Pension funds have been increasing their allocation to alternative investments such as private equity, hedge funds, real estate and infrastructure in recent years. This is driven by the need to achieve higher returns in the low interest rate environment as well as portfolio diversification benefits. However, alternatives come with significant risks that pension funds must carefully evaluate before investing. I will analyze the key reasons for pension funds allocating to alternatives as well as the associated risks and mitigants.
Alternatives help pension funds achieve return targets
With bond yields at historic lows, pension funds are challenged to generate sufficient income to meet their liabilities. Alternative investments provide higher return potential than public markets and thus help pension funds achieve their targeted returns. For example, private equity has significantly outperformed public equities over the past 10-15 years.
Alternatives provide diversification benefits
Alternative investments have lower correlation to traditional assets, providing valuable diversification benefits. For a pension fund with significant equity and bond exposure, adding alternatives can reduce overall portfolio risk. Furthermore, some alternatives like infrastructure generate steady cash flows, providing diversification by return stream.
Alternatives come with liquidity risk
While alternatives promise higher returns, they come with risks like lower liquidity compared to public markets. Asset owners must be aware of lock-up periods and redemption restrictions associated with most alternative investment vehicles before allocating significantly to this asset class.
Complex alternative strategies require expertise
Evaluating and monitoring complex alternative investment strategies requires specific expertise which most pension funds lack internally. They must rely on external investment consultants or partners to source opportunities, conduct due diligence and manage ongoing oversight.
Increasing allocation to alternative investments helps pension funds meet return objectives and manage risk through diversification. However, alternatives pose liquidity and complexity challenges requiring specialized resources.