The Role of Alternatives

Stocks for the long run!” is the familiar admonition by aca-demics to individual investors. Sure, equities might earn the highest nominal returns, but they also bring plenty of unnerving volatility. Institutional investors have long relied on alternative investments to shelter participants from market storms. While some of these assets are available to defined contribution (DC) plan investors, plan sponsors have typically shunned them to avoid complicating their plans and to hold the line on costs.

Alternative investments can be defined in terms of their unconventional asset classes, such as real estate, private equity, infrastructure and commodities, or by their strategies, such as hedge funds that invest in public equities and bonds, but through an unconventional approach. What is essential is that they deliver return streams unaffiliated with mainstream equities and bonds. “With alternatives, an investor would get superior returns, superior risk management, or both, and wind up on a better, more efficient frontier,” notes Anne Lester, head of retirement solutions for J.P. Morgan Asset Management in New York.

Alternative asset-class returns are distinctive because they are driven by different economic forces than those affecting public companies. Commercial real estate, private equity and infrastructure go through longer investment and revenue cycles. Commodities can be favorably reactive to inflation shocks, and alternative strategies such as hedge funds produce returns reliant on specialized manager skills. Accordingly, institutional investors, with long time horizons and few liquidity requirements, have relied on alternatives for decades. However, their illiquidity and infrequent valuations are obstacles for defined contribution plans.

“From an investment perspective, we believe in alternatives,” says Wyatt Lee, co-portfolio manager of target-date strategies at T. Rowe Price Group, Baltimore. “Several years ago, we did a lot of research on alternatives in a target-date fund [TDF] and demonstrated that, with a reasonably sized allocation, you could improve portfolio construction and diversification.

“Different alternatives could be beneficial at different points in the glide path,” he adds. Private equity, which can earn higher returns than public equity, would make sense for people early in their careers, who could hold it over the long term. Commercial real estate is coveted for its steady returns and low correlation with public equity. “The fund of hedge funds we use tends to have a relatively low volatility, almost like that of investment-grade fixed income, and I could see using that as participants get closer to retirement,” he says.

So far, DC-feasible solutions for private equity have yet to take root, but exposure to real estate comes in several forms such as commingled funds that invest directly in commercial real properties, as well as real estate investment trust (REIT) funds that buy shares of public real estate companies. “Direct real estate is truly an alternative asset class, and a better diversifier than a public REIT fund,” says Greg Hobson, senior financial adviser at Greenspring Advisors, in Towson, Maryland.

J.P. Morgan Asset Management is one of the industry’s largest managers of direct real estate for institutions and that firm has long included it in its TDFs. “We have a neutral position of about 7% throughout the glide path,” Lester says. “It provides volatility management early on, when investors have a lot of equity. At the end of the glide path, it’s a consistent source of income, as it pays stable and predictable yields. The real estate component has been a true source of added value throughout the life cycle, and it manifests in a much higher Sharpe ratio.”

The illiquidity gets in the way, however, and the direct real estate exposure is available in TDFs only in collective trust form. “We’ve chosen to not pursue putting direct real estate into a mutual fund because of the liquidity and fee considerations,” she says.

At T. Rowe Price, Lee says, public REIT exposure is seen as an effective rival of the private sort. “Our real estate team found that REITs have delivered the same kind of long-term return as direct real estate, once you adjust for leverage, and for smoothing in valuation,” he says.

It is not a simple question, though. The table compares the returns of direct real estate and REITs over several time periods, as well as the Standard & Poor’s (S&P) 500 and a balanced portfolio of stocks and bonds. Returns on direct real estate are quite steady, while the record of REITs looks more like that of stocks and for these periods is just as volatile.

Another source of nontraditional returns in DC plans is real assets, which can react more in line with inflation than do stocks and bonds and better protect participants’ purchasing power. Whether they are really alternatives—and how to implement them—is up for debate. “We definitely believe in inflation-sensitive assets and use them in every TDF glide path,” says Jacob Tshudy, director of defined contribution investment strategies at SEI in Oaks, Pennsylvania. “It might be in TIPS [Treasury inflation-protected securities], and, in all but one client plan we have a multi-asset product that includes commodities.” Such funds can, additionally, include public equities of natural resources and infrastructure companies.

“We also include TIPS in the core menus of most clients, as they are not necessarily a risky product,” Tshudy explains. “But commodities are something we include only in a fund we manage, so individuals can’t invest too heavily in something that can be very volatile.”

The dyspeptic markets of last year, with a sharp drop in equity values in the fourth quarter, provided a proof of the benefit of alternatives, Lester says. “Direct real estate valuations were stable, and investors got a total return of 7% to 8% from the current income. In those sorts of markets, it’s like a bond on steroids.”

Art by Henrik Drescher