Alternative investments can be used by defined contribution (DC) plan sponsors to improve diversification, potentially enhance total returns and reduce portfolio volatility, as well as streamline plan investment lineups and combat negative participant investing behaviors, according to speakers at an OppenheimerFunds webinar.

While defined benefit plans have relied on alternatives for decades, DC plan sponsors have been slow to use them. Kathleen Beichart, head of retirement and third-party distribution at OppenheimerFunds, said this has been because DC plan sponsors are worried participants won’t understand the investments and there may be a low take up rate by participants or they may over-allocate or to these options. In addition, some plan sponsors are just not excited about adding another investment type to their plans.

But, Paul Temple, senior vice president and head of DCIO sales at OppenheimerFunds, said offering alternatives may help plan sponsors manage their fiduciary responsibilities and increase the probability of participants reaching their long-term goals. “Plan sponsors have a fiduciary responsibility to act prudently and within the best interest of participants,” he said. “They have an obligation to diversify investments based on market conditions ‘then prevailing.’”

Participants are concerned about suffering bad losses in a down market cycle, and managing that volatility is key to helping participants reach their goals, Temple noted. At the same time investments cannot be too safe or earnings will not outpace inflation. He said adding alternatives addresses these risks.

Temple added that advisers can use this to differentiate themselves from the competition. “Plan sponsors may not be looking into alternatives; they may not be paying attention to them,” he said.

NEXT: How alternative investments help

Mark Hamilton, chief investment officer for asset allocation, and head of the Global Multi-Asset group at OppenheimerFunds, says in the current bond market, there is an expectation of structurally lower returns, in part because of the interest rate environment. “Are bonds, which have provided solid returns, going to be able to deliver returns that keep pace with inflation?” he asked. “We’ve relied on bonds to offset equity risks; as interest rates rise, will bonds provide the degree of protection they have in the past?”

As for the equity market, Hamilton noted that equities are above averages in long-term valuations. “What that says is, as we move forward, equities are not likely to achieve the same level of return,” he said. “Will traditional portfolios of bonds and equities satisfy investor needs over the long-term? This has sparked interest in alternative investments.”

Hamilton explained that real assets—such as real estate investment trusts and commodities—have good performance in periods of high inflation, where traditional assets do not do well. They can provide a valuable source of diversification that provides protection in inflationary periods. Income alternatives—such as master limited partnerships (MLPs), leveraged loans and catastrophe bonds—can mitigate against interest rate rises. They provide significant returns during periods of high interest rates. Alpha alternatives, such as hedge funds, can provide a cushion when the market is going down. They tend to have low correlation to market, and returns are less determined by what is going on in the equity market.

OppenheimerFunds suggests a portfolio that is a blend of all three types of alternative investments—multi-alternatives. An analysis has shown a hypothetical multi-alternatives portfolio has less volatility than the S&P 500, Hamilton said. It can provide a supplement to, and more diversification than, traditional equities.

“When you think about all the different categories of investments that can be used to diversify a fund menu, a plan sponsor could easily come up with a menu of 40 to 50 funds,” Temple noted. But, plan sponsors need to provide options without cluttering up the menu. “A multi-alternative choice potentially improves consistency of returns, helps reduce volatility, helps reduce correlations to the market and helps hedge risk, all in one fund versus six or so,” he said.

Temple added that packing alternatives into a single investment option provides a one-stop allocation solution, simplifies educational efforts, reduces the chance of participants’ performance-chasing behavior, and reduces due diligence for plan advisers and sponsors since they will be only monitoring one fund versus many.

However, OppenheimerFunds suggests plan sponsors limit participant allocations to multi-alternatives to 15%. According to Temple, plan advisers should work with plan sponsors and their recordkeepers to set allocation limits they deem appropriate; some may decide the limit should be less than 15%. Plan sponsors' investment policy statements (IPS's) should also be reviewed for asset class restrictions or asset allocation requirements, and amended, if necessary.

According to Hamilton, when structuring a multi-alternatives strategy, plan advisers and sponsors need to consider liquidity and the ability for participants to move into and out of funds. Alternatives with the lowest liquidity are not the best for DC plans; those in the middle can be okay; but, alternative investments with high liquidity are appropriate.

Hamilton suggested combining non-traditional assets of all varieties in a multi-alternatives portfolio, seeking low correlation to stocks and bonds and flexibility to adjust to a changing market. “Plan advisers and sponsors should actively manage risk, making sure the underlying investment vehicles in the strategy are not themselves becoming too correlated,” he said.