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MONITORBenefits and Pensions

Alternatives Post-crisis:New OPPOrtuNities

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Benefits and Pensions Monitor Meetings & events

At the Super Return pri-vate equity event in 2009, one of the first speakers was Leon Black, the co-founder of Apollo Global

Management. His opening remarks were: ‘We are in the midst of a perfect storm’ and how he couldn’t be more ex-cited about the opportunity.

That, in some ways, tells the story of what’s happened in the alternatives mar-ket post-financial crisis; in 2009, Apollo Global Management had $30 to $40 billion in assets under management and towards the close of last year their assets were up as high as $200 billion, said Alan Flanagan, Global Head of Private Equity Real Estate Fund Services, BNY Mellon.

He shared some thought leadership on alternatives. One study BNY Mellon did with FT Remark, ‘Split Decisions1,’ focused on the whole array of alterna-tive investment managers. The second, ‘Building for the Future2,’ a BNY Mel-lon report in conjunction with Preqin, focused on the illiquid space ‒ private equity, real estate, and infrastructure.

‘Split Decisions’ found the most im-portant factors considered when mak-

Demographics and urbanization are two of the factors which will change how insti-tutions invest in the future. At the Benefits and Pensions Monitor Meetings & Events ‘Alternative 2017’ session. Alan Flanagan, Global Head of Private Equity Real Estate Fund Services, BNY Mellon; Max Andres Widmer, a Client Portfolio Manager repre-senting the Invesco Global Asset Allocation Group; and Wei Xie, Strategic Director in the Office of the Chief Investment Officer at OPTrust; looked at the state of alternative investments today and tomorrow.

ing a private equity allocation had to do with performance ‒ the type of funds, the projected returns, and what has been done in the past.

Environmental and social issues were down on the list of considerations. “There’s a lot of willingness to get into the environmental and social issue space, but it just hasn’t really kicked off yet from a pure allocations standpoint,” said Flanagan.

In terms of fees, the typical 2% man-agement fee and 20% performance fee has come under significant attack. One report estimates that 1.56 per cent is the average management fee paid to-day. “That’s probably more weighted to the hedge fund space because we cer-tainly have seen lower fees in the illiquid space,” he said. Historically, allocators are more comfortable with the incentive fee approach rather than management fees and that’s “really manifested itself in terms of due diligence,” he said.

Due diligence efforts over the last few years have increased significantly by allo-cators wanting to get in to see the asset managers and understand how they run their business. They want to know that the managers are not just getting rich on man-

agement fees ‒ which was something we saw pre-crisis. “Two per cent on an $8 to $10 billion fund meant there wasn’t really much enticement for incentive,” he said.

In terms of the real asset story, a study2 in conjunction with Preqin, a statistical data collector in the real asset space, shows that on the demand side the first issue is really about population growth and the aging population. An interesting statis-tic is that today there are twice as many children and teenagers under the age of 15 as there are people over the age of 60. In terms of requirements, it means a sig-nificant investment across the globe will be required in the future in areas like se-nior housing, pharmaceuticals and medi-cal centres. This is a phenomenon which is occurring right now and we’re already starting to see the shift,” said Flanagan.

Levels Of GrowthThe next trend is urbanization. The UN

estimates 54 per cent of the world’s global population live in urban areas and this is expected to grow to 66 per cent by 2050.3 Megacities with populations of 10 million plus are expected to grow from 28 per cent today to 41 per cent by 2030.2 “The level of investment that will be required to fa-cilitate the levels of growth to urbaniza-tion is enormous and is coming,” he said.

Millennials represent a quarter of the global population and are a possible permanent driver of urbanization.2 The Millennial generation has very, different buying behaviour than that of the older

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Benefits and Pensions Monitor Meetings & events

Alternatives Post-crisis:

New OpportunitiesA full house was on hand at the Benefits and Pensions Monitor Meetings & Events ‘Alternative 2017’ session to hear the expert panel discuss alternative investments.

Comprehensive Diversification Under that premise, the only avail-

able way to actually achieve long-term financial goals is through comprehen-sive diversification. “This is exactly what risk-parity strategies are attempting to do. They’re geared to design, build, and manage better diversified portfolios,” he said, relative to conventional balanced portfolios, which invest 60% of their as-sets in equities and 40% in bonds.

There’s nothing unusual with a conven-tional balanced portfolio until you look at it through the lens of risk. Then it becomes clear that this is not truly a balanced port-folio because its aggregate risk is dominat-ed by equities. “This is all nice and dandy if you have a bull equity market,” he said. However, during a period of inflation or recession, this portfolio will not be able to provide the necessary diversification.

