Alternative assets have long been the domain of institutional investors seeking to increase their risk-adjusted returns, but defined contribution plan sponsors now have the opportunity to access these assets in the form of liquid alternatives in their target-date fund offerings.

Over the last five years, the expected returns of traditional balanced portfolios in target-date funds have “really collapsed on themselves,” said Michael Sager, vice-president of multi-asset and currency management at CIBC Asset Management Inc., during Benefits Canada’s 2022 Defined Contribution Investment Forum in January.

While equities and bonds were “hugely supported by the cyclical tailwind” that was unleashed by the policy response to the coronavirus pandemic, those policies are beginning to wind down. But those policies are being withdrawn at levels of asset prices that mean valuations are even more challenged today than at the end of 2019.

Read: 2021 DC Plan Summit: Fitting liquid alternatives into DC investment portfolios

“We’re left with a world where earnings growth and margin increases will be more modest in equities [and] . . . bond yields are still, relatively speaking, rock bottom, so valuations and, therefore, expected returns are still challenged for traditional assets,” he said.

Rising inflation has also taken centre stage, continuing a months-long hot streak that saw it reach an 18-year high in December according to Statistics Canada, which Sager said calls for “nimble” investment solutions that can respond to these myriad risks. “So the challenge is, how do we boost expected returns in a way that’s very user-friendly and transparent? And that’s where liquid alternatives really come into their own.”

Liquid alternatives have numerous benefits, he said, noting they’re valued daily, consistent with a traditional mutual fund’s T+2 liquidity, making it relatively easy to get in and out. They also offer diversification benefits to target-date funds’ typical portfolio mix. The regulatory framework around liquid alternatives have also been clearly defined.

“I think what we’re really doing is marrying the best attributes of a state of the art hedge fund investment process with the best attributes of mutual funds,” Sager said.

Read: 2019 Top 40 Money Managers Report: Investment lessons for DC plans from their DB parents

Focusing in on absolute return liquid alternatives, Sager said these solutions have more flexibility and opportunity to invest in a wider range of asset classes, investment strategies and geographic opportunities and take long or short positions, all of which can mitigate the size of portfolio drawdown when equity markets take a hit and help members achieve better outcomes overall. He gave an example of one such liquid alt, which included commodities, currencies, real return bonds and nominal bonds, as well as volatility strategies.

“All of these are additive and diversifying and help improve the performance and the consistency of the performance of other more traditional portfolios,” he said, adding these solutions don’t “always and everywhere” have the highest expected returns, but they do capture a different source of return.

“We’re not just thinking about riding the market index. . . . [We’re doing] something a little bit different so that we mitigate and smooth out performance to the market while still maximizing our ability to achieve our long-term performance goals.”

Read more coverage from the 2022 Defined Contribution Investment Forum.