Alternative investments are no longer an optional extra—they are now an essential component of most high-quality portfolios today. As investors seek ways to diversify away from equities and fixed income, particularly post-financial crisis, they’ve become more comfortable with alternatives. In response to growing demand, established managers have institutionalized, new managers have sought to capture market share with innovative product design and fees have come down.
While these changes haven’t eliminated all the complexity associated with allocating to alternatives, they have enabled investors to access a broader array of strategies than ever before. Hence, the challenge for pension plan sponsors is not finding alternative investments; rather, it is determining the right mix of investments to meet their specific needs.
Alternatives can offer exposure to a different set of return drivers, potentially reducing investors’ reliance on equity risk premiums and improving prospects for long-term growth. Some private markets investments, for example, can be a more efficient use of capital. Alternatives, which have a different pattern of returns to traditional markets, can also help reduce the volatility of an investor’s overall portfolio.
They are not, however, immune to extreme or tail events. Alternative investments involve specific risks that may be greater than those associated with traditional investments, and investments of these types may engage in speculative investment practices and carry additional risk of loss. Such risks can be addressed with certain alternative strategies that can generate positive returns in volatile markets, and by using long volatility and high convexity structured portfolios.
Practical Implications
The best way for plan sponsors to capture the returns available within alternatives is to gain access to a portfolio with multiple underlying mandates. Common ways to do this include funds of hedge funds or buyout funds of funds. In future, however, more institutional investors will adopt a risk factor-based approach, seeking broad exposures to, for example, real assets, illiquid opportunities, alpha, credit and insurance. This approach can help capture unique opportunities and ensure plan sponsors efficiently allocate capital relative to their risk budget.
Ultimately, alternatives can increase the quality of an investment portfolio and help pension plans focus in on specific goals and outcomes. This has driven them more into the mainstream.
Andrew McCaffery is Global Head of Alternatives, Aberdeen Asset Management