Is that all there is?

—Miss Peggy Lee

In 1969, American singer Peggy Lee won the Grammy Award for the Best Female Pop Vocal Performance for her version of the song “Is That All There Is?” Originally written during the 1960s by American songwriting team Jerry Leiber and Mike Stoller, who were inspired by the 1896 story “Disillusionment” (Enttäuschung) by Thomas Mann, the lyrics capture a person’s disenchantment with life’s events. The song begins with a little girl witnessing her family’s home burning down, then seeing her first circus—and later, falling in love for the first time. In the song’s refrain, with each experience she asks, “I that all there is?” expressing her successive disappointment.

* * *

As we consider DC investment offerings, we may ask the same question, “Is that all there is?” Many DC programs anchor heavily on mainstream stocks and bonds, both in the target-date allocations and the core investment lineups. Unfortunately, at the time of writing, we are in a low-yield world, with core U.S. bond yields of 1 to 2 percent, which center return expectations on 1 to 2 percent (net of inflation, that’s near 0 percent). U.S. stock valuations are similarly high, with dividend yields near 2 percent and cyclically adjusted P/E multiples well above 20x, which, based on history, may mean 10-year future returns of 5 percent or less. Yet, investors don’t expect returns of 2 to 5 percent; and many require much more to meet their retirement goals. Where might they turn? In this book thus far, we have discussed the four pillar asset classes: capital preservation, fixed income, equities, and inflation-hedging assets. In this chapter, we’ll take a look at a fifth pillar—alternative strategies a plan fiduciary may consider to help participants achieve either higher returns or reduced risk—or both—all with a continued focus on our objective of increasing the probability that participants will attain sustainable spending in retirement.

Thus instead of asking, “Is that all there is?” we may ask ourselves, “What are the alternatives to stocks and bonds?” When we say alternatives, most may think primarily of less-liquid investment strategies, such as hedge funds and private equity. There are, however, many additional components of the alternatives bucket for DC plans. For our purposes in this discussion of alternatives, we would start by considering alternative ways to invest such as, for example, adding a global tactical asset allocation strategy to a core lineup or a blended strategy. Then, we would consider liquid alternatives such as multistrategy solutions. Finally, we would take a look at potential less-liquid alternatives, such as hedge funds and private equity, while also taking into account the operational and other issues associated with these strategies.

Overall, our mission with alternatives is to find incremental return potential and/or risk diversification away from mainstream stocks and bonds. In the following pages we’ll take a look at what alternatives are, why to consider them in DC plans, and consultant views on alternatives. We’ll also review alternative investment approaches, consider how liquid and less-liquid alternatives compare, and explore how alternatives may be folded into a DC plan as core assets and/or within blended investment options.

WHAT ARE ALTERNATIVE ASSETS?

A 2013 paper from the Defined Contribution Institutional Investment Association (DCIIA), titled “Is It Time to Diversify DC Risk with Alternative Investments?” focuses on three primary categories of alternatives: absolute- and total-return, private equity, and real estate strategies. Consultants would add many more alternatives to this set. In our 2014 DC Consulting Support and Trends Survey, we asked consultants to identify which investments they consider to be “alternatives.” As shown in Figure 9.1, nearly all respondents (95 percent) identified hedge funds and private equity as alternatives. The vast majority of firms also defined long/short equity (90 percent), private real estate (90 percent), absolute return (86 percent), and currencies (86 percent) within the alternatives set, while a minority added unconstrained equity (29 percent) and bonds (26 percent), REITs (24 percent), and tactical asset allocation (21 percent) to the list.

As you can see, this list is a bit of a hodgepodge, as it includes less-liquid, liquid, and alternative investment approaches. You may also notice that this list includes several of the inflation-hedging asset classes, such as commodities and REITs, that we addressed in Chapter 8. As discussed in that chapter, real assets offer diversification and other benefits relative to stocks and nominal bonds. In this chapter, we’ll look at additional ways to add benefit beyond liquid real assets. Given this focus, and as noted in the introduction to this chapter, we will group alternatives into three broad categories: alternative ways to invest, liquid alternatives, and less-liquid alternatives.

