The challenges of alternative assets
Despite the overall growth of private markets over the past 15 years and the growing interest in alternative assets, pension funds around the world face several challenges when managing their portfolios in search of better risk-adjusted returns.
One key factor influencing their decisions is demographics. Funds with more retirees than active contributors often have a lower tolerance for risk as they need to generate returns and liquidity to pay out pensions sustainably.
This is particularly relevant for illiquid investment classes like private equity and venture capital, which can take years to realize returns, are sharply dispersed between top and bottom performers, and have unpredictable exits that are outside of investors’ control.
A fund’s economic health also plays a crucial role. A fund with a strong funding ratio – where projected assets exceed projected liabilities – can afford to take on more risk in pursuit of higher returns. But underfunded plans may need to prioritize safer, more liquid investments to preserve capital and ensure its obligations are met.
Liquidity concerns are particularly relevant for alternative assets. Unlike stocks or bonds, which can be quickly sold to meet liquidity needs, assets like private equity or venture capital require longer periods to build up activity and deliver returns.
So, pension funds need to carefully manage their portfolios to ensure they have the liquidity necessary to meet their short-term needs while still investing for long-term growth to meet the fiduciary duties toward their sponsors and members.
Pension funds generally take a long-term investment view, often planning 30 to 50 years into the future. To manage this well, especially in defined benefit or hybrid defined benefit schemes, they conduct regular asset-liability studies that assess demographic and economic trends, expected returns, and market and regulatory conditions. These studies guide their overall investment and asset allocation strategy and help them strike the right balance between risk and return.
However, short-term market conditions may force adjustments. For example, if public markets underperform for a sustained period and aren’t generating the returns needed to meet the fund’s required return goals, pension funds may look to alternative investments to fill the gap. At the same time, growing opportunities in private markets, along with improving expertise in managing complex, illiquid investments, have made alternatives more accessible.
Venture capital, however, is often seen as a niche investment within pension fund portfolios, especially compared to private equity.