Which alternatives? Well, that depends

Alternatives to traditional fixed-income allocations take different shapes based on the different roles fixed-income investments play in asset owners' investment portfolios.

Three asset owners — two pension systems and an endowment — are using different asset classes and allocations to get fixed income-like investment results, based on their philosophies about what fixed income provides for them.

At the $25.4 billion Employees Retirement System of Texas, Austin, its 30% fixed-income allocation is divided among suballocations of rate-based, credit-based and transition investments — temporary investments used to shift between the other two suballocations, said Leighton Shantz, director of fixed income. However, the system's most recent asset allocation, adopted in February 2013, includes its 10% target on credit-based investments within its overall 79% allocation to return-seeking assets, while the 15% target to rates-based investments is part of its 21% risk reduction and liquidity assets allocation. The pension fund will reduce its overall fixed-income allocation to 25% in 2015; its current allocation is 30%.

“We had core-and core-plus-based, traditional allocations to fixed income ... we thought it made more sense to bifurcate fixed income into two distinct asset classes based on our needs,” Mr. Shantz said. “Looking at our actuarial needs, we figured out pretty quickly that we would need to monetize our assets. I found it better to counterallocate, hoarding our liquidity in one book. Coupon and maturities should come out at 8%, which is what we need.”

Through this overall strategy, the pension fund can meet its liquidity needs while not cashing out any return-seeking investments. “We're benchmarked against the underlying assets, but trusts like ours get into trouble when they monetize assets at a loss,” Mr. Shantz said. “We want to strategically position the portfolio in the other direction so that all our liquidity needs are met.”

Texas Employees' credit portfolio includes emerging markets and high-yield debt, leveraged loans and asset-backed securities; its benchmark is the Barclays Capital High Yield bond index plus 2 percentage points. The rates benchmark is the Barclays Capital U.S. Intermediate Treasury index; its transition portfolio is benchmarked to Barclays Capital U.S. Intermediate Credit Bond index.

The Barclays Capital Aggregate index — long the standard in core and core-plus fixed income strategies — “no longer has any relevance to us,” said Mr. Shantz.

The transition portfolio has gone from $3 billion to $600 million in a year. “We liquidated as fast as we could,” he said. “We wanted to get it done.”

At the $14.5 billion Illinois State Board of Investment, Chicago, controlling volatility of fixed income is part of a broader emphasis on volatility across all its investments. “For the last few years for us, fixed income has received a lot of attention and generated a lot of angst,” said William Atwood, executive director. “At the end of 20 to 30 years of good rates, now they're flat. The compensation we expect for conventional fixed income is low or maybe negative.

“The fixed-income, equities, real estate guys all have their view of volatility,” said Mr. Atwood. “We're more concerned about the volatility of our entire portfolio.”

Along with higher-yielding fixed-income investments, “we've increased the use of fixed-income proxies” through the board's 10% separate allocations to core real estate and hedge funds, Mr. Atwood said. “Core real estate functions as a proxy by giving us cash-flow revenue in a rising rate environment, while hedge funds serve as a proxy by providing downside protection if the rates go up.” The pension fund's short position in real assets “also provides a defensive play for a down market,” he said.

ISBI's roughly 20% fixed-income allocation breaks down to 6.9 percentage points core/intermediate fixed income, 4.6 percentage points high-yield fixed income, 4.4 points bank loans, 3.2 points non-U.S. fixed income, 2.1 percentage points emerging markets fixed income and 0.4 point CMBS. The allocation portfolio is 1.6 percentage points short real assets, 0.1 percentage points short hedge funds and 0.2 percentage points short real estate.

“The overall allocation is the same as eight or nine years ago, but back then, we were 80% core,” Mr. Atwood said.

Mr. Atwood said ISBI takes a conservative approach to all its investments. “We prefer derivative exposure and position-level transparency, with minimal tactical moves. Duration of the portfolio is now consistent with the benchmark,” with bank loans and CMBS providing shorter duration, he said. Marquette Associates, ISBI's Chicago-based investment consultant, “works collaboratively with us on asset allocation. The allocation is driven as much by them as anything else. We discuss all these ideas with them; they're pretty conservative in their approach, like we are.”

At many large endowments, fixed income historically has played a lesser role in asset allocations, said Scott Malpass, vice president and chief investment officer, University of Notre Dame, South Bend, Ind., which has a $9.2 billion endowment.

“In the endowment world, there's a wide array of philosophies on fixed income. Among the top 10 to 20 endowments, like Ivy League, they generally don't do a lot of fixed income. They decided long ago that it'd be better to go into credit hedge funds and other strategies that have a lower risk than traditional fixed income but with higher return,” Mr. Malpass said.

Its traditional fixed income allocation is 7.5%, “which is typical for a large endowment. We look at it purely for liquidity and quality,” he said.

The allocation is used to fund the endowment's annual 5% distribution to fund scholarships, academic chairs, university libraries and other services. Thirty percent of the university's overall budget is funded from the endowment.

Mr. Malpass said he wouldn't be averse to looking at increasing the endowment's traditional fixed-income allocation, “but not drastically,” if rates go up. However, he said no decision has been made to do so.

“There needs to be a coming together of risk, return and fees to deliver that fabled 7½% return,” whether for public or corporate plans, said Peter Halligan, U.S. head of fixed income at investment consultant Hewitt EnnisKnupp, Chicago.

“That magic number isn't generally talked about.”