A First Look at Alternative Investments and Public Pensions

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The changing asset allocations of state and local pension plans, with increases in nontraditional investments, has been well documented. However, there has been a lack of clarity about the specific makeup of these alternative investments and whether there should be some standardization.

Using data from the Public Plans Database, this brief examines state and local pension funds’ investments in private equity, hedge funds, real estate, and commodities, to explore which plans have the largest allocations in investments other than traditional equities, bonds, and cash. The brief also examines the broader impact of aggregate allocation shifts on returns and volatility. Key findings include:

  • Public pension plans have boosted their holdings in alternative assets, a shift that reflects a search for higher returns, a hedge for other investment risks, and diversification;
  • Smaller funds held relatively more in hedge funds and commodities, while larger plans held relatively more in private equity;
  • A negative relationship surfaced between the portion of alternatives in a plan’s portfolio and returns — linked primarily to low hedge fund returns.
  • In terms of returns, a 10-percent increase in the average allocation to alternatives was associated with a reduction of 30-45 basis points, primarily due to hedge funds;
  • In terms of volatility, alternatives did not have a statistically significant effect: hedge funds reduced volatility, but real estate and commodities increased it; and
  • This analysis is only a first look at this area; further research is clearly warranted.
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