Why Call Them Alternatives? Especially When it Comes to Asset Allocation

Charles E.F. Millard

Let’s stop speaking about “alternative assets.” Let’s just call them private market assets. Private markets are not “alternatives,” and asset allocation should move beyond the traditional “60/40” to naturally include privates in 401(k)s and other defined contribution plans.

What makes an alt an alt?

The 60/40 Tradition

Traditionally, investments—whether made by institutions or individuals—were composed, essentially, of publicly traded securities: stocks and bonds; equities and debt. Investable assets were mostly publicly tradable and had public information available.

Of course, many private markets’ investments existed: Small businesses borrowed to build; homeowners borrowed to buy. Mostly, these investments were made by banks. Similarly, small business owners would sell “equity” to family members and acquaintances in “club deals,” and larger companies have historically sold all or portions of their equity ownership to employees, individuals or competing or acquiring corporations. But for most investors, publicly available securities represented the vast majority of investments.

The broad understanding that publicly traded securities were the mainstay of investing was epitomized by the “60/40” asset allocation—still the starting point for many asset allocations today: 60% stocks, 40% bonds.

How Investing Has Changed

When publicly traded assets were the main assets available, perhaps that made sense. But today the market for “alternative” assets is huge. Banks have retreated from much of their lending business, replaced by direct lending and private credit as major sources of capital. According to Preqin, private capital has grown to $12.2 trillion from $3.9 trillion, just in the last 10 years. And many companies which, in the past, would have gone public are either delaying going public for longer or simply staying private. There were 7,300 publicly traded stocks in 1996; there are fewer than half that number today.

Private debt is now more than 12% of the investable U.S. market for fixed income. Private equity is now nearly 8% of the global investable market for equity. So how can those markets be called alternatives?

It makes no sense to start with 60/40 in publicly traded securities and then ask how much of that should be allocated to “alts” or privates. That is like saying you are starting with 60/40, but then putting, say, 10% in alternatives. So your allocation will be 54/36/10, as if the 10% were a separate asset class.

The right asset allocation analysis should treat private equity as part of your equity allocation and private credit as part of your credit allocation and ask the following questions: Since private equity is such a significant part of the equity market, how much of my equity allocation should be in private markets? Since private credit is such a significant part of the fixed-income market, how much of my fixed-income allocation should be in private markets?

No Longer off the Beaten Path

Most institutional investors have already figured this out. Between 2013 and 2023, public pension funds in the U.S. increased their allocation to private equity to an average of 11.6% from an average of 6.3%. For wealthy individual investors, platforms like iCapital and CAIS are rapidly making private investments more easily available through financial advisers.

This, of course, makes complete sense, because many private assets can help mitigate risk or enhance return for a similar level of risk. Who wouldn’t use them?

But for the middle class worker dependent upon a 401(k) or other defined contribution plan as their main investment vehicle, privates are rarely available. This makes no sense. The corporation that employs this worker can access private markets. The defined benefit plan for the worker’s neighbor who is a teacher or firefighter can access those assets, and the wealthy friend who lives up the hill has plenty of access. Many investors use privates to further diversify their portfolios, mitigate risk and/or enhance return. But this worker—who may rely on a target-date fund in the 401(k) to pay for retirement—has no access to these investments, even though the investments may help a portfolio deliver better risk-adjusted returns.

To be clear: We are not talking about a DC plan participant allocating, willy nilly, some huge percentage of his or her 401(k) balance to a concentrated portfolio of illiquid assets. We are talking about the judicious, diversifying use of risk-adjusted, return-enhancing private market investments in professionally managed target-date funds and managed accounts. The Department of Labor made clear in June 2020 that private market investments are permitted and appropriate when they are part of professional management and professional investment selection in pooled vehicles. With that guidance, plan fiduciaries should regularly consider private markets as part of their asset allocation analysis as a matter of total expected return—and as a matter of course.

So let’s not call these assets “alternatives.” Let’s make sure that fiduciaries consider these investments for their plans. In doing so, let’s help enhance retirement security for the middle class.

After all … what’s the alternative?

Charles E.F. Millard is a former director of the U.S. Pension Benefit Guaranty Corporation and a senior adviser for Ares Management. This content represents the individual views of the author.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.