Diversification? Are We Having a LTAF?

Traditionally, UK DC pension schemes have focused on investing in daily-traded assets like listed equities and bonds. This focus limited investments in long-term assets like infrastructure, real estate, and private equity that are not frequently priced.

However, these illiquid assets can offer several advantages:

• Improved diversification: Spreading investments across different asset classes, including illiquids, can help reduce portfolio risk.
  

• Supporting the economy: Investing in productive assets like infrastructure can boost long-term productivity and economic growth.  Per Mansion House, this has been a recent focus of UK Government pensions policy.
  

• Potential for higher returns: Illiquid assets may offer higher returns compared to traditional investments, for example pricing reflecting lower competition for assets or areas of inherently higher growth potential (e.g. early stage businesses).

The Rise of LTAFs

In response to the call for greater diversification in DC schemes, Long Term Asset Funds (LTAFs) were introduced.  LTAFs are a type of open-ended investment vehicle specifically designed to enable investment in illiquid assets.  LTAFs raise funds from investors and use those funds to purchase these assets directly.  LTAFs are able to distribute income generated by the underlying assets to investors on a regular basis.

Another Well Established Solution

However, DC trustees should not overlook a well-established alternative -  Investment Trusts (ITs). The earliest ITs were established over 100 years ago and also may offer a way to gain exposure to illiquid assets. ITs are listed companies that take in investor funds at offering and use these funds to invest in a portfolio of assets.  Some ITs focus on the private markets, for example investing in infrastructure assets, property and private equity. ITs generate income from underlying assets and pay out dividends to their shareholders.

Key Considerations

As vehicles, LTAFs and ITs can be thought of as equivalent ways to provide economic exposure to a given pool of underlying illiquid assets.  So, at inception both would offer similar long-term return potential, based on the pass-through returns of the underlying. 

There are, however, some key differences to consider:

• Liquidity - LTAFs are typically less liquid than ITs. Redeeming units in an LTAF will most likely require a sale of underlying assets, which can take time if illiquid. IT shares, on the other hand, trade daily on stock exchanges, offering greater liquidity and flexibility for investors who need to access capital quickly.
  

• Pricing - LTAF unit prices reflect the underlying net asset value.   Pricing is updated less frequently than daily. IT share prices, however, are daily but can deviate from the net asset value (NAV) of the underlying assets. This is because ITs do not trade the underlying assets when shares are sold in the secondary market.  Trading sentiment therefore might lead to the market placing a different value on the assets than the NAV. In current market conditions, many Investment Trusts, particularly those with illiquid assets, are trading at significant discounts to NAV. This could present an attractive opportunity for DC schemes to acquire exposure to illiquid assets at a potentially attractive price point.

Just Another Equity?

Critics may argue that ITs offer few diversification benefits because ITs in essence trade just like equities. This may not be entirely true.

Consider HICL Infrastructure PLC, which is a listed UK share and constituent of the FTSE 250 index.  While its shares trade on the stock exchange, the underlying assets are not listed equities - they are real assets like toll roads, hospitals, and schools.  Its most recent factsheet (Winter 2023) is linked in the footnotes.  

Looking at HICL's historical Beta (a measure of how much its share price moves with the market), we see that for most of its history (post 2006), the Beta was between 0 and 0.5. This indicates a low to medium level of co-movement with the market, suggesting there has historically been some diversification benefit. This accords with intuition – real assets would tend to have different return drivers than traditional equities, offering some diversification.

However, recent trends over the past 18-24 months do show a rise in Beta, indicating greater correlation with the market over recent periods. This recent period also coincides with share price falls, resulting in a deeper discount to NAV (this is in common with many other ITs that hold illiquids).

Take a Broader View

LTAFs are a valuable tool for DC schemes seeking exposure to illiquid assets. However, LTAFs are not the only option. Investment Trusts can offer similar illiquid exposures, and at a potentially attractive pricing point given local market conditions.  A wide discount to NAV may suggest a portfolio that is being undervalued by the market.  

DC trustees can make informed decisions about how best to achieve a well-diversified portfolio by challenging their advisors to take a broader view, thinking outside of the box and keeping a close watch for attractive emergent opportunities.

Charles Marandu FIA CFA has spent over 20 years working with a wide range of boards, helping to align risks and opportunities at the intersection of pensions and investment management. Today he applies this knowledge and skillset in building a portfolio of roles including Advisory and Non-Executive Director engagements. Please get in touch via the Contact link for more information.

Footnotes

https://www.hicl.com/wp-content/uploads/2023/12/HICL-Factsheet-Winter-2023.pdf

The HICL factsheet for Winter 23 reports Beta metrics on graph bottom of page 1 that help to probe the diversification benefit question.  Not an endorsement for HICL stock, and readers should not treat this discussion as a recommendation to trade. For illustrative purposes only.