Part 2 of the Asset Class ‘Back to the Future’ series. The Autumn 2010 edition of Asset Class looked at attractive investment opportunities for pension schemes as traditional investors began looking elsewhere
In the Autumn of 2010, Asset Class focussed on attractive investment opportunities that were starting to draw the gaze of pension schemes.
Traditional investors, like banks and insurance companies, had become far less active in certain areas.
This was not because these assets were low quality.
Rather, they had become far less attractive to traditional investors.
Due to regulation, holding these assets in their portfolios required them to hold a lot of risk-free capital against these assets.
This effectively made them much more expensive to invest in.
Pension schemes are not covered by these regulations, allowing them to assess the assets purely on their inherent risk/return.
These assets shared 3 characteristics:
they were usually illiquid;
offered attractive risk adjusted returns compared to other investment opportunities.
Many also provided high-quality cash income to schemes. Overall, they offered a good balance between risk and return.
What were these assets? They included:
debt issued by social housing associations;
debt to finance student accommodation;
transactions like ‘term financing’ (whereby a pension scheme lends high quality assets, like gilts, to a counterparty in return for a fee and collateral).
...and what happened
Although returns on high quality infrastructure are presently quite low, many pension schemes successfully invested in infrastructure. The long-dated, high-quality and often inflation-linked cash flows are a good fit for schemes’ liabilities.
However, many of the other opportunities did not play out as hoped, or have disappeared as the financial system has healed.
Sourcing some of the opportunities in size (for example, social housing) turned out to be more difficult than expected;
While they often form part of portfolios, the role they play is smaller than many had anticipated.
Other opportunities disappeared because the economic environment changed;
Term financing, for example, became much less attractive when banks’ funding costs fell as a result of easing monetary policy (although some schemes were able to take advantage of the opportunity while it lasted.)
That being said...
There are pockets of assets which remain attractive to pension schemes because other investors are now less active in them.
Banks in particular are no longer as involved in certain parts of the credit market. Regulations are still making it expensive for them (in terms of capital that needs to be held as security) to exploit these opportunities.
For example, lending directly to small and medium-sized companies is a strategy many pension schemes have invested in.
Traditional investors’ ability to invest in certain assets will continue to be affected by new, tighter banking regulations introduced after the financial crisis.
Pension schemes may not be able to access all of them in time or in sufficient size, but it does increase the investment opportunity set.
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