Increasingly, it’s more about what an asset brings to a portfolio than how it is classified.
By Ed McCarthy
Carmen Staltari
Pension plan assets were traditionally broken down into cash (and cash equivalents), equities and fixed income. These groups comprised the bulk of plan holdings, and any investment that didn’t fit neatly into these categories was considered an alternative. This classification method is useful—we still cite the 60/40 equity/bond portfolio and its variations as a metric, for instance—but is it as relevant?
Consider the Pension Investment Association of Canada’s (PIAC) Asset Mix Report’s findings. As of December 31, 2019, participating defined benefit plans reported holding 39% of their assets in alternative mandates versus 31% in fixed income and 33% in equities. (The total exceeds 100% due to rounding up in the reported categories and year-end allocations that exceeded 100%). Three alternative categories—private equity, real estate equity and infrastructure equity—ranked in the top five holdings with global all-cap equity and Canadian universe bonds.
The shift to alternatives has influenced smaller plans, too. According to Carmen Staltari, Director, Investments with Willis Towers Watson, a recent Greenwich survey showed that for relatively small pension plans with assets of less than $250 million, the average allocation to non-traditional, diversifying strategies was 35% compared to 36% for public equity. “That means that today, plan sponsors are now as comfortable with these asset classes as they are with traditional public equities,” Staltari says.
Time to Change Classifications?
Ruo Tan
Given these results, is it time to reconsider which assets should be classified as alternatives? Ruo Tan, President, Segal Marco Advisors Canada, cautions that plans’ increased use of alternative investments does not necessarily mean that “an alternative is no longer an alternative.” However, Tan does believe that the distinction between public-market and private-market investments is more useful than the traditional three-class categories because the private-public categories capture investments’ essential features, such as illiquidity and leverage, more readily. “Private market real estate is typically illiquid,” he notes. “Private infrastructure debt is illiquid. Hedge funds use derivatives that create leverage, which typically will not fall in the public market domain.”
Louis Beaulieu, Director of Risk Management and Asset Allocation at Desjardins Group Pension Plan, says that his firm rarely uses the traditional asset classification terminology any longer. “The reason is simple,” he explains. “It’s that the definition is just too broad and the risk profile is so diverse. So, for us, it’s not about traditional or not. It’s about the asset classes and assets and what they can bring to the portfolio.”
Beaulieu cites Desjardin’s current approach to illustrate his point. The firm has a long-term target allocation of about 35% to private capital with infrastructure and real estate as the predominant categories. “Those two asset classes have been around for a while and we don’t see them as alternatives, but rather as important parts to reach our goals,” he explains. “It’s the same for private equities and private debt.”
Maintaining Perspective
Louis Beaulieu
Instead of focusing on formal classifications, plans need to introduce a top-down framework to determine their risk budget and how much they can invest in alternatives, Tan maintains. This includes reviewing liquidity constraints and liability concerns such as large payouts that will occur in the near future; these conditions indicate a reduced allocation to less liquid assets. “We always say you should have a framework and do a risk-budgeting exercise before you look to individual alternatives,” says Tan.
Also, while it’s important to keep an open-minded attitude on innovation and new opportunities, any asset class must clear multiple hurdles before it’s included in a portfolio, Beaulieu said. Desjardins must be able to precisely understand and model its risk-return profile using multiple scenarios and simulations and determine that the asset provides a genuine additional benefit versus the asset it will be replacing in the portfolio. “With all those steps properly done, then you can say you have done what is expected of a proper fiduciary duty,” he adds.
Staltari shares that opinion. “When it comes to alternative asset classes, it is important that a robust governance structure is in place to ensure the pension plan can sufficiently identify appropriate alternative investments, skilled managers and monitor the program to ensure it continues to meet the predetermined return and risk characteristics,” he cautions.
Be sure to attend The CAiP Alternative Investments Forum, an in-person event September 21-23, 2021 in Montebello, Q.C., where leading experts and top pension fund managers from across Canada will offer insights into new opportunities and risks in the alternatives market.
Ed McCarthy is a longtime financial writer and author of three books, including “Foundations of Computational Finance with MATLAB.”
