Think there’s no place for alternatives? Think again

Most managers of alternative assets oversee a variety of alternative strategies, including private corporate debt, private equity, real estate, long/short global bonds, managed futures and hedge funds. And managers have heard just about all of the objections to these investments—most more
than once.

The objectives are known as the terrible too’s.

Too risky: The real risk lies in not building exposure to alternatives. The primary purpose in adding alternatives to a long-term portfolio is to reduce risk and add sources of uncorrelated return, often with a positive correlation to inflation. While the extent of correlation to traditional, long-only equities and fixed income varies by alternative strategy, the correlations are smaller. In the case of managed futures in particular, there is actually
a small negative correlation to equity and fixed income.

Too soon: The time is now. The tyranny of the calendar is working against plan sponsors. Make any reasonable set of assumptions you wish about future bond market yields, the equity risk premium and inflation, and you will quickly determine that the traditional 60/40 or 50/50 mix—implemented with conventional equity and fixed income—will not deliver the required net real rate of return, never mind chip away at the deficit. The longer the wait, the deeper the hole.

Too expensive: In the past, cost was more of a concern. The downward trend over the last few years in the price of many alternative strategies is now well established and will continue. That said, don’t expect fees to come down to the level of traditional, long-only equity and fixed income strategies, never mind passive options. Many alternative strategies require specialized skills that are scarce and thus available only at a premium. Further, many strategies are capacity constrained, which dictates a higher fee than approaches without capacity constraints. However, fees and expenses increasingly are settling in at a level at which the expected excess return will compensate for the higher nominal cost.

Too illiquid: In many instances, liquidity is highly prized, overvalued and underutilized. Investing in alternatives allows plan sponsors to capture the illiquidity premium and, at the same time, facilitate higher liquidity options—to the extent truly necessary—elsewhere in the portfolio. There are means of exiting an investment early, such as a sale to other investors in a fund, a sale of a private equity interest to a secondary fund or the sale of a hedge fund position in the secondary market. These options, though, are relatively few. More important is to recognize that many strategies actually offer structural liquidity. In the case of the private corporate debt discussed in “The Alternative Approach” (page 33), not only do the loans provide monthly payments, often those payments are a blend of principal and interest on self-amortizing loans, which means that investors begin getting their capital back, with interest, immediately. You may not be able to sell that power plant in which you have an interest, but you can be highly confident that it will deliver a steady stream of stable, predictable cash flow with a positive ratchet to inflation.

Too complicated: To be sure, some fiendishly complicated strategies have been concocted. But many of these disappeared in the credit meltdown and are unlikely to return. Some of the most attractive alternative investments—such as real estate, private debt and infrastructure—are arguably easier to comprehend than some of the more arcane strategies applied to public fixed income and public equity. The knowledge base is expanding quickly in the plan sponsor community, consultants are now better able to advise investors, and managers can provide information and understanding without obligation.

Too small: Today, no plan is too small. Strategies that once were accessible only on a direct basis by the largest funds—with in-house expertise—are now available through a wide range of options, including pooled funds, funds of funds and even exchange-traded funds. “The Alternative Approach” shows how plans can collaborate to take advantage of the experience and scale of the larger funds to participate in large direct transactions. The knowledge required is now widely available and the means of implementation many and varied.

Clearly, plan sponsors are increasingly adopting alternatives and understand that they must make meaningful allocations to realize the benefit. Mercer’s Canadian Asset Allocation study found that 25.3% of the funds surveyed were investing in alternatives; the average allocation was 14.9%. More plan sponsors will join them.

David Mather is executive vice-president of Integrated Asset Management Corp.

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