A WIDER LENS ON ALTERNATIVES

Let’s start with alternative ways to invest. At PIMCO, Asset Allocation Product Manager John Cavalieri and retired Managing Director Sabrina Callin explain in their 2013 paper, “In an Era of Uncertainty and Lower Returns, It’s Time for Alternative Approaches,” that when “traditional approaches to investing are not going to get investors where they need to go, it’s time for alternative approaches.” They address alternative ways to invest, telling us that by “investing alternatively,” they mean not only selecting nontraditional asset classes and strategies, but also nontraditional approaches to portfolio construction itself, including:

• Alternative asset allocation approaches
• Alternative index-construction processes
• Alternative sources of alpha, or excess return
• Alternative return and risk objectives
• Alternative risk-mitigation tools

The paper addresses the alternative asset allocation approaches and tactical allocation as follows: “The traditional approach to portfolio construction focuses on the percentage of capital allocated to each investment strategy and, collectively, to each asset class or category. The classic example is the 60/40 stock/bond portfolio. However, while such a portfolio may appear balanced, from a risk standpoint the allocation is clearly dominated by equities” (see Figure 9.2).

The authors continue by emphasizing the importance of identifying and allocating portfolio assets based on their risk characteristics:

To truly reap the power of diversification, we believe investors should allocate based on the risk contributions of the assets in their portfolio, not their percent of capital. We find that a focus on risk factors, which are the elemental components of risk within an asset class or strategy, is a more effective approach, enabling better risk targeting and diversification.

In addition, we believe it is important to evaluate the prospective risk/reward trade-off offered by different exposures, and to emphasize those that offer more attractive prospective risk-adjusted returns while still maintaining a diversified portfolio. Approaches that rigidly apply equal weights to portfolio risk exposures, as an example, ignore the fluidity of economic conditions and variability of risk-adjusted returns across assets over time.

In DC plans, offering a global tactical asset allocation strategy (GTAA) is a common alternative asset allocation approach and is the additional strategy most recommended by consultants as a stand-alone investment choice (as shown in Figure 9.3). While many plan fiduciaries that offer target-date strategies may believe there is no need to offer another balanced fund in the core, others see many benefits. Not all participants will participate in the target-date strategies, as they may prefer building their own allocations to meet personal risk preferences. Others may desire a manager to actively seek opportunities or manage risk over time based on the global market environment, rather than based on the participant’s presumed time horizon. Yet others may find value in a GTAA approach that differs in philosophy and construction from what is offered via the target-date strategies. Plan fiduciaries may thus view a GTAA strategy as appropriate for the “do-it-yourself” participants who desire the diversification relative to other core investment choices—and who may also like how the strategy is diversified to reduce aggregate risk while tapping into additional return drivers.

CONSULTANT SUPPORT FOR ADDITIONAL STRATEGIES AND ALTERNATIVES

In our 2016 DC Consulting Support and Trends Survey, nearly half of the respondents (44 percent) recommended that plans include, in their core lineup, a balanced option—and over a quarter (27 percent) suggested an alternatives fund. Notably, when asked what type of additional strategy or alternative they would suggest as a stand-alone core option, as mentioned above, global balanced (e.g., global tactical asset allocation strategies or GTAA) topped the list (39 percent), followed by a multistrategy liquid alternative (27 percent). Within a blended strategy, respondents showed greater support for these additional strategies, yet flipped the priority—ranking a multistrategy liquid alternative highest (at 61 percent) followed by a global balanced option (e.g., GTAA) (at 53 percent).

In practice, the Plan Sponsor Council of America (PSCA)’s 58th Annual Survey of Profit Sharing and 401(k) Plans reflecting 2014 plan experience shows that 56 percent of all plans offer a “balanced fund/asset allocation” choice, with 13 percent offering an “alternative asset class.” (Note: These investment choices are tallied separately from target retirement date/lifecycle fund, target risk/lifestyle funds, TIPS, real estate, and other sector funds.) Across all respondent plans’ total assets (reported at $785 billion), PSCA reports an allocation of 5.3 percent to the balanced fund/asset allocation category and rounding to zero in the alternative asset class.

