Over the period 2001 through 2021, the allocation by public pension plans to alternative assets like private equity, real estate, and hedge funds increased from 14% of risky investments to 39%. However, the overall trend masks a high degree of variability across plans as the alternative-to-risky share for pensions in states like Maine, New Mexico, Indiana, Wyoming and Texas increased by an average of 58 percentage points while it hardly changed for pensions in South Dakota, Nevada, Georgia, Iowa and Colorado.
Juliane Begenau, Pauline Liang and Emil Siriwardane, authors of the January 2024 study “The Rise of Alternatives,” investigated the key factors driving the increased adoption of alternatives, focusing on two explanations that are implied by modern portfolio theory:
Pensions have updated their beliefs about the risk/return properties of alternatives–they have become more optimistic about the so-called alpha of alternatives relative to public equities, some more so than others; and
Pensions want to take more risk but are constrained from increasing their overall risky share, forcing them to contort the composition of their risky investments towards alternatives.
Their data comes primarily from the Public Plans Data (PPD) that is maintained by the Center for Retirement Research (CRR) at Boston College. Alternatives included private equity and credit, real assets, hedge funds, and other alternatives. They consolidated private credit and private equity into a single asset class and considered natural resources and infrastructure as investments in commodities. Real estate included core real estate and private equity real estate, but did not include REITs as they are included in public equities. Real estate and commodities were aggregated into an asset class labeled as real assets. Risky investments were defined as everything outside of cash and fixed income.
The authors began by analyzing the role of investment consultants, who provide advice on portfolio construction for most U.S. public pensions. The beliefs of investment consultants were extracted from capital market assumption (CMAs) reports published by many of the major investment consultants. The data confirmed that consultant-reported beliefs about the alpha of alternatives relative to public equities had risen steadily through time, increasing by about 68 basis points since 2001—large enough to generate the observed increase in the aggregate alternative-to-risky share. There was also a strong, positive relationship between a consultant’s reported alpha and the alternative-to-risky share of its U.S. public pension clients. In addition, consultant identity was far more correlated with alternative use compared to a wide range of attributes like pension funding and size. “These ‘consultant effects’ are economically meaningful: clients of the 5th percentile consultant have an average alternative-to-risky share of 8%, whereas clients of the 95th percentile consultant have an average share of 51%.”
Following is a summary of their other key findings:
The risky share has risen steadily, increasing 35 percentage points between 1970 and 2000, and then increasing from 68% to 76% after the turn of the century.
Since 2001, for every dollar that flowed out of fixed income, $2.60 moved into alternatives, and $1.60 flowed out of public equities.
From 2001 to 2021, the alternative-to-risky share rose from 14% to 39%—U.S. public pensions are increasingly using alternatives over public equities to take investment risk.
The risk share of all alternatives has risen. In 2001, the respective shares of real assets, private equity and credit, and hedge funds were 4%, 4%, and 0%, respectively. In 2021, their respective shares were 12%, 10%, and 6%.
Two beliefs explain the increased share. The perceived alpha for the median consultant rose steadily, going from 158 basis points in 2001 to 226 bps in 2021. In addition, the perceived diversification benefits of alternatives rose as measured by a decline in their perceived beta with respect to public equities.
Pensions, which experienced relatively poor performance during the 1990s, were more inclined to move towards alternatives—experience in the 1990s accounts for one-fifth of the cross-pension variation in changes in the alternative-to-risky share from 2002 to 2021.
Pensions allocate similarly to their peers when choosing between alternatives and public equities, and the strength of this effect is large compared to the impact of funding, size, and other pension attributes.
Considering proxies for pension risk-seeking motives, including those related to underfunding, there was a weak and inconsistent link between these proxies and the alternative-to-risky share in the cross-section of pensions—the cross-pension variation in the adoption of alternatives cannot be explained by deterioration in funding.
Binding portfolio constraints could not generate the observed shift in the composition of risky investments without a simultaneous shift in beliefs.
Supply-side factors may have contributed to the rise of alternatives as investor access to privately held firms via private equity limited partnerships has improved over time—the supply of alternatives expanded from 2% of all global risky assets in 2000 to 8% in 2020. However, the change in supply cannot explain the large cross-sectional variation in alternative adoption.
Consultants whose clients invest heavily in one type of alternative may not necessarily invest heavily in others—consultants disagree on the alpha of different alternatives and advise their clients accordingly.
Their findings led Begenau, Liang, and Siriwardane to conclude: “Our empirical findings collectively suggest that the rise of alternatives has been fueled by a shift in beliefs about their alpha relative to public equities. In contrast, there is weak and inconsistent support for explanations based on risk-seeking motives that the evidence presented is more consistent with updated beliefs explaining the shift.”
Pensions Overweighting Alternatives
Begenau, Liang, and Siriwardane found that pension plans now allocate almost 40% to alternatives. That’s almost five times their global market cap weighting. Is that an overweighting based on the beliefs that they generate significant alphas? That certainly seems to be the case given the evidence presented in “The Incredible Shrinking Alpha” which showed that alpha was getting harder and harder to generate because the markets were becoming more efficient over time as: academics converted what was once alpha into beta (systematic sources of risk); the competition was getting more skilled; the supply of dollars chasing the shrinking sources of alpha had dramatically increased; and the supply of victims that could be exploited was shrinking due to the dramatic increase in the market share of indexing strategies (and other systematic, transparent, and replicable factor-based strategies) and retail investors shifting from buying individual stocks to funds. In other words, while the investors were becoming more and more skeptical about active management in public markets, they were raising expectations for active management in private markets. That seems illogical.
With that said, there are good arguments to consider high allocations to alternatives (personally, over half of my own portfolio is now in alternatives).
Particularly with the introduction of interval funds, expense ratios in alternatives have fallen dramatically. Investors no longer have to pay fees of 2% (expense ratio)/20% (incentive fees). For example, Cliffwater, a leading provider of alternatives, doesn’t charge any incentive fees on their private credit and private equity interval funds, and their management fees are well below 2%.
The long investment horizons of pension plans allow them to take on significant amounts of liquidity risk that are implicit in many alternatives, allowing them to earn the illiquidity premium. (Note most high net worth individual investors can also accept significant illiquidity risk).
The passage in 2002 of the Sarbanes-Oxley Act greatly increased the cost of being a public company, today companies are waiting to become much larger before going public. The result is that by 2020 the number of U.S. publicly listed stocks had fallen 50% over the prior 20 years, to about 3,500.
Another outcome from the passage of Sarbanes-Oxley has been that the smallest quintile has much larger stocks today than has been the case historically. For example, Vanguard’s Small-Cap ETF (VB), with $58.8 billion in assets under management, had an average market cap of $6.5 billion (not so small cap) at the end of July 2024. The takeaway is that to capture the takeover premium in small companies, private markets (in the form of private equity) provide a greater opportunity than in public markets. A related takeaway is that because the factor premiums in current asset pricing models have been larger in small caps than in large caps, the opportunity to capture them should also be greater now in private equity than in public markets, while also earning the illiquidity premium.