Alternative Assets Have Made Pension Funds Safer

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Pennsylvania teachers may have been distressed by a recent New York Times article saying that the state’s retirement fund run for their benefit “put more than half its assets into risky alternative investments” and that “the math didn’t work out, spurring an investigation.” But the news, for Pennsylvania teachers and public pension funds in general, is much better than the headlines suggest.

Let’s start with the idea of “risky alternative investments” that gets thrown around way too much when it’s used to describe pension fund assets. Traditional investments are publicly-traded stocks and bonds, which make up 57% of the Pennsylvania fund’s assets. Everything else, risky or not, is classified as “alternative.” Most institutional portfolios — pension funds, endowments, sovereign wealth funds and others — have increased their alternative investments from around 5% or less in 2000 to 30% or more. The result has been to lower risk dramatically and to increase returns. And the 2021 annual reports from pension funds should show a great benefit from alternatives.

The many studies on the performance of alternative assets generally fall into two broad camps. Some look at risk-adjusted total returns after fees over a decade or longer, and nearly all of those find that higher allocations to alternatives improve fund performance. Others look at periods of high equity returns and conclude that alternatives overall have had lower total returns than the S&P 500. One by EY published in November found that alternative investments outperformed during the early days of the pandemic, helping to mitigate the big crash in stocks and bonds that could have made pension fund results look devastating:

“Alternative managers outperformed their performance expectations during COVID-19, especially in private equity, where a ratio of 4:1 felt their managers outperformed expectations. Hedge fund performance varied by strategy, but on average almost all significantly exceeded major benchmarks. When major indices were down 15%–20% in early 2020, many hedge funds were only down low single digits. Funds demonstrated their value in preserving capital in the downturn while opportunistically stepping in to capitalize on market dislocations.”

Alternative investments fall into three main categories. The risky part is private equity and venture capital. These are similar to public equities, but are generally more volatile with higher long-term average returns. It’s fair to call these risky alternative investments, and they made up 16% of the Pennsylvania fund. They were down 4% in the latest annual report (as of June 30, 2020) and most pension funds had similar losses. But private equity results are reported at a one-quarter lag, so this represents the market at the bottom of the Covid-19 crash in March 2020. The next round of pension fund annual reports should show large gains from these risky alternatives.

A second alternative is real assets, such as real estate, infrastructure, commodities and other physical assets. These have some correlation with public equities, but generally have significantly less risk. They anchor portfolio value. One real asset — master limited partnerships representing ownership of energy infrastructure assets — was down 35%, along with real energy assets in all pension funds. But as anyone who’s bought gas for a car or oil for home heating recently knows, energy prices are back up and MLPs will be strong positives in 2021 fund reporting.

The third major type of alternative investment is hedge funds offering absolute return or risk parity portfolios. Not only are these lower risk than other types of investments, the absolute return funds have low or zero correlation with the rest of a pension fund’s portfolio, and thus they add little to total portfolio risk. While this is a broad category with many different types of funds, hedge fund performance in general has been strong since June 2020.

“Risky” alternative investments didn’t look great in 2020 pension fund reports, but they weren’t terrible. They should be highlights in the 2021 reports. More important, they have helped diversify what otherwise would be substantial pension fund risks, which will prove very helpful if sky-high public stock market valuations cool or if faster inflation savages bond returns. When stocks soar and interest rates fall, alternatives look dowdy. But at all other times, alternatives can be saviors.

So what was the math that didn’t work out in Pennsylvania? It has nothing to do with investments, alternative or traditional. In 2000, the Pennsylvania fund was adequately funded to pay all future benefits. In 2001, the legislature slashed contributions and raised benefits, so the fund paid out $1.5 billion more in benefits than it got from employee and government contributions. Every year since, $1 billion to $4 billion more goes out than comes in. Overall 20-year investment returns have been decent — if unspectacular — but no plausible returns could have made up that difference. There’s just too much money going out, not enough coming in. The problem was baked in 20 years ago, with tweaks every year or two either to cover up the problem or to make small stabs at reducing it.

So Pennsylvania teachers, and most public pension fund beneficiaries, can look forward to generally good news in 2021. The long-term problems -- overpromising and underfunding — haven’t changed but modern portfolio allocations navigated the Covid-19 crisis well and are positioned to take advantage of whatever market storms are on the horizon.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.

©2021 Bloomberg L.P.

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