Japan’s $1.6 trillion Government Pension Investment Fund (GPIF) is looking for ways to divine the benefits of investing in alternative assets, but without some of the drawbacks that come with them, such as liquidity issues and high fees.
And replicating alts’ performance using traditional exchange-traded funds (ETFs) is one method that seems to have piqued the pension giant’s interest.
The pension fund recently released a report that it commissioned from Nomura Research Institute that investigated replicating alternative assets using exchange-traded assets. The report said that while there are “several drawbacks” that come with investing in alts, replication “could help to mitigate” those shortcomings.
The GPIF said it is allocating to alternatives in order to get better risk-adjusted returns because they “offer different risk/return profiles than public equity and traditional fixed income and tend to be uncorrelated or even anti-correlated with public markets during short-term bouts of volatility.”
The drawbacks of alts, as cited by the report, are that they are “highly idiosyncratic” as a function of the investment strategy and the specifics of the assets involved, and that capital allocated to alts often sits around doing nothing for long periods of time before being invested.
“To successfully invest in alts, pension funds have to scale up their exposure over numerous years while managing risk, evaluating performance, and refining their ability to select investment opportunities,” the report said. “Additionally, pension funds heavily allocated to alts, like certain European/US ones with double-digit alt allocations, have to address the issue of ensuring sufficient liquidity to fund pension benefit outflows.”
The report’s three main areas of focus were: alternatives replication techniques that use traditional/exchange-traded assets; management fees and performance evaluation methods; and basics of alternatives performance data and indexes.
Nomura constructed a replicating portfolio by re-weighting a public equity index to mimic a private equity market index’s attributes, such as its size weights and sector weights. Its implementation method included investing in periodic installments, similar to dollar-cost averaging, and evaluating the performance based on things such as returns and the Sharpe ratio. The institute used a 2018 paper titled “A Bottom-Up Approach to the Risk-Adjusted Performance of the Buyout Fund Market” by Jean-François L’Her as a reference on how to construct index-weight replicating portfolios.
The researchers found that their replicating portfolio’s simulated performance “roughly coincided” with a private equity index’s long-term performance, and that one of the benefits of replication is the ability to rapidly scale up exposure without worrying about illiquidity. The report added that replicator products could be used to deploy capital waiting on a capital call.
The report also said that while private equity fees “look high at first blush,” it found that they are reasonable and not necessarily as high as other asset classes’—at least relative to returns. However, it did note some of the issues investors have with private equity fees, such as charging flat management fee rates regardless of how many assets are under management and charging performance fees even on beta.
Research for the paper included interviews with outside experts, who said that some of the practical drawbacks of replication include inconsistent performance and insufficient precision of replicating high alpha funds’ performance. The report concluded that continued efforts, including research, to improve replication techniques’ accuracy are well-advised.