Reflecting on the “Alternative to Alternatives”


Part 6 of the Asset Class ‘Back to the Future’ series. Head of DB Pensions, Dan Mikulskis, looks at four key themes from the 2015 edition of Asset Class – what’s changed for pension schemes?


What were some of the key themes of Asset Class 2015 and how have they fared in the two years since?

1. Illiquidity

What did we say?

Investing in illiquid assets has continued to be a theme for UK pension schemes.

Deficits had widened, the search for returns had become more pressing and trustees had become comfortable with the complexity.

This theme continues.

The approach to illiquid investing that we advocated in the 2015 asset class (“Stay Ahead of the Illiquid Curve”) focussed on the illiquidity premium at any given time. We believe this is somewhat innovative.

For each illiquid asset class, we calculate the illiquidity premium. We do this by reference to liquid assets of a similar risk profile, credit quality and maturity. We monitor this on a monthly basis.

When deals become available to invest in, we help our clients judge whether the offered illiquidity premium represents a good risk/return tradeoff.

What happened?

While the yields on illiquid assets have remained relatively stable since 2015, the yields on liquid assets have varied quite widely.

A significant selloff in risk assets and credit toward the end of 2015 and start of 2016 meant yields (spread to government securities) available on liquid assets increased. This narrowed the illiquidity premium.

As a result, we favoured liquid assets over illiquids for clients investing around the start of 2016. The risk/return trade off was highly favourable. As liquid spreads have tightened during 2016, illiquid assets have again become attractive.

What’s changed?

Today, liquid market credit spreads have gone through a sustained period of tightening during 2016. This has benefited schemes allocated to credit but reduced prospective returns going forward.

For clients who need higher returns, this has prompted a call to look at opportunities to generate higher returns. Illiquidity premia is one attractive option.

Where do we see the opportunity today?

Today we see value in Secured Leases and Direct Lending, as well as more diversified illiquid strategies at both the investment grade (matching) space and the sub-investment-grade more opportunistic space.

2. Risk management: Spreading your risk, not trying to call markets

What did we say?

A big theme in the asset class 2015 piece was around risk management through three strands:

  • strategies that build in risk control (“When Volatility Controlled Itself”)
  • downside protection (“Rethinking Equity Allocations”)
  • diversification (“Navigating Liquid Market Volatility”)

We also talked about setting up portfolios to control exposure to particular “views” about future states of the world (“Balancing Asset Risks”).

Our investment principles put risk management at the forefront, as opposed to trying to call markets.

What happened?

We believe these beliefs have served our clients well over the last two years.

Looking back, there were multiple events that would have been incredibly hard to predict (prolonged interest rate falls, Brexit and Trump elections to name but a few).

Not only were the outcomes of geo-political events hard to predict, but the market reactions have at times been equally so.

We think this underlines the need to set up portfolios with risk management at the fore. The alternative is to let too much risk ride on being right about a particular future state of both the world, and markets.

3. Investors and Borrowers Go Direct

What did we say?

We revisited our views on direct lending (“Investors and Borrowers go Direct”). This is an area we feel offers a compelling risk-return tradeoff for clients seeking higher returns.

Managers have become more institutional friendly, and trustees have become more comfortable with the key considerations and risks.

What happened?

Since 2015, these allocations have served clients well.

Managers have been able to get significant amounts of assets allocated.

Returns have consistently exceeded our expectations, with sector returns of:

  • 7-8% in 2016
  • c.10% in 2015
  • over 10% annualised in the 5 years to September 2016

(source: Individual managers and Cliffwater direct lending index).

The sector also weathered the credit market storm in early 2016.

While this is by no means a low risk asset class, credit losses were lower than anticipated. We continue to believe this offers an excellent risk/return proposition for clients comfortable with some illiquidity.

What’s changed?

There has been some tightening in the direct lending market.

This is be expected given the market conditions since 2015.


Managers continue to originate deals at attractive spreads in the region of 8-10% over LIBOR in the US direct lending market.

In 2015, we noted the market for direct lending was more established in the US.

Although the European market has grown significantly over the past few years, we continue to see fierce lender competition, higher leverage levels and tighter lending spreads.

For these reasons, we remain convinced the opportunity set in the US is superior.

Where do we see opportunity now?

This is by no means a low risk asset class. But we continue to see areas of the Direct Lending market that present compelling return opportunities for clients, taking into account the risks, for clients that are comfortable with the asset class.

We have observed some loosening of credit standards in certain parts of the market. There is also additional regulatory uncertainty in the US which could affect the market.

For these reasons, we think it’s even more important today to allocate to managers that can be selective in their approach.

4. Rethinking Equity Allocations

What did we say?

In our 2015 piece “Rethinking Equity Allocations” we made the case for viewing equity allocations with a specific focus.

That focus was the components of the allocation that are most material to client outcomes:

1. the beta, or market risk (and return) arising from exposure to the equity market.
2. the style tilt (such as value, momentum or quality)
3. the active manager “alpha”.

Looking at equity exposures in this way has become increasingly popular since.

For example, the billions of dollars invested in Exchange Traded Funds (ETFs). These track style-tilted equity benchmarks, such as those run by iShares, against the MSCI Factor indices.

What’s happened?

Market performance since then has also borne out this way of looking at the world.

Equities have shown positive returns overall since the beginning of 2015, albeit with a significant level of volatility.

The benchmark MSCI World index in US dollars returned +8% in 2016, and was roughly flat in 2015.

The primary driver of risk and return in equity portfolios has indeed been the overall market exposure.

Currency risk has also been significant – the pound fell c.20% against the US dollar in 2016. This means foreign currency equity holdings saw significant performance gains in sterling terms.

Tilts to particular equity factors have added value. However, the story has been a game of two halves.

The low volatility factor has outperformed over the first part of the period…

…with the value factor outperforming over the second part of the period.

This supports the case for a diversified exposure across the factors, as we talked about in the article “Break it Down and Build it Better”.

What’s changed?

The factor-exposure way of looking at the world has gained traction. We’re now seeing:

  1. increased transparency from managers in breaking down the factor exposures of their strategies
  2. a focus on low-cost implementations of systematic factor exposures.

Where do we see opportunity now?

We continue to look for effective ways to generate returns through exposure to style factors.

Implementation can take several forms, including:

  • allocations to active equity managers pursuing particular styles, or;
  • dedicated style factor managers that operate long/short positions, which take exposure to the style factors without taking market exposure.

Click to go back to Asset Class 2017