LAST week, we took a look at two common asset classes that normally form an important part of pension fund portfolios.

As a quick recap — bonds are used to provide stable income flows and principal preservation for the hard-earned savings of retirees. Bonds pay a fixed amount of interest at a predetermined rate and frequency. The issuer of the bond repays the investor 100 per cent of its principal over the life or at the maturity date of the bond. However, bonds can also generate attractive capital gains during times of low interest rates. Stocks provide more aggressive growth opportunities and more upside than bonds. Stocks play an important role in growing the value of a pension fund’s portfolio.

Today, we will take a look at real estate and private equity.

Real estate is a popular asset in Jamaica. Pension funds like it because it is thought to be a way of preserving value over long periods of time and generating revenue during the holding period.

However, real estate is an illiquid asset. This means that it cannot be sold as easily as a bond or a stock. While real estate is classified as an illiquid asset all over the world, in Jamaica, expensive real estate is particularly illiquid because the market of potential purchasers is relatively small.

A small pool of buyers also translates into a stronger bargaining position for the buyer. As a result, sellers can often be price takers in the local real estate market. It is also common for holders of Jamaican real estate to wait a long time before getting their target price or close to it. Real estate deals also attract high transaction costs.

Additionally, the compounded effect of devaluation and inflation often erodes much of the value of the rental income that real estate creates. Many landlords have started to price in USD to hedge the impact of devaluation.

Recently the sale leaseback transaction structure has become particularly popular among pension funds as a way to lock in a stable source of income as well as a fixed target internal rate of return. A sale leaseback is the simultaneous purchase of a piece of real estate (by the pension fund) and the entry to an immediate long-term lease agreement (between the new owner and its lessee). For example, local pension funds have been seen purchasing warehouse space or other industrial properties directly from local manufacturing companies. In turn, these companies agree to lease the property back from the pension fund, usually for a long horizon.

Private equity is perhaps the riskiest asset class and, as a consequence, is intended to provide the highest returns. It involves equity investments in companies (or projects) that are expected to create significant value for shareholders. This value is usually created through a specific investment strategy. For example, perhaps the company is expected to grow rapidly over the next five years because of a new product that it has developed. Alternatively, the company could be purchased with a view to improving operational efficiency and profitability.

These investments are usually offered by professional private equity funds that execute the investment strategy on behalf of investors such as pension funds. Once this value has been created, the investment is usually sold to realise the profit which is distributed among shareholders.

These investments can take place across industries, company life cycles and time horizons. In the USA, pension funds are among the largest investors in the private equity market. However, the asset class usually comprises a relatively small proportion of the pension fund’s total portfolio as a result of the higher risk profile.

In conclusion, none of these investments is mutually exclusive to each other. Pension funds have a responsibility to look carefully at each asset class and allocate funds among them to achieve the optimal risk adjusted return.

Marian Ross is Assistant Vice-President, business development at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm