Alternatives & ESG as Long-term Solutions for Long-term Challenges
Part 2 of our DC research takes a deep dive into the current backdrop surrounding the use of both alts and ESG investments in the retirement space.
The late CIO of Yale Endowment, David Swenson, left an indelible legacy to institutional investors. He is credited with the invention of the so-called ‘endowment model’ which has influenced asset allocation policy worldwide. Swenson advocated a broadly diversified institutional portfolio with an emphasis on riskier assets, and, to take advantage of the liquidity premium, investments in private markets alongside liquid bonds and equities. His significant insight in the late 1980s was that liquidity was a mixed blessing for long-term investors and that in general it should be avoided because of its associated lower returns. Swensen’s approach has been duly copied by other investors, starting with similar endowment funds, but more recently, pension funds and sovereign wealth funds have embraced the endowment model. This has led to unprecedented demand for alternatives - particularly private markets alternatives - and managers have not been slow to provide opportunities for investors.
Institutional investors who allocate to both public and private market assets have two main concerns. The first is modelling and benchmarking: from a portfolio construction perspective what is the optimal allocation to private markets and how do you measure risk and return, manage cash flows and decide on a rebalancing policy? The second concern is around capacity: with private market investments becoming mainstream, can returns be expected to be as strong as in the past, and how can you find opportunity in such an environment?
Strategic asset allocation is usually conducted using stochastic models and mean-variance optimisation to arrive at an efficient portfolio; such models are very sensitive to assumptions used, not just about expected returns, but also volatility and correlation. Combining private and public markets investments in an asset allocation model needs to take into account the apparent lower volatility of private markets (because they are not marked to market), but also importantly cash-flow risk (ensuring there is sufficient cash to meet liabilities and capital calls in various scenarios and that generated cash is reallocated efficiently) and when or if to rebalance if sudden changes in public market valuations cause the strategic allocation to diverge from the norm. PGIM’s IAS team has developed its OASIS model and has written a number of research publications to help institutional investors address these questions. Click here to learn more about IAS.
And, if some areas of private markets may become crowded, where can we find future returns? Part of the answer may be in allocating to non-core opportunities such as:
The other important element of the endowment model for Swenson, and one of the reasons Yale has been so successful, is manager selection. He placed great weight on picking the best and had a preference for specialists, who thought differently from the mainstream and knew their niches and stuck to them. Quoted in the Yale Alumni Magazine in 2005 he said, “You want people of high integrity, high energy, high intellect, people who are obsessed with the market.” PGIM’s multi-boutique model is designed to allow exactly this kind of focus to flourish within its specialist asset class teams.