SHUNNING ILLIQUIDITY
Although the benefits of the illiquidity premium have long been recognised, UK pension funds seem reluctant to make a serious commitment to these types of investments. Instead, they prefer to stick mostly with the status quo of equities, bonds and a smattering of property. One reason is few have the scale, resources and governance required to gain exposure and monitor these more complicated assets.
“Pension funds such as those in Canada have the size to transact directly,” says David Hutchins, portfolio manager multi-asset solutions at AllianceBernstein. “By contrast, most UK funds do not have the in-house capabilities or investment expertise. It is more cost effective for them to invest in diversified growth funds or liquid alternatives, which at 50 basis points is much less than the typical 2/20 fees they would have to pay a manager for an illiquid strategy.”
Another driver is the belief that liquid assets are easier and more efficient to sell in case of an emergency or the need to cover a shortfall. However, as the past year has shown, they are not immune from significant losses in a volatile environment.
“Purely investing in liquid assets can still lead to a scheme being a forced seller if they need to raise cash to pay pensions at a time of market stress,” says Mike Walsh, head of institutional distribution at Legal & General Investment Management (LGIM). “For example, the values of corporate bonds dropped 25% during the financial crisis and transaction costs for selling corporate bonds increased three to four times.”
Stock prices today seem to recover quickly but the political uncertainty caused by the the unexpected Brexit vote and Trump victory has made investors nervous and reluctant to make big changes.
“One of the challenges is that portfolios today are built for normal volatility and correlations and they are not prepared for episodic risks,” says Andy Tunningley, head of UK strategic clients at Blackrock. “We need to look at the liquidity and collateral management requirements and be more thoughtful about how we respond to these episodic events and what solutions can be used to realise cash.”
TOO MUCH LIQUIDITY
Investors may be forced this year though to leave their comfort zone as the stalwart asset classes begin to lose their lustre.
“Over the past five years, bond prices have skyrocketed and equity prices have been dragged up,” says Adam Michaels, principal and senior investment consultant, Conduent HRS. “Investors will not get the same returns as they did going forward which means that the valuations for illiquid assets are better now than they were three years ago. The challenge is that capacity is often small and it gets eaten up quickly which is why you need managers who have the skillset to access these opportunities.”
Not surprisingly, opinions are divided as to the best illiquid assets and optimal weightings that should be applied. The Cambridge study, for example, argues that there is way too much liquidity sloshing around in portfolios and that at least 20% should be slotted into illiquid private assets. The theory is that this will not only narrow the funding gap, but also reduce the likelihood of schemes having to inject additional capital to honour their pension fund commitments. Others contend that it depends on individual funding levels and cash requirements.
In fact, putting a precise percentage figure on the allocation may be dangerous, according to Phil Edwards, European director of strategic research at Mercer Investments.
