As the U.S. stock market continues its unprecedented climb, many institutional investors are worried about the vulnerability of their plans to a severe decline in stock prices -- a market "correction" as Wall Street euphemistically puts it.
On the other hand, most institutions do not want to return to the bad old days when their portfolios were largely invested in bonds and cash, both of which are poor long-term investments.
For this reason, alternative investments are attracting greater attention from both pension plans and endowments and already are becoming more prominent in many of their portfolios.
What are alternative investments? One can fairly describe alternatives as any investment or asset class that is unusual, unfamiliar, or causes discomfort among investors.
A more formal definition would be: those investments exhibiting unique risk and return properties that are not easily obtainable from traditional asset classes. Of course, what is considered "traditional" and what is considered "alternative" varies from organization to organization and also changes over time. For example, 15 or 20 years ago international stocks widely were considered an alternative investment, but no longer.
Today, the term "alternative investment" usually refers to one of the strategies or asset classes shown in the chart. This exhibit follows the common practice of dividing alternatives into two categories, based on whether the underlying investments are liquid; i.e. publicly held and easily traded.
Liquid strategies generally include hedge funds; high-yield or junk bonds; distressed debt; long/short or market neutral strategies; arbitrage strategies; and commodities.
Illiquid, or nonmarketable, alternatives usually refer to partnerships, lasting anywhere from five to 15 years, which invest in one of the following areas: energy (oil and gas), real estate, timber, venture capital or leveraged buyouts.
Reason FOR ALTERNATIVES
There are two sound rationales for investing in alternatives. The first is to take advantage of probably the only free lunch in portfolio management: the ability to add riskier, and therefore higher-returning, assets to a portfolio while actually reducing the volatility of the portfolio as a whole. Although this outcome is counter-intuitive, it is possible because of the lack of correlation between the returns of most alternatives and the typical portfolio composed largely of U.S. stock and bonds. The goal is simple: higher returns at lower risk.
The second rationale for investing in nontraditional strategies is that various alternatives can often best satisfy certain policy requirements: inflation hedging, for example. Despite its dormancy for the past 10 years, inflation has been, and remains, one of the greatest potential threats to plan assets.
For that reason, investment policies often include an allocation to inflation hedges. And the most direct inflation hedges --real estate, energy, timber and commodities -- are all considered alternative investments.
Let's return to the first rationale: higher returns at lower risk. Is this just academic theory, or can it really happen?
Vassar's actual experience over the past 31/2 years provides a good case study.
Exhibit 2 shows how our endowment has been affected by our largest alternative investment -- hedge funds. Roughly 13% of our portfolio is invested in three hedge funds managed by Tiger, Everest Capital and Elliott Associates. The starting date for this chart, July 1994, is when we added our second and third hedge funds.
On the vertical axis is the annualized return. On the horizontal axis is standard deviation -- the most widely used measure of volatility or risk. As you can see, both Everest and Tiger are very volatile, but have provided excellent returns. Elliott has produced a lower return with much lower risk. As a group, the hedge funds have outperformed the rest of the endowment, but with greater volatility.
Now here is the interesting fact that illustrates the magic of diversification: incorporating these riskier hedge funds into our endowment actually reduced the risk of our overall endowment. This is possible because of the low correlation between our hedge fund returns and the returns of our other holdings. In other words, our hedge funds tend to zig when the rest of the portfolio zags. Thus, by investing in these hedge funds, we've both reduced our risk and increased our return -- the free lunch mentioned earlier.
Hedge funds can be expected to make an even more valuable contribution when the U.S. stock market stops generating 20% to 40% returns every year. In fact, in October 1997, when U.S., international, and emerging stock markets indexes were down from 3% to 16%, our hedge funds were up almost 4%.
Of course, investing in alternatives is not a risk-free proposition. As seen above, low correlation between alternative investments and traditional investments is the secret to earning higher returns at reduced risk. However, if the U.S. stock market continues to generate huge returns like it has during the past three years, one would benefit from having investments that were highly correlated with the U.S. stock market.
