Are Alternative Investments Prudent? Public Sector Use and Fiduciary Duty

Abstract

Over the last decade, public pension systems have shifted away from equities and fixed income in favor of alternative investments. We construct panel data of legislative changes affecting pensions, merging these with fund level data from the Public Plans Database. Using these in tandem with data from Preqin we consider governance and financial performance motivations, as well as principal-agent and herding problems that may be unique to alternative investments. We find less liquid alternatives can be of value as a result of (1) better performance and (2) relatively consistent observed pricing. However we also find evidence that Alternatives’ relative performance has waned since 2007 while allocations have continued to grow. Further while some use is justified the prudent person standard is of little protection against herding risks due to its relative benchmarking schema. Given evidence that legislatures are relatively reactionary monitors we conclude that hybrid allocation rules merit consideration.

Note: The views in this piece are the authors’ and do not necessarily represent official views of the United States Department of Treasury.

Keywords: Pension Funds, Fiduciary Duty, Alternative Investments, Hedge Funds, Private Equity, Investment, Political Economy, Governance

JEL Classification: K2, K22, K23, K29, K31