What risk-parity strategies are at-tempting to do is capture the economic diversification from combining asset classes that behave meaningfully different over the entire economic cycle. “While we understand that there’s going to be periods of heightened correlation to the downside, usually triggered by irrational market behaviour, we’re willing to take that trade-off because we know these periods are not long lasting and the fun-damental drivers of asset class prices are different over the long term,” he said.

Risk-parity strategies look to build a financial solution for an investor so that they can navigate the entire economic cycle with minimal participation and large drawdowns, yet simultaneously capturing positive-risk premium.

shore up LossesA lot of the emphasis in these strate-

gies is placed on mitigating drawdowns. “Mathematically speaking, losses are more important than gains.” said Wid-mer. “By mitigating the downside and capturing the compounding effect of interest rates, you end up with more pre-dictable return patterns.”

The diversification framework is argu-ably the most important consideration “if you think about building and managing a portfolio with the aforementioned ob-

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Benefits and Pensions Monitor Meetings & events

jectives in mind. For that, you’ll need to populate your portfolio with assets that are accountable for what we believe are the three relevant phases in the economic cycle ‒ inflation, growth, and recession. To establish asset accountability, we look at their risk and correlation patterns across the entire economic cycle as well as the ability to generate positive risk premium over time and their implemen-tation via highly liquid vehicles,” he said.

However, Widmer said, diversifica-tion is not a function of number of as-sets in the portfolio, it’s “what assets you combine that will yield the sought after diversification effect.”

Another important takeaway is that they do not assign probabilities to the occurrences of any of these three phases which is consistent with the premise of the impossibility to formulate correct mar-ket forecasts. So, in the same way that “we look at the economic cycle as the compo-sition equal phases, the portfolio is built so that each of the asset classes assigned for each phase contributes the same amount of risk to the aggregate portfolio. This re-sults in a capital allocation that will have a higher allocation to assets with lower risk relative to those with higher risk,” he said.

Implementing the portfolio with fu-tures is what “allows us to target specific levels of risk and with that make the port-folio’s risk/return profile attractive relative to the conventional balanced portfolio.” This is obtained by taking advantage of the economic leverage effect the investor gets from using these derivatives, which is very different from conventional fi-nancial leverage. With financial leverage, money is borrowed, holdings purchased, and, should the markets correct, positions are forced sold in order to repay the loan. Futures are highly liquid instruments that provide exposure to specific assets or mar-kets by posting a margin based on an as-set’s underlying volatility which is only a fraction of the actual exposure.

tend to shineNo strategy comes without trade-offs,

he said. Risk-parity strategies are long only portfolios and, as a result of that, they will struggle when the asset class

April 2017 | BENEFITS AND PENSIONS MONITOR 2

generation. Many of them may struggle with a lower income and many of them may be priced out of the existing mort-gage markets.

As a result, the Millennial thought process is really ‘own the experience, not the asset,’ he said. From a real estate per-spective, that’s had an impact as 45 per cent of new development in the U.S. last year was in multi-family dwellings.

This points to a funding gap. A 2014 report by Standard & Poor’s4 estimates the annual gap between investment re-quirement and available public finances to be at $500 billion for each of the next 15 years, he said. That’s not to suggest that private capital will bridge the gap, but there is clearly a shortage in public finances for the requirements and within that gap rests opportunity, he said.

investor AppetiteOn the supply side, there is an increase

in investor appetite across the illiquid space and no decrease whatsoever across infrastructure fund managers. Longer term, it’s still overwhelmingly positive for private equity and infrastructure.

“Alternatives are now mainstream and continue to exceed growth expectations. They are very, very much part of the stable diet now of institutional allocators,” said Flanagan. This is largely driven by perfor-mance challenges in the face of low yield and uncertain economic growth which may well continue for some time.

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‘It is virtually impossible to formulate consistently correct long-term market forecasts.’ said Max Andres Widmer, a Client Portfolio Manager representing the Invesco Global Asset Allocation Group as he introduced the concept of risk parity in asset allocation. Case in point, the U.S. Federal Reserve regularly issues GDP forecasts and as often as it issues new forecasts, it revises the old ones. “If the U.S. Federal Reserve, in its infinite wisdom and access to resources, is not in a position to forecast correctly the GDP, how are we as investors ex-pected to do better than that?”