BACK TO BASICS: WHY CONSIDER ALTERNATIVES?

The short answer is that broadening the opportunity set, or the set of all possible portfolios that one may construct from a given set of assets, can mean less risk and more performance. In PIMCO’s 2015 Defined Contribution Consulting Support and Trends Survey, respondents identified many potential benefits of adding alternative investment choices into a DC plan. Topping this list is “risk mitigation,” which was ranked first or second in importance by 69 percent of the consultants. Risk mitigation is followed by the benefits of equity beta diversification, inflation protection, return enhancement, and rising rate protection. As plan fiduciaries consider alternatives, consultants note as “very important to consider” characteristics such as daily valuation (72 percent) and daily liquidity (67 percent). They also underscore the importance of considering whether the alternatives provider is an established organization, has a strategy track record, offers participant communication, and has a reasonable fee level and structure.

While risk mitigation tops the list of benefits, return enhancement is also noted. Comparing defined benefit (DB) plans to DC plan asset allocations, “alternatives” often garner 10 percent or more of the DB allocation yet are largely absent from DC plan allocations. CEM Benchmarking, a global benchmarking company, also reports DB outperformance by more than 100 basis points over the 1997 to 2015 time frame. As shown in Figure 9.4, the asset allocation within DB plans as reported by CEM Benchmarking reflects an allocation to alternatives of 12 percent compared to the DC plan allocation reported by CEM Benchmarking. It is important to note, however, that alternative assets in DB plans are typically “locked up” in private funds— and DC plans, which generally require liquidity, may focus on liquid alternatives that may not present the same return potential.

In their 2013 paper (noted earlier in this chapter), the DCIIA outlines many of the reasons DC plan fiduciaries should consider alternative investments:

Alternative investments provide an important avenue for effectively diversifying the risk in DC plans. By complementing traditional DC offerings, an alternatives strategy can improve a portfolio’s efficiency and serve the interests of DC plan participants. The potential benefits of incorporating a well-executed alternatives strategy include:

• Potential for Improved Total-Return Performance: Including alternative investments within broad portfolios can contribute to improved plan performance for DC participants, similar to that experienced by institutional investors.
• Reduced Reliance on Traditional Equities and Bonds: Alternatives enable DC plans to complement the traditional asset classes to which DC participants have historically been exposed.
• Incremental Portfolio Diversification: Alternatives can diversify the risk within DC plans’ portfolios, allowing for blended investment portfolios with complementary characteristics.
• Lower Portfolio Volatility: Alternatives have the potential to lower the portfolio’s volatility, through the plan’s investment strategies and through lower correlation to traditional asset classes.
• Increased Consistency of Returns: The combination of portfolio diversification and lower volatility may allow DC plans to potentially achieve increased consistency of returns over time. These benefits are important considerations for any investor in today’s market. Just as institutional investors refine their approaches in order to diversify risk, DC plans can continue to selectively employ similar strategies to improve portfolio efficiency.

The DCIIA explains how alternatives may improve portfolio efficiency by sharing the Aon Hewitt Efficient Frontier analyses, shown here in Figure 9.5.

Thus the benefits of including alternatives in a portfolio can have material effects for plan participants over time.

* * *

In 2008, we spoke with Ross A. Breman, CFA and Partner, and Rob J. Fishman, CFA and Partner, at investment consulting firm NEPC, about the role of less-traditional, alternative investments within DC plans. We asked them about how plan sponsors are using these types of assets, and they told us:

First, let’s define the different product types, and then discuss when and how it’s appropriate to use them. We’ll also look at how these types fit within the framework as potential standalone options. If we consider alternatives in the non-DC sense—say, within a DB plan—we automatically think hedge funds and private equity. The marketplace tends to associate alternatives with high fees, low liquidity, and low transparency.

