Transitioning into alternative assets

By George E. Sullivan, Executive Vice President and Global Head of Alternative Investment Solutions, State Street Corporation

Published: 30 June 2016

State Street research reveals the shift into alternative assets is continuing among sovereign wealth funds (SWFs) and public and private pension funds. Many of these institutional investors have been negatively impacted by the current low interest rate environment, and they are seeking to reposition their portfolios beyond traditional assets.

The pressure is particularly acute for many defined benefit (DB) pension schemes that face significant liabilities and deficits in the current low-return environment, combined with the longer-term challenges posed by increasing life expectancy. Meanwhile, some SWFs, particularly those whose incomes are oil or commodity dependent, are being called on to help plug major fiscal deficits. All of these factors have precipitated an increased focus on alternative assets that may offer positive risk-adjusted returns and greater diversification in this volatile market environment.

Our research underscores the long-term institutional shift toward alternatives. Research conducted by Oxford Economics on behalf of State Street found that 60% of SWFs plan to increase their hedge fund exposure over the next three years. [1] In the same survey, almost half of government pension schemes (48%) plan the same action over this time horizon. [2] Another survey by State Street of private and public sector pension funds found that 35% intend to increase their allocations to single manager hedge funds over the next three years, while 51% will boost their exposure to funds of hedge funds. [3] 

Hedge funds are not the only beneficiaries of this trend. Nearly 9 in 10 (88%) of government pension schemes expect to increase allocations to real estate while 48% of SWFs anticipate further inflows into private equity. [4] This appetite for alternative assets comes at a time when the industry is candid about some of the challenges they face in understanding the impact of these investments. In our global study of pension funds, 46% say they “lack transparency on the risks stemming from alternatives.” [5] 

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Operational changes by investors

This evolution of investment behaviour has prompted internal changes at institutional investors. State Street found that 48% of public and private pension schemes plan to strengthen their internal risk teams over the next three years. [6] This trend is mirrored in the official institutions sector, where 60% of government pension schemes and SWFs said they were “moderately extending” or “greatly extending” their risk and compliance teams. [7] Understanding investments and their associated risks is a crucial component of these institutions’ fiduciary duties.

In addition, institutional investors are bolstering their own corporate governance approaches to enable them to better understand their diversified portfolios. More than nine in 10 (92%) of public and private pension schemes intend to upgrade at least one aspect of their governance in 2016. Among the actions being taken, 45% of respondents will increase training and education for their directors, while 44% intend to overhaul the recruitment process for corporate governance posts [8]: this is critical as many institutional allocators feel there is a need of development among their board of directors in core areas such as overall investment literacy. Just 23% of public and private pension funds think their governing fiduciaries have a solid understanding of alternative asset classes. [9] 

The improvements that are being made are doubly good news. In addition to strengthening the funds themselves, this deeper knowledge supports improved and more transparent dialogue between the funds and their external managers. This comes as hedge funds and other alternatives managers step up their own transparency efforts.

Specific approaches to risk are also growing more sophisticated. Almost all SWFs (96%) have either expanded or are looking to expand their use of risk factor analysis, while nearly two-thirds (64%) plan to increase their use of scenario modelling in the next three years. [10] 

As institutional investors build out their internal risk teams, they are also bulking up their internal talent in other areas. Forty-five per cent of public and private pension schemes said they plan to increase their internal investment teams in the next three years. [11]  This is likely to further improve institutional investors’ knowledge of underlying asset managers and their processes, and help bring about their alignment and understanding with external managers.

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Technology changes at investors

In addition to operational enhancements, institutional investors are building out and improving their technology systems. Government pensions and SWFs are making a number of technology enhancements around cybersecurity, performance and risk analytics, data warehousing and advanced scenario modelling. Sixty-one per cent of these institutional investors (SWFs, government pensions, central banks) intend to boost their headcount for individuals focused on technology. [12] 

Having robust technology systems is crucial. Institutional investors are under increased scrutiny from their investors and regulators, and in turn are seeking greater insight and data from their underlying traditional and alternative asset managers.  A minority of institutions go further and require the reports that alternative asset managers submit to financial regulators, such as Annex IV and Form PF. Aggregating and analysing this data reported by a diverse stream of hedge fund managers focused on multiple strategies, sectors and geographies may not be easy via manual processes or legacy technology systems.

The embrace of automation is a growing phenomenon at institutional allocators. These capabilities will help drive further confidence and understanding of their underlying investments. Managers will therefore start supplying in-depth data more frequently to their clients and enhance their own internal technology systems. This automation may encourage greater standardisation of reporting to end-clients to streamline the overall process.

The migration from traditional asset exposures to increased allocations to alternative assets has posed challenges for institutional investors — challenges that they are candid about rectifying. They are improving risk management, enhancing internal teams and strengthening governance procedures and technology systems to master these challenges.

A note on methodology

State Street 2015 Asset Owners Survey: State Street surveyed 400 pension fund executives across 20 countries covering North America, Latin America and Caribbean, Europe and Asia-Pacific. Respondents included superannuation funds, public pension funds and private pension funds with assets ranging from sub-$500 million to more than $10 billion.

State Street 2015 Official Institutions Survey: During September and October 2015, Oxford Economics conducted a survey of official institutions on behalf of State Street. The survey captured 102 responses from senior executives around the world. Of these, 52 came from central banks and the remaining 50 from sovereign wealth funds (SWFs) and public pension reserve funds.|advertorial|aima|transition_into_alt_assets


[1] State Street 2015 Official Institutions Survey conducted by Oxford Economics

[2] Ibid.

[3] State Street 2015 Asset Owners Survey conducted by Longitude Research

[4] State Street 2015 Official Institutions Survey conducted by Oxford Economics

[5] Street 2015 Asset Owners Survey conducted by Longitude Research

[6] Ibid.

[7] State Street 2015 Official Institutions Survey conducted by Oxford Economics

[8] State Street 2015 Asset Owners Survey conducted by Longitude Research

[9] Ibid.

[10] State Street 2015 Official Institutions Survey conducted by Oxford Economics

[11] State Street 2015 Asset Owners Survey conducted by Longitude Research

[12] State Street 2015 Official Institutions Survey conducted by Oxford Economics