Alternative Investments: An Overview

In 2006, alternative assets made up just 11% of state pension investments. By 2016, that number had shot up to 26% of pension fund allocations. These investments almost entirely came out of what had previously been allocated to traditional equity investments, with fixed income sources’ share of pension fund investments remaining largely unaltered. But what does this mean? What are these investments vaguely labelled “alternative assets,” and why have they become so popular in recent years?

Alternative assets can most broadly be defined as anything that is not a publicly traded stock or fixed-income asset. This can include anything from real estate to commodities to collectible items (that is not to say, however, that CalPERS has a safe full of Honus Wagner cards locked away somewhere). Venture capital and private equity also fall under this category.

Most pension funds’ forays into the alternative asset world are dominated by investments in real assets. The Los Angeles County Employees Retirement Association, for example, is 16.7% real asset and inflation-hedging investments. Just over half of this is real estate, supplemented by investments in infrastructure, natural resources, commodities, and treasury inflation protected securities.

Large pension funds are uniquely suited for investments of these sorts. While real estate is one of the most common investments people make, infrastructure, on the other hand, requires huge amounts of cash and long-term commitments that are not as attractive to individual investors and smaller funds.

Alternative assets carry their own unique costs and benefits. Long-term investments such as infrastructure and stable commodities can shield a portfolio from a market downturn, as they are significantly less volatile than most publicly traded stocks, while still offering a greater ceiling than a fixed-income asset. The downside of this, however, is that they can cause diminished returns during times of economic prosperity by not increasing in value the way most equity investments will. Alternative investments have even been blamed for public pensions’ inability to fully benefit from the strong market of the past ten years. This is a problem when state and local pensions’ assets are barely half of the value of promised future benefits.

While the markets have been thrown into chaos in recent months as a result of the COVID-19 pandemic, this only underscores the importance of seizing opportunities such as a decade-long period of market growth. Investments in assets which exist largely independent of the market during such times prevent underfunded pensions from picking up some of the slack and catching up to their soaring liabilities.

As the markets went up throughout the 2010’s, pensions invested defensively, opting for assets that might shield them from a downturn that did not come for a decade. The past ten years, in fact, were the best on record for simple equity and bond portfolios, but you might not know it by looking at the performance of public pensions. Alternative assets amount to more than a quarter of public pension portfolios, but what do these funds have to show for it, other than a stake in some toll roads?