Institutional investors quicken shift to alternative investments

Allocations to alternatives over past 7 quarters far outpace those for traditional equity and bond portfolios

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Adding: Jay Kloepfer said despite losses in value during the financial crisis, investors stayed in alternatives and are making new allocations.

Fixed income's dwindling return expectations and equities' volatility are causing institutional investors to lean more heavily than ever on alternative investments.

An analysis of hirings reported by Pensions & Investments reveals that 54% of money allocated in manager hirings by institutions since the first quarter of 2011 were for alternatives. Since the start of 2011, investors have made a total of $94.6 billion in alternative investment commitments, including real estate, compared with $79.6 billion to equities and fixed income.

This compares to $9.3 billion committed to alternative investments and $6.1 billion invested in real estate in 2003 by North American investors, according to the Eager, Davis & Holmes Tracker Hiring Analytics Database. In that same year, investors made $50.1 billion of investments in equities and $15.8 billion in fixed income. (This excludes balanced and global tactical asset allocation mandates.)

While the trend toward alternatives is old news, what's new is the quickening pace. The reason: Investors have no where else to go.

Alternative investment hirings skyrocketed to $20.5 billion so far this quarter, accounting for the bulk of the $27.32 billion money managers in all asset classes — including stocks and bonds — were given this quarter to date.

This is an increase of almost 67% from the $12.3 billion investors committed to alternatives in the third quarter of 2011 and more than 122% above the allocations in the first quarter of 2011.

The biggest slice of total commitments to alternatives so far this quarter went to private equity, which accounted for $8.5 billion in commitments, up from $5.5 billion in the third quarter of 2011. Real estate was second, with $3.9 billion, followed by real assets other than real estate, with $3.89 billion. Investors committed $3.5 billion to hedge funds.

Even though some alternative asset classes such as real estate got battered during the market downturn of 2007 and 2008, investors are reconfirming their belief in the return and diversification benefits of alternative investments. Institutional investors, especially public pension plans, are expected to continue to shift into alternatives and out of fixed income and equities.

These days, many public pension fund investors and some corporate ones are looking at alternative investments — such as infrastructure, market-neutral strategies and more conservative hedge funds — to replace fixed income, said Jay Kloepfer, executive vice president and director of capital markets and alternatives research at San Francisco-based consulting firm Callan Associates Inc. He expects alternatives allocations to continue to grow in public pension plans.

Higher allocations

Corporate plan executives considering winding down their defined benefit plans have higher allocations to fixed income, he said.

Even so, the 60% equities/40% fixed-income allocation that was standard decades ago is long gone. Callan executives anticipate the typical public pension plan's fixed-income allocation, for example, could start heading toward 20%, Mr. Kloepfer said. Many plans already are in the 30% to 20% range for fixed income.

Indeed, according to the Wilshire Trust Universe Comparison Service, the median allocation to alternatives by public plans with assets greater than $1 billion was 15.07% as of June 30, up from 1.81% as of June 30, 2003. During the same nine-year period, the median allocations to equities and fixed income dropped to 50.68% and 25.96%, respectively, from 56.8% and 31.35% respectively.

While alternatives' share of the typical corporate pension plan also has been rising, those investments are still relatively small compared with their overall allocations. According to Wilshire, the median allocation to alternatives by corporate plans with assets greater than $1 billion was 4.2% as of June 30, up from 2.93% as of June 30, 2003.

Investors are looking to replace fixed income with real assets such as infrastructure, said Joe Azelby, New York-based managing director and head of the global real assets group at J.P. Morgan Asset Management (JPM).

The $152.1 billion California State Teachers' Retirement System, $238.4 billion California Public Employees' Retirement System, US$167.2 billion Canada Pension Plan Investment Board, US$115.4 billion Ontario Teachers Pension Plan and Norway's $620 billion Government Pension Fund Global all have added large allocations to infrastructure by trimming their allocations to fixed income and equities.

“Trading out of bonds, which are at the lowest level of our lifetime, into infrastructure is a low-risk trade,” Mr. Azelby said.

Institutional investors are even interested in hard assets, such as gold and art.

“With interest rates so low, pension fund and insurance company clients are all of a sudden interested in investments that they wouldn't have considered a couple of years ago,” said Scott Minerd, chief investment officer, Guggenheim Partners, based in the Santa Monica, Calif. office. “They are not earning enough on fixed income to fund their liabilities and they are not sure what to do with stocks because the equity markets have been so brutal, so they have been looking at other investment classes such as hard assets.”

Even once-stodgy fixed-income allocations now have a dose of alternatives mixed in. One of Guggenheim's more popular investment offerings is a multistrategy one that can include private credits such as middle-market debt as well as leveraged loans.

The trend to more alternatives shows no sign of abating.

A recent Russell Investments survey of institutional investors showed the average allocation to alternatives was 22%, and the majority of respondents indicated allocations would remain the same or increase over the next one to three years across all alternatives categories. Some 32% expect to increase hedge funds and real estate; 28%, private infrastructure; 25%, private equity; 20%, commodities; and 12%, public real estate and public infrastructure.

It all comes down to one big question investors are asking themselves these days: “How do you get there from here,” with “there” being the 7.5% or 8% assumed rate of return public pension plans are using, said Michael Schlachter, Denver-based managing director of consulting firm Wilshire Associates.

The answer, they believe, is to shift more assets into alternative investments.

“Venture capital, leveraged buyouts and real estate are some of the few asset classes that, at least in theory, should get you something higher” than current stock and bond returns, Mr. Schlachter said.

While many allocations to alternatives such as real estate fell in value during the financial crisis, investors have kept their money in those assets classes and are making new allocations, said Callan's Mr. Kloepfer.

Investors that had real estate allocations are reconfirming them at between 5% to 10%; the typical private equity range also is from 5% to 10%, he said.

Still, there is a limit to how low most investors will push their equity and fixed-income allocations, Mr. Schlachter said. “Stocks are a cheap way to get market exposure, and we are overdue to get performance out of stocks,” he said, noting bonds are a low-risk, low-cost way to protect portfolios.

“There is a level people will not go below and a limit to how much they will put into other asset classes,” Mr. Schlachter said.

This article originally appeared in the September 3, 2012 print issue as, "Shift to alternatives quickens".