The increased market volatility over the past year has brought the benefits of diversification to the forefront again. Alternative assets can improve diversification. Historically, alternative product options for qualified defined contribution (DC) plans were limited because of the need for daily net asset value (NAV), high liquidity, and low fees. But in recent years, new solutions have been developed that allow investors in DC plans to access that universe more easily.
Aon sees alternative investments as best fitting into DC plans within multi-asset portfolios such as target date funds and objective-based funds, rather than as standalone menu options.
Products dubbed “alternative risk premia” (ARP) have been launched to provide exposure to key drivers of hedge fund returns in a format that is liquid and has lower fees. Multi-alternative risk premia fund assets totaled more than $73 billion as of September 2018 , an increase of approximately $18 billion year over year. The market for catastrophe bonds—liquid securities with performance linked to insured natural perils—is exhibiting similar growth, reaching record issuance in 2017 and 2018. On the private real estate side, daily-valued funds are also increasingly available.
The Role of Alternatives in a Portfolio
Investors have traditionally relied on their bond holdings to moderate drawdowns in their stock holdings. However, even after a strong run, bonds are not immune to volatility—and at times may provide limited protection during an equity sell-off. Investors can benefit from including other options in their portfolios that have low correlation to both stocks and bonds and a positive expected return, as seen in hypothetical Figure 1.
Figure 2 shows the expected return and risk for an illustrative 60/40 portfolio, as well as for hypothetical portfolios including alternatives. Adding alternatives to a traditional portfolio is expected to reduce risk while maintaining a similar return level, or to enhance return for the same risk level.
Investors have traditionally relied on their bond holdings to moderate drawdowns in their stock holdings.
The capital market assumptions (CMAs) utilized in Figure 2 were developed by Aon’s Global Asset Allocation Team and represent the long-term capital market outlook (i.e., 10 years) based on data at the end of the fourth quarter of 2018. The assumptions were developed using a building block approach, reflecting observable inflation and interest rate information available in the fixed income markets as well as Consensus Economics forecasts.
Our long-term assumptions for other asset classes are based on historical results, current market characteristics, and our professional judgment. Expected returns are using AHIC Q1 2019 10 Year Capital Market Assumptions as of 12/31/2018. CMAs contain projections about future returns on asset classes. These do not assume additional alpha for active management strategies within these asset classes, and are modeled to represent a low nominal fee passive index, with the exception of hedge funds and private equity, where traditional passive investments are not available.
Therefore, the model assumptions for hedge funds and private equity strategies include a higher model fee impact for these asset classes. You cannot invest in an asset class directly, or within the model asset classes assumed within the CMAs. CMAs do not include asset class fees or any underlying expense ratios. Expected returns are geometric (long-term compounded; rounded to the nearest decimal). Expected returns presented are models and do not represent the returns of an actual client account. Not a guarantee of future results.
Figure 2 uses AHIC’s 10-year capital market assumptions as of Q1 2019. The portfolios use the traditional asset classes of global equity and core fixed income and the alternative asset classes of core real estate, insurance-linked securities (ILS), and alternative risk premia. The allocation to each alternative asset class has been constrained to a maximum of 10% of the total portfolio. Ten percent is a sample constraint, and liquidity considerations must be taken into account when determining final weights.
The 60/40 portfolio consists of 60% global equity and 40% core fixed income. The portfolio with alternatives targets the same return level as the 60/40 portfolio, and is allocated as follows: 10% to core real estate, 10% to ILS, 10% to alternative risk premia, 41% to global equity, and 29% to core fixed income.
A Range of Alternatives
The range of alternative investments attractive to DC plans has grown in recent years; however, considerations specific to DC plans must be addressed before investing. In addition, manager selection and active oversight remain key when constructing alternative portfolios.
Alternative risk premia (ARP). Systematic strategies that take advantage of known anomalies in market pricing driven by human behavior or structural constraints. Such strategies provide exposure to some of the main return drivers for hedge funds, such as value, momentum carry and equity option risk premia, and have low correlation to broad markets. They are typically implemented through liquid instruments, and are available in relatively liquid fund structures at lower fees than traditional hedge funds.
Insurance-linked securities (ILS). Return comes from collecting insurance premia in exchange for bearing the risk of property losses due to natural disasters. The more liquid investment options are in the form of catastrophe bonds issued by insurance companies to transfer the risk to capital markets. Return streams are generally uncorrelated to financial markets.
Private real estate. This strategy generates the majority of return from investing directly in commercial real estate and provides diversification, relatively high income, and attractive risk-adjusted returns. It is available through funds that manage liquidity by using a small allocation to REITs and careful management of the cash flow from underlying properties.
Implementation Considerations for DC Plans
DC portfolios have special requirements when including alternatives, such as:
- Liquidity. Some investments, such as private real estate, are less liquid than traditional assets. This can be addressed by including these assets in either packaged or custom fund-of-fund or multi-asset solutions, sized appropriately and combined with other highly liquid investments.
- Fees. Some alternative funds have traditionally charged performance-based fees. Because of the need for daily NAV calculation in DC plans, performance fees can present challenges. This has been addressed by the launch of an increasing number of products with flat management fees. In addition, DC investors are sensitive to fee levels. This can be managed by investing a portion of the portfolio in systematic strategies, such as ARP, that can be managed at a lower cost.
- Governance. Alternatives require a higher level of oversight due to their relative complexity. Considerations such as higher required operational and investment due diligence, style monitoring and capacity constraints are important.
- Participant understanding. Some alternative strategies are new to defined contribution participants, and may require additional education with a focus on key return drivers, risk drivers and diversification benefits.