Institutions’ Appetite for Alternatives Still Growing

Institutions’ eagerness to adopt alternatives as part of their overall investment strategy is rooted in their desire for greater diversification, lower volatility and enhanced returns in a low interest-rate environment, according to Cerulli. In addition, investors are looking to alternative strategies to provide income, since deriving income from the traditional asset classes has proven more difficult.

Cerulli says survey results also confirm that consultants have generally expanded their clients’ allocations to hedge funds, private equity and other private investments across both defined benefit (DB) and nonprofit institutional investor types since year-end 2008. Going forward, investment gatekeepers also anticipate increasing the proportion of alternative investments used in institutions’ portfolios through 2015.

Another ongoing trend identified by Cerulli is investors’ interest in addressing more complex and volatile markets by abandoning the traditional style-box approach to asset allocation. Instead, investors are opting for a risk-based or objective-based methodology. As Cerulli researchers explain, an objective-based framework allocates assets into categories according to the role that they assume within the portfolio—for example, diversification or return enhancer—as well as how they help to diversify specific portfolio risks. As a result, many investors are abandoning their view of alternatives as a separate asset class, Cerulli finds, and are classifying them according to the investment’s desired objective or outcome.

This reclassification typically leads to higher allocations to alternative assets over time, researchers explain. Institutional investors on the nonprofit side appear especially likely to receive guidance arguing for more alternatives, Cerulli says, as about 50% of gatekeepers expect increased alternatives use for endowments, and 33% expect increased use for foundations during the next one- to two-year period. Conversely, fewer than one-fifth of these gatekeepers plan to decrease their endowment and foundation clients’ exposures to alternatives.

Cerulli says DB pensions across plan types—corporate, public, and Taft-Hartley—have increased their exposure to alternative assets during the past five years to meet a diverse range of investment objectives. 

Post-2008, most U.S. corporate DB plans were underfunded, which presented a major challenge considering persistent low interest rates. Cerulli says DB plans often could not afford to concurrently derisk and earn the needed return to fund future liabilities. As a result, these plans continued to allocate to return-seeking assets, Cerulli says, such as hedge funds and private investments, to enhance diversification and generate returns. Over the past year, robust equity markets and rising interest rates decreased the gap between pension assets and liabilities, and have resulted in improved funding levels for many corporate DB plans.

While 31% of consultants expect to raise their corporate DB clients’ allocations to hedge funds, 19% expect to reduce exposure. Additionally, exactly one-quarter of gatekeepers plan to increase corporate DB clients’ private equity holding and 19% expect to decrease allocations, Cerulli finds. Lastly, less than one-fifth (18%) of consultants plan to expand their corporate DB client’s exposure to other private investments, and 12% anticipate decreasing exposure.

On the public side, Cerulli says DB pensions continue to struggle to achieve actuarial returns between 7.5% and 8%. To meet these high target rates of return, 40% of consultants plan to raise their public DB pension clients’ allocations to hedge funds, and 47% anticipate increasing exposure to private equity and venture capital over the next one- to two-year period, Cerulli finds.

Interestingly, Cerulli’s report also finds institutional investor exchange-traded fund (ETF) use is beginning to move beyond exposure to just equity and bond strategies and into the world of alternative investments. Cerulli suggests investors, from DB pension plans to defined contribution (DC) plan participants, see alternative ETFs as a way to potentially enhance portfolio returns while also gaining better intraday liquidity and transparency features compared with other forms of alternatives.

Cerulli researchers suggest these facts, along with the point that alternative strategies tend to be pricey from a fee perspective for certain product structures (such as mutual funds), have drawn the attention of many seeking inexpensive exposure to the alternatives asset class.

While commodities ETFs still dominate a large percentage of alternative ETF assets, at about 58%, they have suffered as a result of the gold sell-off in 2013, Cerulli says. Some of the largest commodities ETFs endured substantial outflows in 2013, Cerulli finds, and 2014 has brought continued volatile monthly flows year-to-date for commodities ETFs. Cerulli expects that as the U.S. dollar continues to strengthen, growth in the commodity space will struggle, as the U.S. dollar and commodities generally have an inverse relationship.

Cerulli says hedge fund firms are increasingly interested in the use of inverse and leveraged inverse ETFs for their portfolios. Inverse ETFs allow investors to bet against the market, as they are designed to move in the opposite direction of their benchmarks. Investors can buy an inverse ETF as a hedge if they are looking to make a bearish bet on the market versus trying to outright short a stock or index position, which Cerulli says may pose liquidity concerns or trigger other prohibitions, especially in the individual retirement planning context.  

Of the ETF providers surveyed by Cerulli, 43% stated that the alternative ETF asset class was a primary focus of product development.

More information on how to obtain a full copy of “The Cerulli Edge – U.S. Monthly Product Trends” is available here.