Why HK pensions’ alts deficit could come back to bite

Hong Kong’s pension funds are not allocating enough to alternative assets and in the long run that could prove detrimental to their performance as conditions change and investment returns become harder to come by, some industry experts say.

A comprehensive new report published this week shows Hong Kong’s $156 billion pension fund industry grew at an impressive compound annual growth rate of 8.5% in the 10 years to end-2018. According to Willis Towers Watson's annual Global Pension Assets Study, it was the third-fastest growing pensions industry out of 22 major markets covered.

But in other key respects, Hong Kong is a laggard.

In the biggest markets covered by the report – Australia, Canada, Japan, the Netherlands, Switzerland, the UK and US – there has been on average a seven percentage-point increase in allocations to ‘other assets’ including alternatives over the past 10 years (and a 19-percentage-point increase over 20 years).

That increase has been at the expense of equities, whose aggregate allocation as a proportion of these markets' total investments dropped by 20 percentage points over  20 years.

Hong Kong's pension fund industry, however, invests a much lower proportion of its portfolios into alternatives compared with its bigger peers, where this pot of asset classes now accounts for roughly a fifth. 

“If you look at the average pension schemes in Hong Kong, it's nowhere near that; [it’s] probably less than 5%,” Jayne Bok, head of investments for Asia at Willis Towers Watson, told AsianInvestor.

That's partly down to local restrictions but, in the long run, Hong Kong's heavy reliance on listed equities could create performance challenges, pension fund industry specialists warn.

Hong Kong's Mandatory Provident Fund (MPF) scheme, the city's biggest pension scheme, has strict rules about what qualifies as approved investments, Regina Liu, head of Hong Kong institutional at JP Morgan Asset Management told AsianInvestor.

“Derivatives usage is limited for hedging purposes only, and with that, you could imagine it being quite challenging for the inclusion of alternative products, not to mention the challenges around liquidity as well,” she said. For instance, investing in hedge funds requires the use of derivatives and such rules keep investments in such asset classes under a tight leash.

A lack of education among the investing public about the risks and benefits of investing in alternatives is another challenge. “The general public may not have the needed expertise to appropriately manage the risks of investing in alternatives. Governments and trustees are mindful of this when they consider bringing alternative investment options into mandatory defined contribution schemes,” Liu said.

The low adoption of alt assets in Hong Kong’s pension portfolios, arguably, didn’t matter when global liquidity was easy, public and private markets were soaring and financial market volatility was near-to flat.

Hong Kong's pension funds have held back from diving into alternatives due to their lack of experience but also because returns from traditional assets have been sufficient, courtesy of one of the longest equity bull runs in history, Bok said. But now the global economy faces a completely different environment, with global economic growth slowing and market volatility and interest rates at higher levels.

Last year was notably problematic as several major indices, including the S&P 500 and Dow Jones Industrial Average in the US lost 6.2% and 5.6%, respectively. That’s in contrast to 2017, when the two indices gained 19% and 25%, respectively.

HEAVY EQUITY RELIANCE

For Bok, the collective experiences of Hong Kong's pension fund decision makers may not be enough to help them ride out these more turbulent times. “The prior generation experienced abundance, rising markets, the property boom of Hong Kong; but the next generation is going to face seven years of famine instead of seven years of feasting.”

With equity markets doing well until early 2018, there was no real incentive to shift around assets.

“Up until now, we didn't have to work the pension system too hard to get the returns we needed. Equity markets helped, it gave us a bit of a free lunch,” Bok said. 

About 66% of MPF’s assets were invested in equities at the end of June 2018. There is a case to be made for greater diversification of pension assets.

Yet another challenge is adding alts as a portfolio diversifier. If not done carefully, it can lift the volatility level of a portfolio.

“If you invest in a single asset class, a single hedge fund or private equity fund for example, you are investing in a highly active strategy, mostly associated with higher risk, and at the same time you are taking on idiosyncratic manager risk, so it is indeed possible that you will add to the portfolio’s volatility if you implement that way,” Bok noted.

That said, there are ways around this through multi-strategy and multi-manager investing.

“One of the trends we’ve seen is the rise of implementation through multi-strategy, multi-asset, multi-manager mandates. For a smaller pension scheme, this approach makes more sense as the multi-manager can implement across a wide range of alternatives for them.”