Asset allocation is widely considered to be the most critical aspect of investment management. That’s why alternative investments are an important — if not essential — option for pension funds.

Alternative investments, such as infrastructure and direct investment into real estate, can improve returns and reduce risk on a portfolio that has a traditional mix of equities and fixed-income instruments. This is particularly true for portfolios whose primary focus is on long-term results, particularly pension plans, which usually are designed to last many decades or even forever.

And effective risk management, which largely entails reducing portfolio volatility, is a baseline requirement to ensure pension plan success.

Hindsight is 2022 for investment diversification

To see the benefits of diversification into alternative assets such as these, look back no further than 2022.

Although historically there’s been a negative correlation between bond and stock returns, occurred in 2022, when equity indices and bond benchmarks both showed losses.1 In comparison, we saw gains in infrastructure and direct real estate investments.

Why infrastructure?

Just as pension plans are focused on the long term, core infrastructure assets like airports, power plants, utilities, hospitals and telecommunication towers are built to last.

These are considered blue chip assets, with a steady cash flow over long horizons that result in stable long-term returns.

In addition, infrastructure investments benefit from a dominant market position, high barriers to entry, favorable regulatory treatment and low risk of losses. For example, consider the competitive positions of Toronto Pearson Airport, Rogers Wireless, or Hydro-Quebec. They have high positive cash flow from core infrastructure that provides a buffer against economic slowdowns or recessions.

Why direct real estate?

The overall benefits of direct investment in real estate are many: investment diversification, an excellent balance of risk and reward, a predictable income stream and protection against inflation.

Because sectors of the real estate market behave distinctly, investing in an array of real estate assets encompassing residential, commercial and retail provides further diversification and reduced risk.

Direct real estate provides greater diversification and greater control over management than indirect investments in real estate, such real estate investment trusts (REITs).

Not for all pension plans

Fully funded pension plans usually do not need to consider alternative investments, choosing instead to purchase long-duration, low-volatility fixed income assets to lock in the plan’s asset-liability match.

In addition, pensions should consider that alternative investments offer almost no short-term liquidity. However, most pension plans don’t have that need, freeing up money to invest in assets that are designed for long-term return.

Another key consideration is portfolio size: Portfolio managers need a large pot of money to invest because alterative assets often come with a high price tag, and for a smaller portfolio, allocating a high percentage of their money in alternative assets can result in a highly concentrated portfolio that only adds risk.

HUB Investment Consulting offers client specific services which include everything from investment consulting and governance to service provider searches and manager research. Our clients include corporate plan sponsors, foundations and endowments, not-for-profit organizations, trusteed plans, public plans, corporate pools of capital and high net worth individuals.

1 Top 1000 Funds, “Positive stock and bond correlation will make portfolios more volatile,” December 20, 2022.