Alternative Investments? State & Local Pension Portfolio Use and Performance

Abstract

Over the last decade, Defined Benefit (DB) public pension systems have come under greater stress. Pensions have experienced two recessions, demographic shifts and generally bad public budget circumstances. Pensions have modified their allocation strategies over this period, generally shifting away from equities and fixed income allocations in favor of alternatives. What’s more, the stated justification for alternatives has shifted as well, from an emphasis on relative performance (alpha) towards diversification away from systemic shocks (beta).

In this paper, we investigate motives for the employment of alternatives and the performance of these investments, considering both governance and financial performance motivations. We consider possible principal-agent and herding problems that may be unique to these portfolios, and find that the prudent person standard is of little protection against herding risks due to its relative benchmarking schema.

Controlling for changes in governance, we find that private equity and other less liquid alternatives can be of value because of their relatively consistent pricing, whereas more liquid assets are more susceptible to price volatility. In fact, improvements in diversification (beta) can arise as an artifact of illiquidity.

Keywords: public pension funds, defined benefit, asset allocaiton, alternatives, hedge funds, private equity, prudent person

JEL Classification: G23, K31