This is the eighth installment of an ongoing series on managed funds – part one: using the Sharpe ratio to assess fund performance; part two: identifying appropriate benchmarks for private equity funds; part three: evaluating common measures of private equity performance; part four: understanding the negative impacts of pension fund complexity; part five: revealing the perverse incentives of pension fund managers;Â part six: demystifying co-investment; and part seven: fighting back against hedge fund fees.
The problem of yield
Few people think too much about their pension funds. They assume they will get the promised benefits, whether they are defined benefits (as most have been structured until very recently) or defined contribution plans. But many pension funds have been hard pressed to bring in the necessary investment return in order to cover ever-growing payouts. While the total pension fund assets under defined benefit plans fell by a hair over the last year, they still account for 64.7% of total assets under management. That is a lot of defined obligations to cover.
We have commented on this problem in a series of prior research notes, but it is worth revisiting the subject once again in light of the latest research. All evidence points to continued, and even increasing, appetite for alternatives as pension funds strive for yield. Funds need market-beating returns in order to meet their obligations. That can mean taking bigger risks in the hunt for yield. And that can mean real trouble in the event of a market correction.
Looking for alternatives
Alternative assets have become increasingly popular with pension funds and other large-scale allocators in recent years. It is understandable why. While the current bull market has brought rich rewards to investors, the market return is often insufficient to cover looming pension liabilities.
In its latest survey of the world’s 300 largest pension funds, Willis Towers Watson (WLTW) found that pensions were continuing their heavy allocations to the alternatives space. Worldwide alternatives and cash now account for 21% of the biggest pension funds’ asset allocations. In North America, the allocation is even starker, with alternatives and cash accounting for 34.8%.
The appetite for this sort of investment makes sense in the context of pension funds’ needs. And it is unsurprising that American pension funds would see higher levels of allocation; compared to the staid European and Asian fund allocators, even America’s cautious and rules-bound pension managers look aggressive.
A most dangerous game
Private equity and alternatives have shown higher reported returns over time, which has been a major driver behind the trend of higher allocations. But these returns may not be as they seem.
In theory, illiquid assets are supposed to demand a higher return. Unfortunately, allocators too often assume that simply because an asset is illiquid that it will inherently produce higher returns. This is a classic post hoc ergo propter hoc logical fallacy, i.e. “Since event Y followed event X, event Y must have been caused by event X." But the illiquidity is not what produces the higher return. Rather, higher returns are demanded as a necessary recompense for the illiquidity. Yet many allocators act as if the reverse is true. And this is a serious problem.
We need only look at this week’s headline-grabbing announcement that Uber will be conducting a $2 billion bond issue, with $1.5 billion carrying a whopping 8% interest rate. It was originally going to be just $500 milion, but the second tranche was added as a result of overwhelming demand. It is big private allocators like pension funds that will be gobbling up those bonds. But it is the desperate hunt for yield that is driving those decisions, not intelligent risk-adjusted decision-making.
Verdict
The key takeaway for investors is they should pay close attention to what their pension funds are doing. Many are in the process of re-evaluating how they allocate to private equity and other alternatives. That is the result of dogged criticism regarding high fees and hidden costs. But the real risk is that, in the desperate hunt for higher yield, pension funds will end up allocating to increasingly risky and lower quality assets.
The current market has been awash in liquidity. But that is now tightening. As the market shifts to this new reality, easy money may not be so readily available. Private companies and illiquid assets could end up becoming a serious problem for pension funds in need of both steady flows of income and constant capital appreciation.
Investors would be wise to keep close watch of any managed pension funds to which they are exposed. The long bull market has led to some strange allocation behavior. A value investor would be better served taking their retirement into their own hands rather than leaving it to stretched pension managers.
Disclosure: No positions.
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