit (or at least consider exploiting) the illiquidity premium to enhance returns for those members with a long term investment horizon, who really need it. Alternatives play a big role here, and the research reveals that this payoff for reduced liquidity has in many cases led to better returns”.
But it is more than just returns, says Sukha. “You also have to understand and quantify the risks, gauge the unintended consequences, and select an asset management partner who can navigate the complexity and make the right judgement calls”.
Ndabe agrees that we fundamentally have to change our mindsets. “We live in an environment of political risk and flux but we still have to consider the long-term perspective, and allow our members to benefit from the illiquidity premium”.
He offers “You can get involved in projects that give you excellent returns – such as infrastructure investing – where you’re not just making a good return, but you’re actually making a difference to the economy in a lasting and impactful way”. As examples he suggests investing in telecoms, roads and schools which are long-dated, inflation-sensitive and meets your liabilities, with the added benefit of making a good impact on the sustainability of the economy.
But be sure to do your due diligence with these, he cautions. While the modern toolkit of the trustee has to include more than just bonds and cash, you still have to weigh up the risks and rewards and make the appropriate decisions based on that. Education enables this.
Looking internationally by comparison, Ndabe states that pension funds have investment boards that are allocating up to 35% in alternative markets. But before we can get there here in South Africa, we need to upskill ourselves as trustees.
What are the structural impediments to us charting a new course?
Said Themba Mfeka: “The biggest problem is that we tend to look at the negatives around something for instance, like illiquidity, rather than the benefits. Long-term just seems too far away, but the shift in perception is undoubtedly necessary…. Investing in “real assets” not only carries manageable risk, but aids transformation and job creation”.
All panellists agree that the industry has to demystify the perception that alternatives are high risk when in fact they could provide fruitful returns over the long term. We must upskill ourselves to realise that alternative asset classes can offer institutional investors the flexibility to invest through the market cycles, as an additional arrow in the fiduciary’s quiver. But we must quantify the risk properly and make sure you understand it properly. Don’t keep it at arms’ length.
- “Past performance breeds complacency — look beyond the traditional”.
- “Education is paramount to ensure everyone looks beyond the traditional normal”.
- “Do your due diligence: there are opportunities that embrace both sustainability and social responsibility”
- “Look at the benefits, not just the liquidity”
- “Trustees must take ownership of investment decisions, instead of relying solely on consultants. Push your consultants to allocate more to alternatives”.
- “We need to understand what that investable universe looks like and educate ourselves, because it’s just so vast”.
- “It’s equally important who you partner with”.
Ultimately, we should not look at alternatives only from a returns point of view, but look at how we can grow the economy – it should be an argument about sustainability.
“You cannot dig a hole in a different place by digging the same hole deeper”.
Edward de Bono