Taking a Step Back
Three main factors explain defined benefit
plans’ increasing use of alternatives in
recent years, says Catherine Keating,
CEO of United States Institutional Asset
Management at J.P. Morgan. First, they
look for new sources of returns, both in
terms of appreciation and yield. Some
turn to real estate for the yield and inflation protection offered, while others
gravitate to the absolute return of private
equity as an attractive counterweight to
their fixed-income holdings.
Second, plans hope to decrease the
impact of the “volatility storms” that
have become more frequent. “A volatility
storm is when the equity markets go
down and the discount rate goes down,
so the assets are down and the liabilities
are up,” Keating says. That leads some
DB plans to invest in top-quartile, diversified hedge funds for returns that meet
or exceed equity with one-third to one-half of the volatility, for example.
Third, plans want diversification. J.P.
Morgan sees alternatives used particularly
for global diversification, Keating says, as
plans seek to diminish the “home bias”
in their portfolios’ holdings. Some plans
choose to invest in emerging markets
like China and Brazil via private equity
or hedge funds, or invest in commodities these growing countries will need.
Commodities also tend to do better late
in the business cycle, she says, so they can
balance out equities in that way.
Yet, why does SEI’s poll find that fewer
plans now hold more than 10% of the
portfolio in alternatives? “My guess is
that, with all the volatility in the past
few years, they are taking a step back
and saying, ‘Let’s make sure this is where
we should be,’ and ‘Do we have the right
tools?’” Waite says.
Sponsors have increased their selectivity
in the use of alternatives, Keating says.
“We see them taking more risk but being
very careful and patient in how they do
it,” she says. She attributes that largely to
these investments’ complexity and spon-
sors’ desire to understand elements like
their risks and liquidity.
Also, Keating says, defined benefit plans
find themselves in very different places
from a decade ago. Many have seen their
funded levels drop as volatility increases,
and these plans vary widely in their
funding ratio, liabilities duration, and
mix of active employees to retirees. “The
last decade really has been one of differentiation for corporate DB plans,” she says,
“so clients invest with different return
goals.” Some pursue liability-driven
investing (LDI) strategies, while others
seek out new sources of good returns.
There also has been some interest in
options such as infrastructure and timber,
Kloepfer says. Infrastructure provides a
chance to find a different return stream,
and some see timber as akin to real estate,
but with more interesting diversifying
characteristics, he says. Timber resembles
a sort of natural bond, as the trees grow
gradually over time, so it has some characteristics like fixed income.
Focusing on Liquidity
Many corporate plans now prioritize
liquidity when thinking about alterna-
tive investments. “On the corporate side,
we see a lessening of interest in illiquid
strategies, as plans contemplate freezing
or look at liability-driven investing,”
says Sean Gill, a Partner at Cambridge,
Massachusetts-based investment consul-
tant NEPC, LLC. Frozen plans have to
plan for reducing less-liquid allocations
over time, says Jay Love, an Atlanta-
based Principal at Mercer Investment
Consulting, Inc. So, investing in less-
liquid investments like private equity
and private real estate makes less sense
for these plans. The plans cannot do
anything with these longer-range alter-
native investments in the short term, he
says, “so it is more a matter of planning
that, as they get payouts, they will lower
their new commitments.”
Investing in private equity, for instance,
“can be difficult when a sponsor might
want to liquidate the plan,” Waite says.
“These are long lock-up vehicles, 10 years
or more. Is it going to continue to make
sense eight years down the road?” With
alternatives, “the interest for these plans
is what they might do to hedge risk on
the ‘risky’ part of the portfolio,” Kloepfer
says. Something like a long/short equity
hedge fund can help dampen volatility.
Public plans have a different situation.
Callan sees rising numbers, both in the
percentage of plans investing in alternatives and how much of their portfolios go
into this area, Kloepfer says. Public plans
do not have the freezing issue looming.
“With public plans, especially the large
ones, the general feeling is that they are
in this for the long haul,” Waite says.
So, that explains why public plans invest
more in real estate than private plans,
since real estate often involves a long-term time horizon, Kloepfer says. That
tends to be public plans’ biggest alternatives allocation, he says, often followed
by private equity. Public plans that have
long invested in real estate have remained
static or increased that allocation, Gill
says, while newer investors tend to view
it as a more opportunistic allocation
in distressed areas, as opposed to core
types of investments.
An interest in opportunistic allocations
has become a trend in public plans,
Gill says, as has more “real asset”
strategy interest to hedge inflation and
offer exposure in areas like energy. He
also sees larger allocations to a “risk
parity” strategy using specific products
such as Bridgewater Associates, LP’s
All Weather product, or thinking about
portfoliowide moves such as overlays
and derivatives to achieve better risk-adjusted returns. —Judy Ward