Understanding Alternative Investments.

Author:Fu, Elizabeth
Position:Best Practices
 
FREE EXCERPT

Public and private pension funds are increasing their use of private market investments, otherwise known as alternative investments, (1) and for public pensions, in particular, the practice has resulted in heated debate. On one side, advocates argue that pension plans can reap great rewards from investing in alternatives, so long as appropriate considerations are made. On the other side, opponents see great risks that might not result in enhanced performance. Because of this debate and the growing number of alternative investments in public pension plan portfolios, (2) GFOAs Committee on Retirement and Benefits Administration sought to shed light on the topic. This article summarizes the committee's alternative investments checklist, which is available on GFOAs website (gfoa.org).

DEFINING ALTERNATIVE INVESTMENTS

"Alternative investment" is a broad term that encompasses a wide array of assets and investment strategies that are not considered "traditional." Traditional investment strategies involve taking long-only positions (assets that are purchased with the expectation that they will increase in value) like stocks, bonds, and cash. Alternative investment strategies can involve use of short positions (assets that are purchased with the expectation that the value of a stock will decrease in the short term), leverage (making an investment using borrowed capital), and/or derivatives (financial securities that are valued based on underlying assets), and they generally include all other non-traditional assets that offer less liquidity. Common alternative investments include private equity, hedge funds, real estate, and real assets/commodities. (See Exhibit 1 for the common types of alternative investments and their characteristics). These strategies can result in performance returns that outperform traditional investments.

DEFINING AN INVESTMENT STRATEGY

Before making investment decisions, public pension plans should evaluate factors such as need for income, need for liquidity (the ability to convert an asset to cash quickly), tolerance for risk, tolerance for volatility (the amount of uncertainty or risk about changes in the value of a security), and investment time horizon (the length of time over which an investment is held before it is sold). After evaluation and consulting with investment professionals, actuaries, and other advisors, the plan should develop a long-term asset allocation policy, which defines the assets necessary to achieve the plan's investment return and risk objectives. (3) The asset allocation policy guides a public pension plan's investment decisions, including whether to invest in alternative assets.

UNDERSTANDING THE RISKS AND BENEFITS

If a public pension plan determines that alternatives align with its asset allocation strategy, the plan should also consider the inherent...

To continue reading

FREE SIGN UP