During the past decade, growth in the outsourced chief investment officer (OCIO) space has been driven by institutions’ lack of internal investment resources to cover and manage all asset classes, and a lack of access to higher-quality investment opportunities.
Recent research from Cerulli Associates, a global research and consulting firm, indicates that these OCIO clients are increasingly seeking alternative investments to diversify their portfolios and to obtain higher returns than those currently available from public investments.
According to “The Cerulli Edge—U.S. Asset and Wealth Management Edition, June 2019 Issue,” corporate defined benefit (DB) plans are generally not the largest holders of alternative investments, and most professionals who work with DB plans report that allocations tend to be found in plans that remain open. Although there could be call for using alternatives to better hedge liabilities, derisking corporate plans will likely see more value in using alternatives in their risk-seeking investments. OCIO providers indicate they expect allocations to alternative asset classes to increase for nearly all institutional client types while equity allocations are trimmed.
Cerulli notes that for years, many corporate DB plans, especially larger ones, have taken steps to derisk pension liabilities by freezing benefit accruals and/or closing to new participants after facing significant pressure to immunize the volatility of liabilities on corporate balance sheets and income statements. The investment application of derisking for this $2.6 trillion institutional client type is liability-driven investing (LDI), which is essentially the close matching of a plan’s assets and liabilities.
“While there are many reasons why corporate plans would not be interested in alternatives, alternative asset managers appear to see the forest through the trees,” Cerulli says. Two-thirds (65%) of alternative managers responding to a 2018 Cerulli survey cited corporate DB plans as an area of opportunity during the next 24 months. One subset of the derisking corporate universe verifies this view.
In the 2019 Cerulli Corporate DB Derisking Survey, mid-sized corporate DB plan respondents, with assets between $2 billion and $10 billion, were asked about near-term (next 12 months) plans for asset management search activity (including new and replacement searches). Private equity, real estate, and hedge funds are among the strategies or asset classes cited for “high” or “moderate” future searches. Cerulli asserts these answers from this group suggest plans’ continuing desire for better risk-adjusted returns.
“What areas of the broad and diverse alternative investment spectrum could appeal to corporate plans?” Cerulli queries? It observes that private debt is increasingly in demand from insurance general accounts and corporate DB plans—two types of institutions in which income generation and asset-liability management often come into play. Private debt or private credit (sometimes referred to as “alternative credit”) is a diverse asset class that is rapidly growing relative to much larger public markets.
According to the Cerulli report, long-duration private debt can add to the availability of securities open to a plan that is actively hedging liabilities. Additionally, if corporate plans focus more on the cash flows of their liabilities, it is logical they must emphasize the cash flows of their invested assets. The credit quality of the underlying borrower typically determines the predictability of cash flows from a debt instrument. In today’s market, with many institutional investors growing concerned about the sustainability of the current credit cycle, they may look favorably on private credit because it has historically offered more certainty of repayment of interest and principal than some other types of debt securities.
Although there could be call for the use of alternatives to better hedge liabilities, derisking corporate plans will likely see more value in using alternatives in their risk-seeking investments. Specifically, a derisking plan will seek predictable risk-adjusted returns and/or potential for downside risk mitigation. When corporate DB plan sponsors commit to derisking, they generally separate their investment portfolio between liability-hedging assets and risk-seeking assets. As the liability-hedging side grows, the risk-seeking side gets smaller. The smaller risk-seeking portfolio, therefore, becomes more susceptible to volatility (such as that experienced in late 2018) and asset drawdowns, even as most plans must continue to seek risk-adjusted returns.
Cerulli says, whether debt- or equity-oriented, hedge-fund-style absolute return strategies could play a role in optimally managing risk-seeking assets. Many institutions continue to voice their displeasure with hedge fund expenses and the underperformance of certain strategies and managers. That said, Cerulli does not believe that institutions are averse to many underlying strategies or are dismissing the role those strategies could play in a risk-seeking portfolio—the growth of so-called hedge fund replication strategies is one piece of evidence.
“Derisking corporate DB plans will require more due diligence on the diversifying and risk-mitigating aspects of certain hedge fund style approaches such as absolute return, multi-strategy, and opportunistic fixed income,” the report says.
According to Cerulli, the ultimate long-term alternative asset is infrastructure, which, due to its income-producing attributes, might offer an attractive option for a derisking pension plan that anticipates operating until the last beneficiary is paid (i.e., the plan sponsor’s goal is not to terminate via a pension risk transfer transaction). This smaller, niche alternative asset class, used primarily by larger international institutions, can encompass debt or equity from toll roads, to transportation, to communication infrastructure and energy-related assets. In addition to better long-term risk-adjusted income, institutional investors seek infrastructure investments for their diversifying qualities and their role as an inflation hedge.
However, Cerulli notes, if a pension plan sponsor has a goal of termination through a pension risk transfer (PRT) transaction with an insurance company, most alternative investments would no longer be applicable as the plan approaches PRT. That said, with interest rates (and the discount rates most plans use) relatively low and most plans underfunded, many plans will continue to manage assets relative to liabilities for some time, Cerulli concludes. Therefore, certain alternative investments will play important roles for corporate DB institutional asset owners.Information about how to purchase Cerulli Associates’ reports is here.