With the volatility that has dominated traditional asset markets for the past two years expected to continue in 2023, institutional investors are increasingly looking to alternative assets to provide yield and stability to their portfolios.
Two-thirds of institutional investors surveyed by Natixis said that they expected a portfolio that included a 20% allocation to alternatives would outperform a more traditional 60/40 investment mix. A growing number of defined contribution managers are looking toward following that lead and incorporating more alternatives into their plans as well.
“To say that the performance of equities and fixed income has been rough would be an understatement,” says Luke Vandermillen, managing director of retirement investment support for Principal Asset Management. “That has created more interest and generated more discussions for those looking at investment lineup options.”
While the bulk of their clients remain institutional investors, Neil Brown, head of fund investor relations with the sustainable infrastructure investors Actis, says there have been more discussions over the past year with defined-contribution plans or their advisers, a trend he expects to continue.
“It’s been an unusual market in that both stocks and bonds have gone down together, so it’s been a harsh portfolio market for many investors,” he says. “Naturally that means people look at the full gamut of alternatives, including private equity, infrastructure, real estate, and more liquid strategies.”
Democratization of Alternatives
The increased interest reflects an ongoing trend toward the “democratization of alternatives,” Brown says, as the industry looks for ways to open up access to investors that may previously have not had access to them.
Another factor that has encouraged plan sponsors to expand their allocation to alternatives is the Department of Labor letter that came out in December 2021, with guidance around incorporating private equity into DC plans, including keeping such investments in a multi-asset framework run by someone who understand private assets.
“Plan sponsors are looking at how they can offer additional flexibility within plans and something that’s not correlated with the markets,” Vandermillen says.
Still, the inclusion of private assets within workplace retirement plans remains relatively low. Within target-date funds, just 9% of plans hold real estate private equity and 5% hold real estate private debt, according to PGIM, and numbers are even lower for those holding hedge funds, private equity, or liquid alternatives.
Private real estate assets are a common starting place for plan sponsors working on an alternative strategy.
“A lot of conversations center around the ability to invest in real estate and how the plan is providing access to real estate as an asset class,” Vandermillen says. “There are a lot of different flavors and a lot of different ways to do that.”
Beyond real estate, some plan sponsors are starting to look at other asset classes, including private equity, private real estate, and infrastructure, says Michelle Rappa, a managing director and client advisor with Neuberger Berman.
“These assets may hold up a little better, and some of them can reduce volatility, so plan sponsors and their advisers are thinking about getting more diversification into a plan so that the ride is a little smoother and they have better outcomes,” she says.
Private assets may be better able to deliver on such goals than other types of so-called alternative assets, such as real estate investment trusts or emerging-market debt, that have become relatively commonplace within plans, Rappa says. Discussing those differences may be one way that advisors can add value to plan sponsors who are considering alternatives.
Todd Stewart, managing director of investment research at SageView Advisory Group, says his firm’s clients have not seen too much interest in alternatives to date, but he says that new products in the space from providers have led to conversations.
“When it comes to liquid alternatives and real assets, historically investors or plan sponsors have looked at including them as the third tier of assets in their menus, as a diversification tool for participants,” he says. “That has shifted somewhat in the last couple of years as they’re increasingly viewed as more of an inflation-hedging strategy.”
Still, there are several obstacles that continue to keep alternative investments out of most 401(k) plans, including platform availability, costs, and benchmarking challenges, Stewart says.
“There is also some concern about fiduciary risk that a sponsor might incur by offering these, whether that’s true or not,” he says.
Section 404(c) of the Employer Retirement Income Security Act (ERISA) does relieve some fiduciary liability for participant investment decisions if participants have enough information to make informed decisions. Plan sponsors might have concerns that it’s difficult to provide such information for alternative investments, according to experts.
For some the solution is incorporating alternatives into target-date funds or managed account offerings.
“Our research shows that there would be few participants that would be comfortable understanding that investment and making their own investment decision to allocate a portion of their retirement account to that type of investment,” Vandermillen says.