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Making room for alternatives in pension fund asset allocations

RisCura’s Fran Troskie argues that it has become vital to look beyond traditional asset classes.

Making room for alternatives in pension fund asset allocations

 

By Fran Troskie

 

Financial markets have been hard-hit this year, but pension funds have really been in trouble since before the Covid-19 pandemic struck. The traditional stalwarts that they relied on for stable returns and regular cashflows – namely cash, property and bonds – have long suffered in a low-growth, low-interest rate environment.

Cash investors have found returns eroded by lower interest rates. Bond yields, too, suffer in a low-interest rate environment.

The South African All Bond Index had gained a meagre 0.9% in local currency terms for the year to 30 July, juxtaposed against the 6.2% return on the (offshore equivalent) Barcap GABI (in USD, 29% in ZAR). Inflation-linked bonds (ILBs), which are at least some form of hedge against inflation, have not fared much better, with the Composite Inflation-Linked Indices (CILI) losing 3.3% during the first seven months of 2020.

This does not mean that there is no longer a place for ILBs, as they continue to be a necessary hedge against inflation. It merely means that there is a need to look beyond the traditional in seeking higher returns and effective inflation hedges.

Property, the other stalwart for pension funds, has perhaps suffered worst. The South African property market, as measured by the All Property Index, had lost over 40% for the year to 30 July.

What should pension funds do now?

Pension funds need to ensure that they can still match their liabilities and meet the retirement funding needs of their members. To achieve this, advisors and pension fund trustees will need to ‘think out of the box’ and consider alternative asset classes.

In mid-July, the ANC’s Economic Transformation Committee released a report titled ‘Reconstruction, Growth and Transformation: Building a New, Inclusive Economy’. The report’s focus is on infrastructure investments as an answer to South Africa’s flagging growth.

The approach is similar to one that has previously worked for China, and which is also being used by that country to repair its post-Covid-19 economy.

The report did not mention the much-debated issue of prescribed assets, but touches on the fact that there may be a change to Regulation 28 of the Pension Funds Act to allow for larger allocations to infrastructure investments.

However, traditional infrastructure investments like roads, rail and ports are not the only form of alternative investments pension funds can, and should, look to. Alternative asset classes can include hedge funds, private equity, private debt, unlisted property and non-traditional infrastructure investments such as solar energy, energy-infrastructure, social housing, healthcare and educational infrastructure.

When judiciously chosen, these investments generate inflation-beating returns and steady income streams. They add much-needed diversification to pension funds’ portfolios and are often better able to match pension funds’ liability profiles.

The opportunity

Consider ‘smart buildings’, for example. We’ve heard of green walls and rooftop gardens but what about buildings that purify the air?

In Mexico City, one of the country’s main hospitals, the Torre de Especialidades, is fighting smog by using Titanium Dioxide (TiO2)-based technology. The building is coated with TiO2 tiles that cover the entirety of the external façade. Special grades of TiO2 can remove harmful nitrogen oxides from the air through a process called photocatalysis. It is estimated that the coating on the hospital alone neutralises the emissions from 8750 cars per day.

What if there was an emerging construction company in South Africa that could manufacture and supply TiO2 tiles to large corporates? Small companies are often unable to source funding from traditional avenues, such as banks. However, through a private equity fundraising or even through equity-crowdfunding, which has grown in popularity in the United States, they could secure the necessary capital.

On an individual basis, these companies are unable to raise the debt capital they need from traditional sources of funding. There may however be other companies, such as those installing solar panels for example, in similar need of funding.

Collectively, if they are bundled into a regulated entity, they can raise capital in the form of loans from institutional investors such as pension funds. In return, the pension funds receive regular interest payments until such time as the loans are repaid. The value of the loans is clear, the coupon payments are predetermined, and the repayment terms transparent.

Outlook

When it comes to viable alternative investments it is not the opportunity set that is lacking, but rather the knowledge about these kinds of investments. Is it up to trustees to educate themselves? Or is it up to advisors to bring these opportunities to their pension fund clients and educate trustees? Perhaps it is a combination of both.

Advisors sometimes bemoan the fact that even when they do bring out-of-the-box opportunities to clients, there is a lack of appetite. The reason is likely that trustees associate alternative investments with illiquidity and a lack of price transparency. But asset managers and asset consultants can clarify these perceived risks, assuage some of the fears and overcome some of the initial aversion to alternative investments. And, pension fund trustees can move the industry forward by expecting their asset consultants to highlight new and interesting opportunities.

With interest rates likely to be lower for longer in a post-COVID-19 world, it is critical that pension funds look to alternative investments for higher and inflation-beating returns, which are no longer being provided by traditional asset classes. The diversification benefits will also help insulate returns against what is likely, in South Africa at least, to be a deep and prolonged economic downturn.

 

Fran Troskie is an investment research analyst at RisCura

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