Managing asset allocation with alternative classes: Part 2

1. Understand the benefits of each alternative option with respect to your plan’s asset-only or liability-driven investment objectives.
2. Consider any additional risks that accompany alternative investments.
3. Assess the impact of alternatives on total plan volatility and returns to determine where and how much to invest.

I then discussed some of the potential benefits associated with including alternative asset classes in a pension plan. I examined how real estate, infrastructure, mortgages, private equity and commodities can offer the potential for enhanced returns, improved liability matching, inflation protection and investment-return smoothing.

In this article, I will turn to the final two steps in the three-step framework and focus on the risks and how these assets fit into a portfolio.

Associated risks
Plan sponsors have to gain comfort with the trade-off between potential benefits and associated risks with alternatives. We define these risks as material considerations that can arise when diversifying away from traditional stocks and bonds. By understanding the main risks, sponsors can mitigate unintended surprises.

Liquidity risk means more than the ability to access assets invested in alternative classes. It also means meeting the cash requirements of the alternative class itself. During the financial crisis in 2008, for example, many sponsors were required to meet capital calls (contributions) for private investments at a time when traditional asset class liquidity was thin. This was due to the structure of many closed-end alternative investment vehicles, which gave investment managers control over when capital was called and paid out. In addition to timing the contribution, closed-end vehicles often give the manager discretion over when the fund is wound-up. This associated risk can reduce the liability-matching benefits of otherwise long-term assets if they are accessed through funds with shorter-term lives.

Leverage has many definitions and is often important to the proper execution of alternative investment mandates. The main consideration for sponsors is gaining comfort around the potential for enhanced losses in times of extreme market stress. This risk can be mitigated through careful manager selection where leverage is managed appropriately and in-line with investor interests.

Alternative strategies are frequently accompanied by higher management fees due to increased operational complexities. In addition, many alternative asset managers charge a participation fee for returns above a given threshold. Sponsors need to determine what fee structure is acceptable for a given investment.

In addition to the specific risks noted, there are several governance issues that may need to be addressed. Because many alternative investments involve privately traded assets, there are potential difficulties with respect to benchmarking performance and matching policy benchmarks. While there are accepted benchmarks for commodities and to some extent mortgages; real estate, infrastructure and private equity benchmarks are still hotly debated by investment professionals. Closed-end funds provide additional challenges in matching policy weights, both due to difficulties in timely rebalancing and, particularly, if the manager has discretion over capital calls and fund windup.

Selecting an investment management partner with aligned interests can help to reduce some of the risks associated with alternative assets. Organization structure, fees and vehicle configuration (e.g., closed-end versus open-end) are some of the indicators plan sponsors can use when evaluating the degree of alignment. Conflicts can also arise in decisions to buy, hold and sell assets if an asset manager is involved in multiple business lines. Generally speaking, the greatest alignment of interest arises when managers are not receiving additional fee sources outside the investment management fee.

Bringing it all together in asset allocation
Historically, institutional investors have relied on modern portfolio theory to determine the optimal mix of assets. This approach relies on setting assumptions about asset returns, volatility and correlations among asset classes. Past returns from representative benchmarks often provide a starting point for determining asset class returns, volatility and correlation; however, there are a few lessons about alternative investments that you should keep in mind:

1. Past performance is not indicative of future results
While historical data is useful for most assumptions, factors such as future interest rates, inflation and equity risk premiums can be very different compared to our past experience. It’s important to confirm that past data is still valid in the context of the current environment. This is especially the case with alternatives, where the proxy benchmarks may have short histories, as they often do.

2. Be aware of unintended factors when using proxy benchmarks
Investors can look with some confidence at historical risk and correlation data from real estate, mortgage and commodity benchmarks. Infrastructure and private equity, however, can pose challenges: their proxy benchmarks are based on a blend of public benchmarks or listed equities, which may provide noise unrelated to the actual investment. For example, listed infrastructure benchmarks that track stocks of infrastructure companies may exhibit greater equity risk than that of direct infrastructure investments. If available, returns from an actual strategy can provide better guidance for setting assumptions.

3. Stress test assumptions
Once assumptions are set, it is important to stress test the impact of any changes. Small changes in asset class expectations can have a material impact on asset mixes set through portfolio optimization. A proper stress test can help to inform the ultimate asset allocation decision.

With a proper game plan and approach to understanding alternatives, plan sponsors of all sizes can gain exposures that help to meet investment objectives.