Asian pension funds’ hunt for yield could be pushing them into poorly understood asset classes that will one day result in significant losses.
Government-imposed quantitative-easing programmes implemented in the developed world, initially in the US but subsequently rolled out in Japan and Europe, have driven bond yields to prolonged historic lows.
This has created problems both for defined benefit (DB) schemes – managing towards a fixed future obligation to a member when they retire – and for defined contribution (DC) schemes, which are seeking to grow contributions as much as possible over the life of the investment.
In both cases the reach for yield has lured institutions into risk assets – longer-duration illiquid investments – in growing numbers. Chris Ryan, Hong Kong-based head of MSCI’s Asia-Pacific business, noted pension fund clients had been moving into real estate and infrastructure, including loans in both sectors.
For institutions with long-term liabilities, the appeal of higher-yielding and longer-duration assets is considerable. Many Asian countries have young working populations, meaning pensions are stacked with members who won’t retire for years.
The speed of accruals in these funds means allocations must be made at rapid rates. The monthly net cash flow from Korea’s National Pension Service is up to $3 billion. “The picture is similar for other funds around the region,” said Ryan.
One measure of the impact is the swelling size of Asian infrastructure funds. The average Asia-focused unlisted infrastructure fund has more than doubled since 2011 to $467 million; those closed so far in 2015 stands at a seven-year high, finds data provider Preqin.
More than half of infrastructure investors based in Asia now allocate to the asset class via a distinct infrastructure allocation, it reports. Plus many more funds are coming online: 80% of Asia- headquartered managers are raising their first vehicle.
South Korea, where $6.8 billion has been raised in the last 10 years, leads the region by size, followed by China with $4.1 billion and India with $4 billion.
This follows strong growth in Asia’s private equity fund market, which has more than tripled in size since the financial crisis, to more than $370 billion.
But fund figures are likely to be only the tip of the iceberg since an increasing number of pension funds are investing directly. Direct investments are hard to estimate, given that they are private.
But consultants say the economics are stark and driven by a wider trend for investors to leapfrog managers to reduce the impact of fees on absolute returns.
Today’s low yields mean fund manager fees – which are typically fixed – take a bigger relative bite out of total returns. The economics for direct investment are compelling in illiquid asset classes such as infrastructure and private equity, noted Peter Ryan-Kane, head of portfolio advisory for Asia Pacific at consultancy Towers Watson.
“Many investors historically have been paying 1.5% in headline management fees and getting 15-20% internal rate of return. Now that IRR is more like 10- 15%, many are saying, ‘let’s do some sort of club deal with other sovereign funds and bring our total costs to around half of what they were,’” said Ryan-Kane.
Yet cutting out the middleman could be a false economy. Particularly in specialist asset classes, many institutions lack the expertise of seasoned fund managers and are ill-prepared for the bumpy ride these assets often entail.
Pension funds that have invested in overpriced assets, or that may not have the expertise to manage if prices correct, could sustain big losses. And that would cost end-investors.
Infrastructure is one sector where managers say risks are poorly understood. It has a history littered with failed first-mover investments, said Warren Allderige, managing director of Pacific Harbour Holdings, a credit fund based in Hong Kong.
He suggested Asian pension funds were at an added disadvantage because they used an investment paradigm developed in the past in the US and Europe that wasn’t suitable today. “[US and Europe] have better legal systems and less government pressure,” he said.
He contrasted the power sector in Hong Kong, which fits the historical European model – there is a monopoly and the government is ready to raise rates to support the industry – and in China, where there is an open market and several power producers have gone bust because they have been unable to produce economically as market prices have fallen.
Poor understanding by investors is made worse because the large cash inflows into Asia’s pension funds can’t keep up with the limited supply of illiquid assets, driving up prices. “Concentrated pools are being pushed into a limited number of locations, including infrastructure, real estate and loan markets. But there is not the supply of those assets for prices not to be pushed around,” said Ryan.
For now the resilience of demand suggests that a sudden correction in prices, and widescale losses by pension fund investors, is a relatively remote prospect. If there are sales, new buyers will come to market because they have cash to allocate. “If there’s a price decrease, it will be from a fall-off in demand and that is several years off,” said Ryan.
However, investors are still being lumbered in increasing numbers with assets they don’t understand. Ryan-Kane believes a sell-off will come sooner than many expect, that sharp drops in valuation would create “forced sellers” from pension funds, creating a secondary market where little exists today.
“Buying is easy, but we know sovereign funds are poor sellers,” noted Ryan-Kane, adding those who are unfamiliar with these assets and lack internal processes to understand the risk, will be among the sellers, at prices additionally depressed by the low liquidity of these assets.
Allderige believes inexperienced infrastructure debt investors will be hit by problems associated with unreliable cash flows coming from a reluctance to raise rates or tolls. Those with shorter duration investments would be the first to realise losses, he argued. Pension funds which will succeed will be those that are equity investors with a long holding period that sits in long-term allocations, he added.
But for the rest of Asia’s more adventurous pension funds, when the tide goes out they could find themselves as exposed as swimming without trunks.
For the full feature on Asian pension funds, see the current (July) edition of AsianInvestor magazine.