According to a white paper from Rocaton, alternative investment strategies can have a place in the growth portfolios of defined benefit (DB) plans. The primary objective of a liability driven investing (LDI) growth portfolio is to provide defined benefit plans with expected returns greater than the expected growth of the plan’s liability, the paper contends. Traditionally, growth portfolios have mostly embraced public equity strategies, Rocaton says, but although they provide strong long-term returns, equities are susceptible to significant drawdown risk that may have a negative impact on a DB plan’s funded status.

The authors of “Incorporating Alternatives in an LDI Growth Portfolio” believe DB plan sponsors should consider certain alternative investment strategies that aim to generate attractive returns with less drawdown risk than the broad equity market. Their paper examines strategies in four primary categories: long/short equity at the more liquid end of the spectrum; convertible bonds; distressed debt; and event-driven strategies.

Rocaton lists other strategies as well, including private equity, long/short credit, managed futures, low-volatility equity strategies, and various short-duration or high-income real estate strategies.

“We recognize many plan sponsors are likely to use private equity and private real estate,” says Matt Maleri, partner and member of Rocaton’s capital markets/asset allocation group, and a co-author of the paper. Distressed debt funds, which attempt to take advantage of corporate events, are a bit less liquid, Maleri notes, likely with quarterly or annual liquidity, rather than a full lockup. The events can be anything that has an effect on the firm’s debt, from a restructuring to a bankruptcy, or anything that puts serious pressure on the firm’s outstanding securities. “They’ll buy assets cheaply and hopefully that is a way to get equity-like returns,” he explains, adding that some plan sponsors may need more explanation to help them feel comfortable with the strategy.

The strategies have a few criteria to recommend them in a DB plan, Maleri says. Convertible bonds and long/short equities, because they fall in the more liquid end of the spectrum, are probably more likely to be accepted more quickly, Maleri says. “And they generally use plain vanilla securities,” he observes. “They’re not trading in anything esoteric. Convertible bonds are pretty transparent. Most public equities traded on the exchange are easy to understand.”

If lowering volatility is the goal, says James Gannon, managing director, asset allocation and risk management at Russell Investments, introduce asset classes that are uncorrelated or less correlated with equities, such as private real estate, infrastructure or hedge funds that don’t fit traditional equities profile, which a lot of DB plans use in their growth portfolio.

The types of pension plans likely to use these strategies are split fairly evenly between plans that are open and ongoing, with new participants entering and a liability that rises every year, and those that are closed or frozen, Gannon says. “We see that closed or frozen plans are less likely to be invested in these alternative classes mostly because of their time horizon,” he explains. “It’s not long enough to gain the advantage of the time horizon. They’re looking at strategies in plan termination or annuitization, and they can’t stand the illiquidity of alternatives.”

But open plans do use alternative investments—most common are private equity investments, as well as hedge funds and private real estate—as part of the growth portfolio, as a way to control volatility and to grow, Gannon says.

Gannon notes that substantial resources are needed to oversee a program with alternatives, and that plan sponsors must be confident their time horizon and strategy won’t change for the length of time the plan is to be invested, in order to achieve the full value.

Illiquidity would make these asset classes very restrictive for plan sponsors considering ending or freezing the plan. “It makes it difficult to operate some of the risk transfer strategies,” he says, “so advisers need to gain an understanding of what the plan sponsor has in store for the plan, so the chief investment officer is not caught off guard.”

LDI is a comprehensive strategy, maintains Jeremy Kish, managing director of TeamCo Advisers. But many people lose sight of this during implementation when they divide the portfolio into two parts, a hedging portfolio and a growth portfolio.

“The challenge with the growth portfolio is the balance between high returns and volatility,” Kish explains. “Including high-volatility allocations in the growth portfolio is a slippery slope. The higher the volatility of assets, the greater the chance of increasing the volatility of pension plan contributions, the very thing LDI is attempting to reduce.”

An allocation to alternatives generally, and to select hedge funds specifically, can be a way to help sponsors carry less exposure to equities while preserving return generation, Kish says: “There is less risk to plan funded status—which is the goal of an LDI strategy.”

But Kish warns that including alternatives in the growth portfolio is not always simple, as all alternative investments are not created equal. “The degree of the fund’s liquidity is one such consideration that plan sponsors should ponder carefully,” he says. “If the goal is to sell the pension plan once it becomes over-funded, then any allocation to alternatives leading up to a sale should be very liquid, as the insurance companies that purchase pension plans often charge a premium for illiquid allocations.”

To that end, hedge fund strategies can be a good fit, Kish says, since they can be quite liquid (daily, monthly, quarterly) and allow sponsors to exit hedge fund investments as they prepare to sell the pension plan. 

Manager selection is critical, according to Maleri, and one of the biggest challenges in alternatives. “Strategies can look very different from one another, but performances can also be very different,” he says. “Unlike traditional public equity strategies, you could have two long/short strategies with very different performance, quarter to quarter, or year to year.”

A hefty amount of research goes into manager selection, from surveying the broad landscape through databases, to good connections with various providers, Maleri says. A compliance review or deep dive into a firm’s operations, such as their trading and compliance policies, is a good practice.

Other factors to examine are the manager’s policies for cash management, handling excess cash or trade allocation. “How do they allocate a particular security across multiple accounts?” asks Maleri, adding that the optimal policy would be to allocate trades evenly across all accounts.

“This is a field where you really have to know managers and be up to date on new shops, which open all the time,” Gannon says. “Have a fairly rigorous due diligence process, and make sure to have a process in place to keep on monitoring the managers.”

If hedge funds are under consideration, Kish recommends taking special care to educate the investment committee, since hedge funds are seemingly much more complex than many other alternatives like private equity and real estate. Since the investment committee often meets on a quarterly basis, it can be challenging to get their time and attention, but Kish calls it “critical to find a way to help them understand the benefit of how a portfolio of select hedge funds might improve the risk-adjusted returns of the plan.”

Research will be needed for the different fee schedules, Gannon says, noting that a long/short equity strategy might have different share classes with different fee schedules for each. A lower fee for a manager might have a higher performance fee, and vice versa, he explains. “For a plan sponsor to understand the implications of different fee schedules is critical,” he says.

The fees should be in line with the manager’s expectations for the product, Gannon explains.” If it’s a low-tracking error, low-expected return product, we wouldn’t want high fees,” he says. “But if the manager and consultant have high expectations for returns, maybe higher fees are worth it. The fees being charged should be aligned with the manager’s investment philosophy. If someone’s charging much higher or much lower fees, you should question why that is.”

Ultimately, Gannon says, the message for plan sponsors is that for all their caveats, alternatives can be worthwhile. “It makes a ton of sense for pension plans,” he says.