Casting for Returns

To juice up their sagging portfolios, pension fund managers are seeking alternative investments.

Fearing that neither equities nor fixed-income investments will generate the returns they produced in the past two decades, many plan sponsors are looking at alternative investments — a term generally applied to hedge funds, real estate, and private equity — to juice up their portfolios.

Ignorance: Not Bliss

To be sure, there has been no mass piling into any of these sectors, especially by company-sponsored pension plans. The vast majority of corporate plan sponsors continue to invest their pension assets exclusively in publicly traded equity and fixed-income markets. (Government-sponsored pension plans have been quicker to embrace alternative investments, and endowments and foundations have been even more aggressive.)

Still, data from consulting firm Greenwich Associates indicates that among large corporate pension plans, allocations to hedge funds doubled last year, to 0.4 percent of all plan assets, while allocations to real estate rose from 2.1 percent of assets to 2.3 percent. Among plans that have gone so far as to make a strategic commitment to alternative assets, actual allocations to hedge funds typically range from 0 to 2.5 percent, while allocations to real estate generally range from 5 to 10 percent, according to Barry McInerney of Mercer Investment Consulting in New York. (Private equity isn’t stirring the same sort of enthusiasm, at least for the moment. Returns there swooned in sympathy with the public-equity markets in the past two years, and total allocations by corporate pension plans to that sector declined from 2.3 percent in 2001 to 1.9 percent in 2002.)

No one is suggesting that all plan sponsors should follow Einhorn’s lead, but consultants do suggest sponsors have a fiduciary duty to at least consider alternative investments. “Ignorance is not bliss anymore,” says McInerney. “Fiduciaries need to be aware of all types of investment opportunities and understand what they are in terms of their return-risk characteristics and how they might fit into their portfolios.”

Fiduciaries will find, in fact, that returns on alternative investments, particularly real estate and hedge funds, have a low correlation to returns on domestic equities — as little as 0.02 for private real estate and 0.22 for private equity, and virtually zero for some hedge-fund strategies, says John Ilkiw, a New York-based consultant at Frank Russell, which advises plan sponsors on asset allocation and investment decisions. That means corporations can tap alternative investments to achieve either higher returns with risk levels comparable to those of a conventional portfolio, or comparable returns with less risk.

Illiquid and (Maybe) Spectacular

Not that it’s an easy proposition. For starters, most alternative investments are illiquid, long-term investment vehicles, often structured as limited partnerships that can tie up an investor’s capital for 5 to 10 years. They offer far less transparency than publicly traded stocks and bonds, particularly in the case of most hedge funds. And historical performance data is not as reliable as historical data for public-market investments, in part because the underlying assets are less commoditylike and, for much of their investment life, are valued by appraisal rather than market transactions.

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