As traditional asset classes underwhelm, global pension investors are seeking new sources of returns, which brings new types of risk.

State Street Global Advisors senior portfolio manager Toby James Warburton said many pension managers worldwide are reluctant to reduce their publicly stated return targets, despite the fact that the rate of long-term average returns from traditional asset classes has fallen.

The disconnect necessitates a rethink of how institutional investors construct their portfolios, with the mix of assets held by major funds likely to become far more complex in the coming years, he said.

As the expected returns from stocks, bonds and real estate fall, pension funds around the world are allocating more capital to niche asset classes.

“You have to start think about adding things in such as emerging market bonds, high-yield hedge funds, private equity, and maybe some factor-tilted equities as well, and it becomes a much more complicated portfolio,” Warburton said.

McKinsey & Company associate partner Eser Keskiner is a consultant who has observed the same global trend in portfolio construction.

Some Canadian firms are using what they have termed ‘relationship investing’ – small minority positions in public companies – in parts of their portfolios to boost returns, Keskiner said.

“Even though they might not have the majority [share], because they have built a relationship and the management know that they’re in it for the long term, they can use that leverage to have outsized influence on the direction of the company.”

Keskiner added that McKinsey & Company was increasingly seeing investors trying to identify thematic opportunities. This approach involves looking at macroeconomic trends, then drilling down to identify pockets within that where the markets may not have yet caught up to the growth profile.

“There is also experimentation going on in some more…interesting fields – for lack of a better term. Things like buying some music rights or pharmaceutical patents. Those are still anecdotal, but it gives you a flavour where people are looking for new angles so they can meet their objectives,” Keskiner said.

While interest rates in Australia are at a record low, they are still relatively high by international standards.

Complexity especially dangerous in a downturn

This means that while local superannuation funds are also looking for diversified sources of returns, they are under less pressure than some of their counterparts in the United States and Europe, which may reduce the risk to which members are exposed.

Media Super investment manager Justin Nunan is one local asset manager who questioned whether it was necessary or wise to increase the complexity in asset allocation at the moment.

“If you are chasing innovative new returns, you may be creating innovative new risk that, perhaps, hasn’t been properly considered. That would be a sleeper agent in our portfolios.”

Nunan said that at Media Super the team is always careful about introducing unnecessary complexity into the portfolio, because what appears to be an acceptable increase in risk during a relatively benign period can get ugly quickly in a market downturn.

“When the water goes out, the last thing you want is complexity,” Nunan said. “You want liquidity, transparency and flexibility.”

Warburton, Keskiner, and Nunan spoke to Investment Magazine ahead of the Conference of Major Superannuation Funds on the Gold Coast March 22-24, 2017, where they participated in a panel titled ‘Turning Our Attention to Portfolio Construction’.

To read all our coverage from Day Two of CMSF 2017, click here.