Today, in DC plans, alternatives refer to less-traditional core offerings. So we could be referring to emerging-market equity, emerging-market debt, commodities, TIPS, [Global Asset Allocation or] GAA, and real estate. These typically are products that are valued daily, offer daily liquidity, and diversify broadly across multiple strategies. In order to identify the roles different types of products play, when we consider alternatives in the DC sense, we often break the category down into two camps: equity alternatives and bond alternatives. Equity alternatives include GAA strategies and unconstrained equity strategies. Bond alternatives include real-return assets such as TIPS and real estate. We should note, however, that while products may fall generally into these broad categories, products can vary greatly and there are many exceptions to the general themes. While GAA typically might fit in the equity-alternative category, for example, a GAA strategy might look to outperform inflation or a cash benchmark rather than a global equity/fixed benchmark.

Alternative strategies can help improve the risk-versus-return profile. Equity alternatives include many strategies designed to provide equity-like returns with more bond-like risk levels, which is attractive for a DC plan. Investing in these alternatives gives us a tool to help reduce the traditional equity exposure and improve diversification for participants without sacrificing return potential. We can achieve this particularly well in target-date strategies. But we can’t simply instruct DC participants to do it themselves.

Today, the number of alternative products available in the DC world isn’t limitless and many DC alternative offerings are expensive. But we also see more competitively priced strategies. While we’re willing to pay for liquidity, there’s a limit to how high the fees can go before the cost outweighs the benefit.

NEPC returned to this theme with a 2014 paper entitled “The Alternative Route: A Smoother Ride for Defined Contribution Plans.” In that paper, the authors note that “now more than ever, alternative asset classes and strategies are deserving of a place in DC plans,” commenting:

If plan sponsors and participants are to move beyond traditional stocks and bonds, the question remains, why? In 2008 we said it was to improve return potential and smooth the ride for participants. That core belief hasn’t changed. Alternatives are essential to institutional portfolios, and within a participant’s portfolio they can improve expected outcomes to and through retirement.

. . . Take for instance the average target-date fund in Morningstar’s U.S. Open-Ended 2046–2050 universe, which according to NEPC’s 2014 assumptions has an expected return of 6.6 percent, expected risk of 15.5 percent, and a Sharpe ratio of 0.3. When you add an alternatives allocation to this portfolio, the overall expected portfolio rises to 6.8 percent and the risk actually drops to 14.9 percent, with an expected Sharpe ratio of 0.4, indicating more efficient returns.

While 20 basis points of added return may not seem like much, consider a 25-year-old employee with $10,000 in assets today. In 40 years, a 20 basis point different in return results in an 8 percent larger asset balance when they retire at age 65. This figure does not give consideration to the expected return in portfolio risk from adding the alternatives allocation, which has the potential to increase the ending wealth differential by even more.

LIQUID ALTERNATIVES: TYPES AND SELECTION CONSIDERATIONS

PIMCO Product Managers Justin Blesy and Ashish Tiwari address liquid alternatives in their 2015 paper “Liquid Alternatives: Considerations for Portfolio Implementation.” In the paper, they note that liquid alternatives is “one of the fastest-growing categories in the investment world.” Since 2008, the number of funds in the United States has tripled to more than 865, and as shown in Figure 9.6 assets under management have swollen to about $493 billion.

Blesy and Tiwari differentiate and provide the underlying rationale for liquid alternative assets and strategies as follows:

Alternative asset classes, such as commodities and emerging market currencies, provide exposure to alternative risk premia whose returns are driven by different economic drivers than traditional portfolios. Alternative investment strategies, on the other hand, are typically actively managed and not constrained by traditional benchmarks. These strategies may provide diversification through the manager’s individual security selection (or active management alpha), with much less reliance on broad stock and bond exposures to deliver returns. Examples of alternative strategies include absolute return fixed income, equity long/short and managed futures [see Figure 9.7].

