UK pension funds are stepping up investments in commodity assets such as farms, timberland, mines and energy projects as they seek to diversify portfolios away from equities, an official at consultant Mercer said.

The 2008/2009 global financial crisis was a turning point for pension funds after their equity-heavy portfolios suffered heavy losses and spurred them to seek alternative investments, said Simon Fox, a principal in Mercer‘s investment consulting business.

“That triggered a step-change in the way that our clients and we think about and look to build out alternative portfolios, and it was the start of introducing things like real assets and commodities,” he told Reuters in an interview.

Alternative investments, which include a broad range of assets ranging from hedge funds to distressed debt to commodities, made up 15 percent of UK pension schemes assets this year, up from 10 percent last year and only 1 percent in 2003, according to a survey of clients by Mercer.

Mercer, a unit of insurance broker Marsh & McLennan, is one of the two biggest investment advisers for UK pension funds, along with rival Towers Watson. Mercer’s UK client base consists of 873 clients with 671 billion pounds ($1.04 trillion) of assets under management.

Only 2.1 percent of UK pension plans surveyed by Mercer had exposure to commodity assets, compared with 8.9 percent in Europe, but in both areas the average allocation by funds active in the sector was about the same at 3.0-3.3 percent.

“Most (UK) clients are still overly reliant on the equity markets, and we would like some more diversification in growth assets, and that means more alternatives coming through,” said Fox, who specialises in alternative investments.

The average allocation to equities by UK pension funds has already fallen to 43 percent of assets this year from 68 percent in 2003, according to the survey.

Mercer recommends that UK pension funds make allocations to commodities that are forecast to show long-term growth based on rises in global population and in per capita commodities demand in emerging markets to the higher levels in the developed world.

“We are constructive on the long-term outlook for commodity prices, not in terms necessarily of a two- or three-year horizon, where I think there are probably going to be continued difficulties,” said Fox. “We’re looking at strategic exposures, rather than tactical ones.”

PREFERS REAL ASSETS

Mercer prefers exposure to commodities through real assets rather than through index products based on baskets of futures, such as the S&P GSCI or Dow Jones UBS.

“We always felt there were inefficiencies in those indices. We were always nervous about the negative roll yield that was coming through,” Fox said.

A roll yield occurs when futures positions are rolled over into forward months before they expire. The yield is negative when forward positions are more expensive than nearby ones.

For those pension funds that move into real assets, their allocation could potentially make up a quarter of their growth portfolios, which excludes allocation to bonds.

“That would include some real estate and construction as well, so maybe 5 percent allocation to natural resources is not unrealistic for some schemes,” Fox said, referring to the growth portfolio.

Pension funds typically invest in real assets through a manager, who arranges ownership of a portion of an asset such as farmland or mines.

“Agriculture we think is interesting, but we find it’s a very difficult market to play with … you have to accept lots of other risks associated with those investments, and navigating that space is more difficult than you might expect,” Fox said.

“Diversification is still part of the argument for an exposure to commodities, and you clearly get a different diversification coming through when you’re looking at it in terms of a real asset perspective.”

Pension funds also have some exposure to commodities through managed futures funds. These are also known as commodity trading advisers (CTAs) because they started off by trading commodities but have since expanded into futures for any asset class.

In the UK, 13.6 percent of funds surveyed by Mercer already invest in CTAs, many of which are funds driven by computer programmes and offer another diversification from equities.

“Ultimately the challenge is finding as many different sources of return as you can to blend together,” Fox said.

Source: Reuters

($1 = 0.6454 British pounds)

(Reporting by Eric Onstad, editing by Jane Baird)