Albert Einstein was once asked what the biggest step was in distilling the complexities of the universe into his Theory of Relativity.
Einstein simply replied, “figuring out how to think about the problem.”
While plan sponsors aren’t faced with the challenges of charting how light and matter move through the cosmos, asset allocation has plenty of complexity—particularly when you integrate increased use of alternative asset classes.
A three-step framework can help us “figure out how to think about the problem” of which alternatives to include in a pension plan and how much to invest in each:
- Understand the benefits of each alternative option with respect to your plan’s asset-only or liability-driven investment objectives.
- Consider any additional risks that accompany alternative investments.
- Assess the impact of alternatives on total plan volatility and returns to determine where and how much to invest.
With a full understanding of benefits and risks—and a coherent plan for fitting them alongside traditional assets—alternative investment classes can be an attractive addition to plans of all sizes.
This article will look at Step 1 and highlight some of the benefits associated with alternative investments. The last two steps of the framework will be discussed in a subsequent article.
Understanding the options
Real estate, infrastructure, mortgages, private equities, commodities and hedge funds are the most-familiar alternative investment classes. This discussion will focus on the first five, since hedge funds can involve a broad array of strategies with risks and benefits unique to each fund. A similar framework can be applied to specific hedge funds once there is an understanding of its characteristics.
The following table outlines the key benefits of each alternative:
Potential benefits
As revealed in the table, alternative investments are attractive because they can enhance returns, match assets with liabilities, protect against inflation and reduce portfolio volatility.
Generally, alternative investments offer comparatively superior returns to public assets because of their private/illiquid nature, the smaller base of investors chasing investments or, in some cases, because they manage the use of leverage (debt). Most assets that are not widely traded need to compensate investors because they can’t be easily converted into cash in the near-term. With its long-term horizon, a pension plan can usually harvest the liquidity premium.
Leverage can also enhance returns if applied properly. For example, a 10% return on $100 yields $10; however, the same 10% return on $100 of assets, plus $20 borrowed, yields $12. The downside is the risk that the “premium” can turn negative in certain environments. Risks that are introduced with illiquidity and/or leverage will be explored in the next article.
From a liability-matching perspective, the cash-flow-generating nature of real estate, infrastructure and mortgages makes them sensitive to interest rate movements. This is important because interest rate movements also affect DB plan liabilities. Moreover, real estate and infrastructure help protect a plan from inflation—real estate because its assets tend to appreciate along with inflation, and infrastructure through contractual agreements that link cash flows to CPI. Mortgages generally offer attractive yields with a short investment horizon, making them more appealing compared to other fixed income investments, but less so compared to assets with lower interest rate exposure during periods of inflation.
Private equity, real estate, infrastructure and mortgages can also reduce the volatility of portfolio returns. With real estate, infrastructure and mortgages, this is partly a function of their cash flow-generating nature: their returns are less reliant on market gains than are equities. Real estate, infrastructure and private equity also help reduce volatility when combined with traditional asset classes, since they are often valued less frequently and/or lagged by a quarter. Sponsors may find this advantageous, given the impact return volatility can have on corporate financial statements. Most alternative asset classes likewise help smooth returns due to their low correlation with stocks and bonds.
Given the potential benefits, alternatives can often enhance total plan risk-adjusted return on both an asset-only and liability-relative basis.
In the next article, we will look into risks of the various alternative assets and how these assets can fit into a portfolio that also includes traditional assets.