Blesy and Tiwari go on to help readers understand the risk characteristics of liquid alternatives:

The varied risk characteristics of liquid alternatives—which reflect an array of asset classes, strategies and manager styles—can complicate the process of incorporating them into portfolios. Long/short equity managers, for instance, typically have a positive equity beta (they are normally net long equities [i.e., they will benefit when the price of equities increases]), whereas equity market-neutral strategies target zero equity beta [i.e., they are constructed to have zero systematic risk and thus the same expected return as the “risk-free” rate]. Other categories, such as managed futures, may have more dynamic equity beta; equity beta may be positive in strong bull markets and negative during sustained market sell-offs. Implementing liquid alternatives in portfolios, therefore, requires understanding not only the different categories of strategies but, perhaps more importantly, comprehending how their key risk characteristics vary across different market environments.

In many ways, it is easier to grasp the risk profile of alternative asset classes, such as real estate investment trusts (REITs), commodities and currencies, since investment products in these categories often share similar benchmarks. While the benchmarks themselves often represent nontraditional sources of risk, investors have a better understanding of the risks they are taking.

However, there is a much greater challenge across most alternative investment strategy categories, as risks can vary dramatically even within the same category. Many of these strategies are often benchmarked to cash or LIBOR [the London Interbank Offered Rate, which is a primary benchmark for short-term interest rates around the world], providing little anchor for the risks in the underlying strategies. For example, a review of the top 10 managers by Assets under Management in the nontraditional bond category reveals significant differences in total volatility and the risk contributions from credit and duration [see Figure 9.8]. Multiple factors can drive these discrepancies, including differences in investment processes, breadth of opportunity set, investment outlook and product structure.

As plan fiduciaries consider liquid alternatives, Blesy and Tiwari suggest they have a solid grasp of several important factors. These include:

• Total volatility and mix of risk, particularly correlations to traditional portfolio risks—equity risk and interest rate risk
• Historical drawdowns and drawdown potential and how they compare with expectations
• Level and use of leverage and options to identify potential hidden risks
• Performance across different market environments

They also underscore the importance of manager selection, noting that “many alternative strategies are more dependent on portfolio manager expertise—a larger component of returns may derive from active manager decisions, not market returns.” They note the return dispersion across alternatives managers may be many times that experienced among traditional fixed-income and large-cap blend managers. Figure 9.9 shows this dispersion. For example, over this time frame return dispersion between the 20th and 80th percentile long/short (hedge fund) equity managers has been more than double that of long/short managers in liquid alternatives and fourfold in large blend equity managers.

IMPORTANT CHARACTERISTICS IN SELECTING ALTERNATIVES: CONSULTANT VIEWS

In our 2015 PIMCO Defined Contribution Consulting Support and Trends Survey, in addition to the importance of daily valuation and liquidity, nearly all of the respondents (96 percent) ranked as “important” or “very important” when adding alternatives to a DC plan that fiduciaries hire a manager from an established organization; plus, the vast majority (85 percent) deemed it “important” or “very important” that the alternatives manager provide at least a three-year track record (Figure 9.10).

For their part, Blesy and Tiwari suggest looking for liquid managers with the following key attributes:

• Exceptional and proven manager experience (defined as returns generated in a consistent and diversified manner, and strong performance during periods of market shocks)
• A well-defined and repeatable investment process
• Depth of research and a demonstrated ability and process to convert research themes into profitable trades
• Understanding of the underlying risk factors and the ability to dynamically adjust such exposures within the portfolio as warranted
• Trading efficiency, often achievable through economies of scale
• A robust risk management framework
• Proper alignment with investor incentives
• Ability to clearly communicate strategies, objectives, and risks to investors
• Regulatory/compliance processes and experience in managing mutual funds and ETFs

You’ll note that among the important selection characteristics in Figure 9.10 is “participant communication support” which is also noted by Blesy and Tiwari suggesting plans consider the “ability to clearly communicate strategies.” While we expect that alternatives are most likely to be blended into custom strategies such as white-label core and target-date funds, it remains important to make available communication materials for participants who seek this information. In addition, consultants believe it is important or very important that alternatives offer a “fee level similar to other plan options” (72 percent), and they also believe that alternatives should have a “fixed fee structure” (74 percent).

