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How Pension Funds Can Cope With Risks In Alternative Investments For Better Returns

Asset classes such as private equity, real estate, infrastructure and even natural resources promise the potential for diversification and enhanced risk-adjusted returns for pension funds.

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By Simon Wafubwa

Risk management in alternative investments is a critical aspect of ensuring the stability and sustainability of pension funds.

Globally, a shallow recession coupled with geopolitical tensions and heightened inflation have created a challenging environment for the traditional assets such as bonds and equities. As such traditional investment portfolios struggle to match inflation and economic uncertainty looms large, interest in alternative investments continues to surge.

Asset classes such as private equity, real estate, infrastructure and even natural resources promise the potential for diversification and enhanced risk-adjusted returns for pension funds. Yet, even though alternative investments are expected to address the risks associated with traditional investments, they bring a complex array of risks for which traditional risk management frameworks fall short.

This means that although alternative investments have increased the potential for advisors to enhance their clients’ portfolio performance, fund managers need to consider the critical ways in which risk has changed and adopt new strategies of portfolio risk management.

One of the most glaring shortcomings of alternative assets is illiquidity. Unlike stocks or bonds, alternative assets frequently lack a quick and efficient secondary market and could be difficult to sell. This becomes especially problematic during an economic downturn or when quick access to capital is needed. During the 2020 pandemic, for example, some pooled investment funds could not grant their investors access to their money which was tied in real estate.

Digging further down, alternative investments are often inherently complicated when it comes to valuation. Traditional valuation models often struggle when applied to alternative asset classes. As such the value of alternative investments can be highly subjective, making it difficult to pinpoint an exact market price and hence, making it hard to resell.

While traditional risk management focuses on historical data to address liquidity and valuation risks, defined thresholds, and reactive strategies is inadequate for alternative investments. The future demands a more holistic and agile approach.

Firstly, enhanced due diligence is critical. Rigorous due diligence must extend beyond financial and operational elements. Investors need a deep understanding of the asset’s market, the investment vehicle’s track record, investment philosophy, and its’ risk management practices.

Secondly, carry out stress testing and scenario modelling. Going beyond standard sensitivity analysis, stress testing models must account for the unique liquidity and valuation risks of alternative investments. This proactive approach will help investors better estimate potential losses under different scenarios.

Finally, we cannot discuss the future without technology. Artificial Intelligence and machine learning hold immense promise for alternative investment risk management. Powerful AI models can rapidly analyze vast and disparate data sets, uncovering potential risk factors and patterns not evident through traditional methods.

AI can also identify hidden trends and potential vulnerabilities faster than manual processes, enabling proactive risk mitigation. In addition, routine risk reporting, compliance monitoring, and due diligence can be automated and streamlined with AI tools, freeing skilled personnel for strategic tasks. Care must be taken, however, to avoid data bias and inaccuracy. Since models are only as reliable as the data they are based on, incomplete or biased data can lead to flawed risk assessments.

The future of alternative assets is intertwined with evolving risk management practices. Alternative investments often escape the immediate volatility of publicly traded markets, but they come with a unique collection of risks. Those who successfully navigate this changing landscape will reap the reward of outperformance, while those who fail to adapt will face significant pitfalls.

Simon Wafubwa is the CEO Enwealth Financial Services Limited.

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BUSINESS TODAY
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editor [at] businesstoday.co.ke
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