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FINANCE SUPPLEMENT - RISK AND RETURN

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Pension funds are under pressure and need to look at alternatives. Mark Smulian reports from the LGC Investment Sum...
Pension funds are under pressure and need to look at alternatives. Mark Smulian reports from the LGC Investment Summit

The growing uncertainty over the ability of council pension funds to meet their long-term liabilities should increase trustees' willingness to consider new opportunities, delegates at LGC's Investment Summit heard.

But when they become involved in unfamiliar markets, funds must be clear how far to go, how to choose expert managers and how much freedom to give them.

Pter Kocourek, executive director of Morgan Stanley Investment Management, told delegates at the Leeds conference: 'The main reason for looking into alternatives is that traditional assets - equities and fixed income - are not expected to have very high returns.'

Mr Kocourek said 'alternatives' are assets that have a low correlation with the movements of the bond and equity markets and so help funds to diversify their holdings and gain the higher returns on offer. Examples include high yield debt, senior loans, commodities, private equity, and hedge funds.

'It has to add something sensible to your portfolio in terms of risk and returns,' he said. 'Just throwing everything into the kitchen sink does not help.'

He explained the distinction between 'alpha' and 'beta' in investment: 'Alpha is the manager's skill to get extra returns adding an extra bit of vim to your portfolio. Beta is equities, fixed income and cash and is linked to the macroeconomic environment.

'Alpha strategies seek a return that cannot be explained by the market; they can be very idiosyncratic and very manager specific.'

Care is needed to select an 'alpha' manager due to the emphasis on personal qualities.

Funds that use alternatives can choose the degree of volatility and risk they wish to take and investment managers can tailor a mix of assets to give the best chance to hit a particular return over a set period.

Mr Kocourek stressed the need for pension funds to take specialist advice on how to implement diversified investment.

'Suppose you are convinced of the idea, and all that remains is to implement it - you have 15 assets classes you have never heard of and a lot of heart attacks in your legal department,' he said.

'We aim to ease that pain a little and give our lawyers the heart attacks, not yours. You need teams that can implement all of this.'

John Harrison, UK chief investment officer of UBS Global Asset Management, pointed out that pension fund deficits were a relatively recent phenomenon caused by the fall in equity values in the early 2000s and low interest rates since.

'There are only two places the money will come from, employee and employer contributions or investment returns,' he said.

'It is clearly in the interest of sponsors and members that more comes from investment returns than from contributions.'

Actuaries had begun to increase projections of longevity, Mr Harrison said, which put further pressure on pensions funds as members lived longer.

He said funds should look to investment in hedge funds and targeted returns, which aim to secure a specific level of return with the least possible risk.

To get the best from alternative investments, which might not be well understood within councils, pension funds would have to trust their investment managers to act without unnecessary constraints, said Iain Lindsay, senior portfolio manager for fixed income and currency at Goldman Sachs Assets Management.

'When guidelines are unduly restrictive it can be counter productive, as it can force an investment manager to do the wrong thing,' he warned. Excessive constraints could, perversely, increase risk as opportunities were missed and investment managers were forced into poorly performing fields.

Pension funds should be willing to unshackle their investment managers. Then possibilities increase tenfold and they can make a large number of small investment decisions that 'working together can really squeeze out risk'.

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