Fee levels are a critical consideration for plan fiduciaries. As noted in earlier chapters, the fiduciaries should seek reasonable fees for the investment offerings and other plan services. It’s important to consider the fee relative to the expected value—both returns and risk management—that an investment may deliver. Blesy and Tiwari note the significant variance in fees across liquid alternatives. They note that “some managers aggregate third-party strategies, passing through underlying fees to end investors. In contrast, other structures that focus on individual securities may offer lower fees.” Figure 9.11 shows a fee comparison for liquid alternatives.

Plan fiduciaries may consider adding liquid alternatives to a DC plan either as a stand-alone investment option or to a blend such as white-label core or custom target-date strategies. As noted in Figure 9.3 at the outset of this chapter, for the stand-alone lineup, consultants recommend a global balanced (e.g., GTAA) strategy (39 percent) or a multistrategy liquid alternative (27 percent).

As mentioned, consultants are far more likely to recommend additional strategies as components of blended strategies. They place multistrategy liquid alternatives at the top of the list with support from nearly two thirds of consultants (61 percent) and this is followed by a global balanced (e.g., GTAA) strategy (53 percent).

ILLIQUID ALTERNATIVES: TYPES AND CONSIDERATIONS

Often referred to as illiquid investments, in our view these are best thought of as “less-liquid” alternatives as they typically have less liquidity than daily—ranging from as little as a week to 10-year waiting periods. This category is composed of private market investments such as hedge funds, private debt, private real estate, and private equity. These investments generally are not traded on public exchanges, nor are they valued daily or traded daily. Despite the lack of daily valuation and trading, DC plans can—yet rarely do—include less-liquid alternatives; DC plans that include less-liquid alternatives typically include them in blended strategies such as custom target- date and target-risk/balanced funds.

Reasons to include less-liquid alternatives mirror those discussed above, including added return opportunity, diversification improvement, and volatility reduction. For less-liquid investments, there’s another added benefit: an illiquidity premium, that is, higher returns in exchange for a longer commitment of capital. In Figure 9.12, in the DCIIA presentation “Capturing the Benefits of Illiquidity,” they provide the following overview of hedge funds, private real estate, and private equity along with the key merits of each. Although not included in the DCIIA presentation, private debt is another increasingly important segment of the alternatives opportunity set largely created by bank retrenchment (such as when banks exit certain markets or cease operations in a specific business sector). The key merits for investors include high income, illiquidity premia, and, for some types of debt, low correlations to equity and bonds.

DC plans present a challenge as nearly all are valued each day and also offer participants daily access to transfer out of the investment offered. Notably, while participants have the ability to trade daily, record keepers report that the vast majority do not trade even once a year. Given this reality, many have questioned whether daily valuation and trading are appropriate for DC plans; fiduciaries may ask, “Why are all participants paying for daily liquidity when few use or need it?” In the 1980s and early 1990s, DC plans were not valued daily. Instead, most were valued monthly or even quarterly. In PIMCO’s 2014 Defined Contribution Consulting Support and Trends Survey, over half of the consultants (53 percent) expected the ability to offer alternatives with greater ease may influence DC plans to move from daily valuation to “some extent” or “a significant extent.” Regardless of whether plans shift back to less-frequent valuation, consultants are unlikely to suggest that less-liquid alternatives be added to the stand-alone core lineup. Rather, they are more likely to combine them within the blended strategies.

DCIIA notes that the valuation and trading issues are manageable: There are “numerous precedents for nonmarket pricing methods” and “liquidity needs can be managed as part of a broader allocation.” Yet we also learn that the risks in offering less-liquid alternatives are “related primarily to inflexibility during a severe downturn” in the markets. Plan fiduciaries are told that participant-level liquidity is needed through all market cycles, and the importance of communicating and documenting decision-making to “minimize litigation risk” is also emphasized. With the added complexity of selecting and monitoring less-liquid alternatives, plus litigation that has focused largely on fees, in general we anticipate slow adoption of less-liquid alternatives within DC plans. Rather, plans may look to global balanced and liquid alternatives for the sought-after benefits.

