It is becoming easier for DC schemes to invest in alternatives. Matt Roberts looks at the opportunities on offer and the considerations for trustees
Defined contribution (DC) pension schemes have long been seen as the ‘poor cousin' when it comes to investing in alternatives - and there are a number of reasons for why they have found investing in asset classes other than traditional equity and bond mandates challenging.
First, the majority of DC pension schemes in the UK access investments through life company platforms and, given the permitted links rules that govern them, replicating the range of investment strategies included in defined benefit (DB) schemes has been close to impossible.
Additionally, the charge cap of 0.75% - an overall fee which includes asset management fees and numerous other costs such as platform charges, custody fees etc - has constrained asset managers, particularly those in the alternatives space where higher charges and performance-linked fees are more common.
Furthermore, the consulting and investment framework for liquid and illiquid alternatives is still developing; a process that is likely to continue over the next few years as future regulatory changes bed in.
However, the combination of the ongoing Department for Work and Pensions consultation on the use of illiquid assets in DC schemes and the Financial Conduct Authority's consultation on permitted links rules has the potential to create a new environment for DC schemes and asset managers alike.
The diversifying qualities of liquid and illiquid alternatives can be of great value to DC savers so it is surely worthwhile overcoming the challenges that have historically made them difficult. Indeed, new solutions are already coming to market.
At Fulcrum, our approach is to group liquid alternatives into three buckets - listed real assets (such as REITs, listed infrastructure and commodities); alternative credit (high-yield bonds, loans, securitised credit, emerging market debt and convertible bonds); and diversifiers (liquid hedge funds and alternative risk-premia strategies).
In contrast, illiquid alternatives encompass direct property, infrastructure, private equity, less liquid hedge funds and more esoteric credit investments, such as direct lending. Understandably, property is often not classified as an alternative, but we include it here for completeness.
We believe there a number of areas DC schemes should consider when assessing alternative investments.
First, the investment case. Schemes should assess how strong it is and how it fits in with its overall strategy and glidepath design - questioning also whether it stacks up in terms of diversification and whether the prospective managers have the right skills.
Costs are also an issue and schemes need to be sure they have certainty on the cost structure of their investment and make sure it satisfies the charge cap when considered with the rest of the investments. Also, schemes need to ask if the fee structure is aligned with its objectives and look at whether it is a reasonable fee overall.
It is important to always push asset managers for the full cost structure. For example, many managers invest in investment trusts to gain exposure to alternative asset classes and these usually have embedded management fees and other costs. This does not make them intrinsically bad investments, but understanding these cost structures, including any performance fees, is critical for making an overall assessment of the investment and its appropriateness for your particular scheme.
There are also liquidity considerations - and schemes need to think about how they should size the position in their portfolio and what could happen in stressed market conditions.
They also need to ask whether the strategy offers appropriate liquidity and, when assessing just how liquid an investment is, it is crucial to go into detail and ensure the liquidity of the terms offered is consistent with the liquidity of the underlying investments.
DC schemes generally offer members daily liquidity, so obtaining an appropriate balance between liquid and illiquid investments will be crucial. While it is possible to invest in assets that capture a multitude of longer term themes, such as clean energy, in a highly liquid form, there are also some fantastic illiquid opportunities out there that require locked-up capital.
Finally schemes need to consider how managers are embedding responsible investment and whether this meets its needs.
It is easy to get caught up in debating personal values about screens, exclusions and so on, but we believe it is possible to build a robust portfolio of alternative investments with attractive risk/return characteristics which reflect well-integrated responsible investing. Careful analysis of environmental, social and governance (ESG) considerations within a manager's investment philosophy and process is critical to understanding the impact on risk and returns. For example, if a manager tilts a portfolio away from high ESG-risk industries or sectors, how are those assets reallocated and how does it change the portfolio's risk/return dynamics and sensitivities?
What was once a distant dream for DC schemes is now reality and evolving quickly. The opportunity to invest in interesting and different alternative investments for savers has arrived, so let's grasp it with both hands and assess the possibilities on offer.
Matt Roberts is head of alternative strategies at Fulcrum Asset Management
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