For the first time ever, the stock market could return 20% or more a year for four straight years. Because of this historic market runup, many marketers are selling alternative investments to pension funds, foundations and endowments, arguing the next decade almost certainly cannot repeat the sensational returns of the 1990s. More aggressive investments are needed to achieve investment objectives to make up for the expected lackluster stock returns, they say.
But that is not sufficient reason to increase a pension fund's allocation to alternative investments. Pension executives should add to their alternative positions only after a careful analysis not only of the relative return prospects for equities, alternative investments such as hedge funds, venture capital and other private investments, as well as fixed-income investments, but also of the risk profiles of each asset class and the role each can play in the overall risk/return profile of the fund.
We have heard the higher return argument in favor of alternatives before -- in the late 1980s when the stock market was coming off the spectacular boom of Reaganomics.
At that time, marketers of alternative assets contended the spectacular returns would not likely be repeated. Others without such motivation -- from academics to many in traditional equity and bond management -- made similar forecasts of market mediocrity for the 1990s. Those forecasts helped fuel the sudden rise of allocations to hedge funds and private equity.
The forecasts were wrong. With only one year to go in the '90s, this decade could be one of the best ever in terms of stock market returns. And some of those alternative investments have not outperformed the equity market on a risk-adjusted basis.
The bull run likely cannot continue without a pause sometime, and after two decades that correction, and the resulting lower returns, seems more likely than ever. But there's a danger in simply acting on that expectation.
Investors use equity risk-premium models to project their asset allocations; a model showing a lowered expected return would lead investors to a higher equity allocation, or risk profile, to increase their chances of meeting their return objective. Just the opposite of what might be appropriate for many funds if the stock market underperforms.
That's why a well-thought-out investment strategy, implemented using a carefully designed, defensible, asset allocation model, is the key to a well-managed pension investment portfolio.