CONTRASTING LIQUID ALTERNATIVE STRATEGIES WITH HEDGE FUND AND PRIVATE EQUITY INVESTMENTS

Finally, Blesy and Tiwari contrast liquid alternative strategies with less-liquid alternatives: hedge funds and private equity investments. They comment:

Initially, hedge funds and private equity funds were the primary way investors accessed alternative investments. Neither was widely available beyond institutional or accredited individual investors, in part because both typically required large minimum initial investments and lengthy lock-ups and offered little transparency. Relative to these semiliquid and illiquid alternatives, liquid alternatives may provide a number of benefits, including:

• Lower investment minimums
• Daily liquidity in most vehicles
• Improved transparency
• For U.S. investors, simplified tax reporting (typically a 1099, not a K-1)

However, there are trade-offs. Not all traditional hedge fund and private equity strategies can be responsibly offered in a liquid alternatives vehicle. Many require capital lock-ups to align the liquidity provided to clients with the horizon of the fund’s investments. Often, this embedded illiquidity premium can offer the potential for more attractive returns than can be achieved in liquid strategies, and in a world of lower-return prospects, this higher return potential may be an attractive benefit of hedge fund and private equity strategies.

It is important to note, though, that several strategy types, including managed futures and equity long/short strategies, increasingly can be implemented in liquid vehicles without a significant reduction in return potential, whereas private real estate, infrastructure and private equity strategies may necessitate reduced liquidity to achieve investment objectives (see Figure 9.13).

IN CLOSING

We started this chapter by asking, “Is that all there is?” But as we have seen, for plan sponsors, there is in fact a lot to consider when asking the question “What else?” Alternatives in their various forms have the potential to improve outcomes for participants—especially in a low-return environment for mainstream U.S. stocks and bonds. While we tend to call the various portfolio components examined in this chapter “alternatives” by convention, plan fiduciaries recognize that this is not a category of similar strategies—it is instead a very heterogeneous array of investments. What perhaps unifies them under a single moniker, aside from convenience, is generally what they don’t offer—dedicated exposures to traditional stock and bond asset classes—and not what they do.

In considering alternatives in DC plans, in our view it is key for plan sponsors to consider, relative to other DC investment offerings, the following attributes that alternatives may bring to a portfolio:

• Ability to add diversification and reduce volatility relative to other DC investment offerings.
• Opportunity to add return, especially through different market environments.
• Liquidity available relative to the plan or blended strategy liquidity needs.
• Valuation frequency and methodology.
• Merits and risks of each strategy type and stand-alone asset.
• Manager skill compared to traditional active strategies and certainly versus passive approaches. To warrant the higher fees associated with these strategies, plan sponsors must have (relatively) greater confidence in the underlying manager’s ability to achieve the strategy objectives.

In addition to evaluating the potential alternatives, a plan fiduciary should also consider the plan’s ability to stay the course. While diversifying into alternatives may add value across market cycles and, at times, deliver impressive results relative to mainstream stock and bonds, plan fiduciaries are likely to experience concern or even frustration when these strategies lag behind. Fiduciaries will need to manage behavioral tendencies to chase returns for the recent winners, and more importantly avoid “fleeing” from strategies when they lag behind. This chasing and fleeing behavior would assuredly hurt long-term returns as plans would buy high and sell low. You also may hear of adding diversification as a “regret maximization exercise,” in that you may regret having any diversification when you don’t need it . . . and then you regret not having more when you do. We hope plan sponsors will look beyond the stocks and bonds to reap the diversification and return opportunities within alternatives.

QUESTIONS FOR PLAN FIDUCIARIES

1. Are there additional investment strategies that may offer risk mitigation or return benefits to plan participants?
2. Should a global balanced (e.g., GTAA) strategy be added to the stand-alone lineup?
3. Should a multistrategy liquid alternatives fund be added to the stand-alone lineup?
4. Is the investment default asset allocation optimal? Would the addition of a global balanced strategy, multistrategy liquid alternatives, or individual liquid alternatives improve potential outcomes?
5. Should less-liquid alternatives such as hedge funds, private real estate, or private equity be considered as additions to blended strategies?