Public Pensions Should Weigh Pros and Cons of Alternative Investments

Hedge funds have been producing low returns, but slightly less volatility, while other alternative investments are associated with more volatility, a study found.

In order to hedge against investment risk and seek higher returns, public pension plans have looked toward alternative investments, notes a study by the Center for Retirement Research at Boston College.

The allocation to alternative investments more than doubled from 9% to 24% during 2005 to 2015, according to data by the Public Plans Database (PPD), which accounts for more than 95% of pension assets. These alternatives contain a variety of assets including private equity, hedge funds, real estate, and commodities. The research also noted significant returns from alternatives as opposed to traditional equity. Between 2010 and 2016, traditional equity returned about 14% compared to private equity at 25% minus fees.

State and local pension plans were somewhat late to adopt alternative investing due to their complexity, but once plans were comfortable with these strategies, adoption steadily increased. In 2005, for example, the maximum share held in alternatives by any plan was less than 30% and half of plans held less than 10%. As of 2015, however, the maximum allocation among plans was more than 50%, and only 9% of plans held less than 10% in alternatives.

As adoption grew, pension plans portfolios compositions changed as well. Between 2005 and 2015, the allocation to real estate dropped sharply, while investments in hedge funds rose significantly. However, hedge funds have not performed well relative to other asset classes since the financial crisis, the research notes.

In terms of returns, a 10% increase in the average allocation to alternatives was associated with a reduction of 30 to 45 basis points, primarily due to hedge funds.

The researchers conclude, “The empirical results revealed a consistently negative and statistically significant relationship between alternative investments and returns on the total investment portfolio. Regression with various asset types showed this relationship stemmed primarily from low hedge fund returns. But, the analysis also found that hedge funds were related to slightly less volatility of the portfolio, while other alternatives, such as real estate and commodities, were associated with more volatility.”

The full research study may be downloaded from here.