Can Diversified Liquid Alternatives offer pension schemes greater returns and diversification than traditional portfolios? New whitepaper from CAMRADATA explores

With some pension schemes moving away from the conventional diversification benefits of a mixed equity/bond portfolio, CAMADATA’s latest whitepaper on Diversified Liquid Alternatives (DLA) considers DLA as an alternative to obtain diversification and also considers the risks involved.

The whitepaper includes insight from guests who attended a virtual roundtable hosted by CAMRADATA in October, including representatives from Barclays, Barnett Waddingham, Isio, Law Debenture, Fulcrum Asset Management LLP, LGT Capital Partners and Partners Group.

DLA are designed to give pension schemes exposure to assets that can sometimes be hard to access, with the chief aim of finding sources of returns that are less correlated with equity markets. Traditional bonds are where this diversification has been found in the past, and for many portfolios it still is. But these ‘balanced’ portfolios are now under pressure.

The CAMRADATA whitepaper highlights in the Barclays Global Aggregate Corporate Bond Index, more than 40% of the bonds are now rated triple-B, suggesting there is a significant equity-like risk in fixed income portfolios. A structural change like this is one of the drivers behind the move to DLA.

Sean Thompson, Managing Director, CAMRADATA said, “There is an argument that the conventional diversification benefits of a mixed equity/bond portfolio are diminishing. Partly because low rates in government bonds have caused investors to substitute government debt with corporate debt, also known as ‘credit’.

“This, in turn, has led to ‘credit creep’ which refers to how the pressure to obtain yield means investors have bought more deeply into higher yielding corporate bonds, while reducing their exposure to safer government bonds. The result is more risk.

“Our panel explored if DLA really is a means to obtain diversification, in a safe and controlled way, and the complexity within these portfolios. The discussion considered this in the context of volatile markets that have recently tested all kinds of strategies.”

The CAMRADATA discussion began with attempts to define each of the three key elements in DLA strategies – the asset classes involved, the liquidity profile of underlying investments and crucially the sensitivity of returns to traditional asset classes.

The conversation then turned to risk and return objectives, before the investment consultants on the panel were asked whether now was the right time to allocate to alternatives, given the miserable yields on much sovereign debt and the high price of many equities.

The panel also discussed how some investors without the resources to deal with complexity looked for a one-stop shop for all alternative asset classes; communication and the need for greater transparency, especially when it comes to fees, before returning to the theme of illiquidity in the context of DC pensions.

Key takeaway points were:

For one panellist diversified meant multiple asset classes and positions; liquid meant less than one year to trade; and alternatives are anything that isn’t public equity and fixed income.

Another said that diversified meant more than three asset classes, anything less they categorised as ‘Balanced’; however it was in defining liquidity that panellists produced the widest range of opinions.

Pension schemes are becoming more comfortable with investing in private markets, with one panellist saying they are looking a lot more within alternatives, especially private market assets with illiquidity being an additional source of return.

Markets have matured over the last ten years, and much had changed, from the cost of implementation to underlying central bank influence and more recently growing dispersion between assets. Nevertheless, there was an embedded fear of making mistakes which had to be addressed.

On the continued trend to passive management, this creates inefficiencies and therefore opportunities for active managers. But one panellist said you have to work hard to find those opportunities, and think about opportunities across both liquid and illiquid strategies.

Regarding COVID there were no great surprises, but one panellist likened the situation to 2009, after the Great Financial Crisis had struck and said it is after the crisis that opportunities present themselves. That is when active managers get to work.

The conversation turned to communication and the need for greater transparency with hedge funds. One panellist said their team wanted to know more than customary fund factsheets revealed, including how managers allocated risk across positions in theory and in practice over time.

The vast range of alternative asset classes today, including Real assets, Alternative Credit and Diversifiers, can be intimidating to many trustees as standalone strategies.