BENEFITS AND PENSIONS MONITOR | April 20173

from 12.8 to just 1.2 in 2016.Externally, the low-interest rate en-

vironment has caused risk premia across all asset classes to compress, forcing in-vestors out into the risk curve to find other assets to generate returns. This is particularly challenging for a defined benefit pension plan because the ex-pected return on assets determines the discount rate for liabilities. A lower dis-count rate means the present value of liabilities is increasing.

Primary toolThe plan’s ability to bear risk is de-

creasing, which means from an invest-ment strategy perspective “we must con-tinually look for ways to improve our risk management capabilities,” he said. OP-Trust’s total fund portfolio construction framework is its primary tool to enhance risk management.

Its approach is built upon two “core pillars.” It starts with harvesting di-versified risk premia, which provides a strong foundation and offers portfolio resilience. However, time horizon mat-ters, which mean risks also need to be managed dynamically. “We have to be responsive to the external environment and understand how it’s changing,” he said. The process also takes into consid-eration other contextual factors such as regulation, governance framework, orga-nizational capabilities, and resourcing.

Capabilities in AlternativesStrong internal capabilities are a key

enabler to the overall strategy. “When we talk about alternatives, whether il-liquid or liquid, the strategies should be employed in a thoughtful way. Not hav-ing the appropriate capabilities generally means that you won’t extract the benefits that you would expect from those asset classes or strategies,” he said.

Overall, illiquid alternatives play an important role within OPTrust’s total fund portfolio. Teams have been inter-nally managing these strategies for quite some time starting with the real estate group in 2004 and the private markets group, which covers both private equity and infrastructure, in 2005. It has built up critical mass internally to seek out opportunities within attractive segments of these markets. “Having the right part-ners and the right relationships to drive deal flow and the ability to add value into businesses to generate growth are really the drivers behind potential outperfor-mance in these asset classes,” he said.

Liquid strategies“For us, illiquid alternatives serve as

a starting point in portfolio construc-tion. We want to have a core exposure to those asset classes because we think that we can deliver strong value-added per-formance.” Infrastructure and real estate also provide stable long-term cash flows and have characteristics that match those of the plan’s long-term liabilities.

Liquid alternative strategies are cur-rently an area of focus because they pro-vide diversification to the total fund. Just as they have done in the illiquid alter-natives space, OPTrust is acquiring the internal skills necessary to execute these strategies efficiently and effectively.

“From our perspective, everything has to be implemented in a way that is fit-for-purpose for the organization. Our contex-tual challenges are unique and that really drives how we think about integrating different types of strategies.” BPM

1. Split Decisions, Institutional Investment in Alternative Assets, 2016, BNY Mellon and FT Remark

2. Building for the future: How Alternative investment managers are rising to the demo-graphic challenge, 2016, BNY Mellon and Preqin

3. United Nations, Department of Economic and Social Affairs, Population Division (2015). World Population Prospects: The 2015 Revision, Key Findings and Advance Tables. ESA/P/WP.241.

4. S&P Capital IQ Global Infrastructure: How to Fill a $500 Billion Hole, January 2014

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Benefits and Pensions Monitor Meetings & events

BeNefits AND PeNsiONs MONitOr wOuLD Like tO thANk the sPONsOrs Of this eVeNt

correlation increases to the downside triggered by irrational market behav-iour. They are designed to harvest return across different periods of the economic cycle and exhibit low correlations to broader capital markets. This is what makes risk parity strategies an ideal risk mitigating complement and core hold-ing in a well-diversified allocation.

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Investors today tend to frame the world through a lens of ‘challenges,’ said Wei Xie, Director in the Office of the Chief Investment Officer at OPTrust. “But as we think through challenges, we also think about the opportunities and the potential for innovation. It’s all about finding solutions and improving upon what we already have.”

OPTrust developed its Member Driven Investing (MDI) strategy to deal with the internal and external challenges that it faces. The core focus of MDI is on “how to make investment decisions bet-ter aligned with what our members want: pension certainty.”

funded status firstAs a pension management organiza-

tion, OPTrust’s approach differs from asset managers. “We focused on the funded status of our plan, first and fore-most. To us, it’s not just about invest-ment returns,” said Xie.

There are two primary objectives that support the goal of pension certainty ‒ sus-tainability and stability. OPTrust has to earn a rate of return that is sufficient to cov-er its liabilities over the long term. In doing so, it seeks to keep benefits and contribution levels stable at their current target levels.

But there are challenges. Internally, it is a mature and maturing plan. In 20 years, its dependency ratio has dropped