Balance the key to alternative assets

t is probably a reflection of its growing importance that two senior staffers from the Federal Treasury used an address to a Melbourne conference in late May to paint a broad picture of alternative investments in the superannuation industry.

Andre Moore and Stephen Monage from the Financial System Division of Treasury used their conference paper to point to the increasing importance of allocations towards alternative investments by institutions, including the fact that the recently-established New Zealand Superannuation Fund (the New Zealand equivalent of the Future Fund) had a long-term goal of allocating 25 per cent of its portfolio to alternative assets.

Moore and Monage said it was important to understand the drivers for institutional investment in alternative asset classes and, in doing so, trustees needed to balance a range of often competing and interrelated considerations.

It said trustees were increasingly receiving advice from asset consultants to use alternative assets to bolster fund returns while reducing their overall volatility.

“Much of the promise of superior long-run returns from alternative investments is derived from the ability of superannuation funds, as relatively patient, long-term investors, to access the premium associated with investing in relatively illiquid investments such as private equity and infrastructure,” the paper said.

“An allocation to alternative assets is also seen as a means to reduce the overall volatility of superannuation fund returns, as the returns derived from such assets are viewed as being independent of returns derived from traditional asset classes.

“For example, infrastructure investments are viewed as a source of stable, long-run cash flows throughout the economic cycle, while hedge funds explicitly seek to deliver absolute returns independent of market cycles,” the paper said.

It said a series of papers by researchers at the University of NSW into the attitudes of mostly larger superannuation funds towards alternative assets had revealed that trustees had a particularly buoyant view of alternative investments as vehicles for enhancing returns while managing risk.

“In one study, the funds surveyed expected their private equity investments to outperform listed equity by over 4 per cent a year, while helping to reduce overall portfolio risk,” the paper said.

“In the case of hedge funds, an international study of large institutional investments in alternative assets suggested Australian pension funds expect returns of over 10 per cent in 2007, compared with return expectations of 7 to 8 per cent by European and North American institutions.”

Looking at the risk factors involved in alternative investments, the Treasury paper said trustees needed to manage two major categories of risk, namely that the investment was inappropriate for the fund’s circumstances and implementation risk.

“The first of these risks might arise if the trustee assumptions about the returns from these assets prove to be overly optimistic, or if the risks inherent in alternative investments are not fully understood,” it said.

“Alternative investments are not homogenous, and the risks inherent in the different asset classes can very considerably. However, several types of alternative assets, most notably private equity and hedge funds, may exhibit a high degree of sensitivity to changing economic conditions, due to their use of gearing,” the paper said.

“In recent years, leveraged buyouts in Australia have typically resulted in gearing ratios of approximately 250 per cent and a gearing ratio for the corporate sector as a whole of 65 per cent. Equity investments by superannuation funds in such transactions will, therefore, be more vulnerable to deteriorating economic conditions than more traditional investments in listed equities,” it said.

The paper went on to say that the importance of superannuation fund investments, including in alternative assets, was not limited to their contribution to improving the retirement incomes of Australians and meeting the challenges of an ageing population.

It pointed to the fact that almost half of the funding for Australian venture capital and later stage private equity funds had been sourced from superannuation funds, while domestic superannuation funds had also accounted for approximately one-fifth of assets allocated to Australian hedge funds and funds of hedge funds.

“The degree to which trustees are able to integrate alternative asset investments successfully into their broader investment portfolios, and meet or exceed performance benchmarks, will have long-term consequences for household wealth accumulation, levels of consumer demand and government income support for the sector,” the paper said.

“As a result, policymakers could be expected to monitor closely how these trends evolve over coming years and the extent to which actual outcomes match expectations.

“The impact of alternative asset investments on whether these outcomes are realised will ultimately depend on long-term trends in superannuation fund exposures to these assets and their performance,” the paper said.

“If investment theory is borne out in practice, alternative asset investments could contribute to a further improvement in the outcomes projected by the intergenerational report,” it said. “However, should these investments be poorly managed or not realise their promise, there is a significant potential downside, particularly given the extent of leverage associated with alternative assets such as private equity and the difficulty of exiting poorly performing, relatively illiquid assets such as infrastructure.”