Another risk is that an investments committee or board might panic and withdraw funds from an uncomfortable strategy at exactly the wrong time. When Vassar first invested in the Everest hedge fund, it was down 19% after nine months. The manager was brought in to reassure us that nothing, including the strategy, the people, and the process, had changed since we invested in the fund. The college wisely stayed the course and today, Everest is up more than 20% annualized since inception.
Poor manager selection is another major risk. One's choice of managers is so important because there is a wide disparity among managers of alternative investments, as illustrated in Exhibit 3. The far right column shows the spread between a manager just making it into the top quartile and one just falling into the bottom quartile of his peers. One can see that among stock and bond managers, there's not a whole lot of difference between a top quartile manager and a bottom quartile manager. In the alternative area, however, it's another story. Note the huge spreads between good and bad hedge fund, venture capital or LBO managers.
Finally, all of these factors can culminate in the overall risk that no one should ignore: career risk. This is the risk that one's career could be impaired by doing something different from what everyone else is doing -- and not succeeding.
There are several ways to reduce the risks involved in alternative investments. First, ensure that all decisions are driven by sound policy, including the detailing of specific rationales for alternatives. None of us can control the markets. We can, however, make certain that sound investment policies exist and they are implemented wisely and efficiently.
Second, perform strong due diligence. Evaluating prospective managers requires great attention to the four Ps: people, philosophy, process and performance. Exhibit 4 lists some specific characteristics that should be analyzed.
Finally, using a fund-of-funds mitigates several types of risk: manager risk, because several different managers are included; due diligence risk, because there's another level of oversight; vintage year risk for venture capital and LBO partnerships; and frankly, career risk, because if things go sour, you may be able to deflect some of the blame and therefore a portion of the career risk to the fund-of-funds manager.
Let's assume you are convinced of the rationales for adding alternatives to your portfolio and you wish to pursue the idea further. What are some of the initial steps you can take to get started?
* Educate yourself. Attend industry conferences that specifically address alternative investments. Read everything you can get your hands on about different strategies. Maintain files containing related articles, research studies and manager reports. Then expand the educational effort to include your staff and your investments committee.
* Rewrite your investment policy statement. A few institutions might still not have a written investment policy or, more typically, the existing policy might be outdated. So begin the process of writing or updating your policy, and ensure the new policy contains the rationales for alternatives.
Recommend the policy include a specific allocation to some of these alternatives. If that doesn't fly, explicitly list some alternatives as permissible investments within other asset classes; for example, venture capital and leveraged buyouts within the equity allocation. Efficient frontier models, which are a staple of the asset allocation process, are a great tool to showcase the benefits of alternatives.
* Present peer comparisons to your committee or board. Most members are very interested in what everyone else is doing. This is certainly not the right reason to invest in alternatives, but the end might justify the means. According to Pensions & Investments' 1998 survey of plan sponsors, the top 200 defined benefit plans had 6.4% of their assets invested in alternatives. The average endowment, according to Cambridge Associates, now has 13% of its portfolio invested in alternatives.
* Finally, the best strategy for getting started is to enlist some strong allies. It is not necessary to fight this battle alone. If you employ a consultant, ask the consultant to put together a presentation on alternative investments.
A board or committee member can be another good ally. If a venture capitalist, for example, sits on your committee, ask him to lead a discussion on venture capital at the next meeting. Other members will often defer to "the expert." Also, some members might have had good results with alternative investments in their personal portfolios and will gladly relay that experience to the rest of the committee.
Fund-of-funds managers also are good sources of information and expertise. Most of them are more than willing to make educational presentations for nothing more than a five-minute plug at the end for their own services. Contact colleagues for the names of highly regarded managers.
Alternative investments can fulfill certain policy requirements better than traditional investments. They also can provide greater diversification and increase the returns of your overall portfolio while reducing risk.
Those institutions that wisely incorporate alternative investments into their pension plans or endowments should earn big dividends in the years ahead, especially if the U.S. stock market party comes to an abrupt halt>