A First Look at Alternative Investments and Public Pensions

Since the financial crisis, public pension plans – like other large institutional investors – have moved a significant portion of their portfolios into investments outside of traditional equities, bonds, and cash. These alternative investments include a diverse assortment of assets – private equity, hedge funds, real estate, and commodities. This shift reflect s a search for greater yields than expected from traditional stocks and bonds, an effort to hedge other investment risks, and a desire to diversify the portfolio. The Public Plans Database (PPD), which covers nearly 95 percent of pension assets, shows the allocation to alternatives more than doubling (from 9 percent to 24 percent) between 2005 and 2015. This brief begins to explore the implications for state and local pension plans of moving away from traditional stocks and bonds to other types of assets. The scope of the inquiry is narrow; it does not address fees, disclosure, or administrative issues. Nor does it assess how these alternative assets are utilized within each plan’s overall investment strategy. Rather, the analysis investigates two basic questions: 1) which plans have made the largest shift to alternatives? and 2) how has the shift affe cted investment returns and volatility? The discussion proceeds as follows. The first section provides a quick overview of alternative investments. The second section documents the extent to which state and local pension plans engage in alternative investing. The third section attempts to find a link between plan characteristics and the proportion of the overall investment portfolio allocated to alternatives, and uncovers no systematic relationship. The fourth section looks at the relationship between alternatives and investment performanc e, finding lower after-fee returns – primarily due to poor hedge fund performance. Hedge funds do reduce volatility, but their effect is offset by the greater volatility associated with real estate and commodities. The final section concludes that, whil e the focus on returns and volatility may be too narrow and the time periods analyzed too short to draw any definitive conclusions, the relationship between alternatives and public plan performance merits further analysis.