John Harrison: Alternative investments under fire

John Harrison is Director, Multi-Asset at Henderson Global Investors and Independent Investment Adviser to the Surrey County Council pension fund. 

The recent CLERUS report on the mis-selling of alternative investments by consultants[1] has attracted significant press attention. That was probably the intention given the provocative language used in the report and the desire of the authors to profile CLERUS’ services in reviewing advisor recommendations. Headlines are cheaper than advertising after all. But is there any substance to the report’s accusation that consultants have hoodwinked the local government pension scheme (LGPS) into buying alternatives on false information?

It is important to state at the outset that I am not independent on this issue – very few people with LGPS investment experience are. Over the last 30 years I have managed, advised, and consulted to a wide range of LGPS funds. It is this experience that leads me to challenge the CLERUS conclusions, which in my view are overstated and largely unfair.

The report does highlight one risk within the strategy-setting process – the potentially spurious ‘science’ of asset allocation modelling. No one can know with accuracy what future returns and volatility will be from any ‘risk’ asset, let alone the correlations between them. We are therefore forced to use the past as an imperfect guide and make educated guesses about how this may change in future. For traditional asset classes we can look back over decades of past data to see how the relationships change over time. Alternatives have less of a history and therefore require bigger and possibly less educated guesses.

But have consultants abused this process by biasing the inputs to suit their business interests – the central accusation made in the report? This is much harder to prove. There is a plethora of academic evidence that diversification across asset classes dampens volatility and improves risk-adjusted returns. It is therefore entirely justifiable to assume a better risk-adjusted return from a diversified portfolio than from a single asset class.

The problem is in defining how significant this benefit will be looking forward, especially as the relationships between asset classes can change very quickly. In my experience, consultants do at times assume overly optimistic risk/return characteristics for alternatives. The easy way to identify this is to ask the consultant what their model’s optimum allocation to alternatives would be if they did not impose an arbitrary upper limit. If it is a very high number, it suggests the model’s inputs are flawed.

But the accusation is deeper. It implies that LGPS funds have moved into alternatives purely because they have naively followed their consultant’s strategy models and have suffered a performance cost as a result. That is excessively simplistic. The growing use of alternatives reflects several factors – the desire to exploit illiquidity premiums (private equity), to offset inflation risks (infrastructure), or to dampen volatility (hedge funds and diversified growth funds or DGFs). Given the rollercoaster ride from equity markets in recent years it is hardly surprising LGPS funds are looking for ways to generate the returns they need more consistently. LGPS funds on average have retained a far higher allocation to equities than other UK pension funds or international institutional investors, so it is misleading to suggest they have been bamboozled by their consultants into over-diversifying into alternatives.

Similarly, it is misleading to suggest that cash-plus benchmarks have been selected to hide the resultant performance shortfall or make incentive fees easier to achieve. The report highlighted hedge funds and DGFs in particular as using cash-like benchmarks. Hedge funds often have limited correlation with market direction (which is why investors own them) so a cash plus benchmark is not unreasonable as a basis for performance fees. Returns from DGFs, by contrast, are likely to be more closely correlated with market direction, but I do not know of a single LGPS fund that pays a performance fee on a DGF based on the cash-plus benchmark.

The LGPS faces many challenges in closing funding deficits. Diversification will be one of the tools that will help them achieve this. Ignoring alternatives probably will not.

[1] CLERUS, 2014. Mis-selling of Alternatives by Investment Consultants? A Review of Methods used to Promote Alternatives and Dress-up Performance, [pdf] CLERUS. Available here.