Allocating to alternatives: A role-based guide for corporate DB plans

Amid the economic and market volatility of recent months, we’ve seen a growing number of defined benefit (DB) corporate plan sponsors and consultants exploring the potential benefits of adding alternative investments to their portfolios. Over the past 20 years, allocations to alternatives have steadily grown and today represent roughly a quarter of the average plan portfolio. For some plans, however, this remains largely uncharted territory.

To help them map a path forward, this paper offers a role-based framework for aligning different types of alternatives with a plan’s return-seeking and liability-hedging objectives. It also takes a deeper dive on hedge funds and private equity, including their potential benefits in the current investment environment and key considerations for plans establishing an allocation. (We’ve written separately about the role of private investment-grade credit here.)

Lastly, we look at the decision to allocate to alternatives through a liquidity lens, offering a case study to help plans think about stress testing and levers for managing liquidity.

Defining alternatives: A role model

Alternatives are often defined by what they’re not — that is, they are not long-only investments in publicly traded stocks and bonds. But that isn’t especially helpful, as it leaves plans to consider a wide range of strategies that invest across many asset classes and can pursue returns in very different ways. Instead, our framework focuses on the role that different alternative investments can play in a plan’s return-seeking and liability-hedging allocations.

Return-seeking allocations

We generally think about three “building blocks” for return-seeking portfolios, and alternatives may play a role in each (left side of Figure 1):

• Core equities — As plans derisk over time and reduce the size of their return-seeking allocation, they may need that smaller allocation to work harder and help enhance returns relative to traditional equities. Plans might consider private equity and extension (140/40 or 130/30) strategies, for example.
• Defensive equities — Here, the focus is on pursuing some downside mitigation without giving up too much upside. Net-long equity hedge funds may fit the bill.
• Diversifiers — Meant to pursue meaningful downside mitigation versus equities and to exhibit some liability-like characteristics (e.g., low correlation to equities), diversifiers might include market-neutral hedge funds, infrastructure, real estate, and sub-investment-grade private credit.

Liability-hedging allocations

Within the liability-hedging allocation (right side of Figure 1), we think credit diversifiers, such as private investment-grade credit, can play a liability-matching role while also expanding the opportunity set beyond traditional public investment-grade credit and potentially enhancing returns. Plans might also consider a portable alpha approach that combines liability-matching beta with independent sources of active risk. This could be implemented, for example, by pairing a market neutral hedge fund with Treasury futures — the aim being to replicate the liability-matching profile of Treasuries while pursuing active return in other markets. (Some plans accomplish this less directly by investing in a market neutral hedge fund on the return-seeking side and using a completion manager on the liability-hedging side to hit a hedge-ratio target.)

Next, we share our perspectives on the current case for hedge funds and private equity, as well as some of the key considerations for plans contemplating allocations to each.