Fri, 31/03/2006 - 07:59
Allocations to asset classes such as hedge funds by European institutions are profoundly mistaken, argues Guy Fraser-Sampson.
Allocation to hedge funds and other so-called alternative assets is very much a tale of two continents. To those accustomed to dealing with institutions in North America, where allocations of, say, 15% or more to each individual asset class à la Yale Model are accepted concepts, it comes as considerable surprise to learn that even the whole of private equity and hedge funds combined together total just 1% of pension plan assets in the UK. Why such a huge discrepancy?
There are various obvious reasons, such as misunderstood liquidity issues, a blind prejudice in many quarters against alternative assets in general, and the difficulty of fitting alternative asset returns (particularly in the case of private equity) into traditional risk models. However, I would argue that these are some of the symptoms rather then the causes of the disease. For these we have to look a little deeper, or rather a little higher, for these are to be found at the strategic level rather than the tactical.
I submit that there are two main causes, and that they are inter-related. The first is that the whole concept of Multi Asset Class investing, of which the Yale Model is a classic example, has been largely ignored in Europe. Even today it is difficult to find many who have actually read David Swensen's seminal work 'Pioneering Portoflio Management', even though this was published over five years ago, and the Yale Model itself has been widely publicised in investment circles for at least the last decade and a half. The second is that, unlike their US counterparts, European pension funds typically do not have a Chief Investment Officer and supporting in-house investment professionals. I do recognise, however, that there is considerable regional variation here throughout Europe; my statement is almost universally true in the UK, but less so in countries such as Sweden and the Netherlands.
In the UK, the Myners Report into the pensions industry drew attention, amongst other things, to the lack of coverage of such asset classes as venture capital, and to the illogicality of having investment decisions being taken by lay trustees with no financial skills or investment management experience. Myners recommended a system dominated (at least so far as investment matters are concerned) by independent trustees supported by in-house investment professionals. Sadly, these proposals proved far too sensible to be adopted by government and the UK legislature chose instead to entrench still further the position of sponsor-nominated trustees, even though the National Association of Pension Funds' own figures demonstrate, shockingly, that UK pension trustees spend an average of just four hours a year on investment matters.
Clearly the former is a product of the latter. With no professional expertise available, and little time to discuss even the most basic of investment issues, Multi Asset Class investing simply falls by the wayside. Though this may seem staggering, given both its common sense appeal and the consistent success which it has enjoyed in the US, even to broach the subject with their UK pension fund clients is seen as a practical impossibility by pension consultants. Their position, so far as it has been explained to me, is that they see no point in recommending a course of action which they know their client has no resources to implement. Bringing lay trustees up to even a basic level of understanding of things such as hedge funds and private equity requires a considerable education process for which neither the time nor the inclination exists.
This argument has a certain force to it at first glance but, with respect to all those worthy professionals in the consultancy business, I believe it to be specious. It surely must be the case that the duty of an investment consultant does not stop with the 'what' and 'why' of asset allocation but also extends to the 'how'; consultants routinely get involved with (and frequently actually run) the manager selection process, for example. If they believe that any client's optimum investment strategy requires the putting in place of additional resources and/or a whole new alterative way of doing things (appointing a CIO, or contracting out the management of the whole fund, for example) then surely they have a duty to say so.
I cannot believe that any intelligent investment professional would not today deem Multi Asset Class investing worthy of at least serious consideration in setting asset allocation levels, even though there may be compelling reasons in individual cases for departing from it in whole or in part. What is not acceptable is that clients should not even be informed of its existence, or warned that by not following it they risk significant under-performance for which they may be held personally liable, and which may very well bring about exactly the sort of funding shortfalls which we are currently experiencing. It is here that I part company intellectually with the consultants' argument which I have outlined above.
The consultants' duty is to recommend the investment strategy most likely to result in a pension fund being able to pay its liabilities as they fall due both, in the immediate future and beyond (this has nothing to do with so-called Liability Driven Investment, which in fact guarantees that a pension fund will not be able to do this). The available benchmark figures offer clear evidence that the only way to do this is to diversify extensively into asset classes such as private equity, property and hedge funds. If the pension fund client lacks the resources to be able to do this then it is the consultants' duty to advise them either to hire in those resources or to contract out the investment management of the fund. No other interpretation of the position seems possible to me.
In conclusion, then, the allocation issue for hedge funds lies at the strategic level, not at the tactical. Instead of fighting for a larger slice of the cake, one should be arguing for a larger cake; far from private equity and hedge funds being competing asset classes, they are in fact complementary and should be forming roughly equal 15% to 25% tranches of any properly constituted portfolio. That is why I have referred to them throughout as 'so-called alternative assets' since they should in fact be viewed as mainstream, while it is others, such as bonds, which actually struggle to justify their inclusion in the portfolio of any pension scheme in deficit.
The crux of the matter is this: Multi Asset Class investing has proved dramatically successful in the US when properly implemented, and can generate similar out-performance in Europe, and greatly increased allocations to asset classes such as hedge funds form an essential part of that approach.
Guy Fraser-Sampson is a well-known writer and speaker on investment strategy, asset allocation, private equity and hedge funds. His new book 'Multi Asset Class Investing' will be published in June as part of the Wiley finance series.
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