Alternate Routes

Measuring Risk

But the very definition of “alternative investment” continues to be a source of confusion. Pension funds define such investments differently.

For example, many pension funds include hedge funds in the alternative category—but not Minnesota’s, which avoids hedge funds. Bicker says many hedge funds provide little transparency into their investment process.

The Minnesota board defines four categories of alternative investing: private equity funds, including both leveraged buyout and venture capital funds; investments in oil and gas, energy services, and other resource-related fields; real estate investments; and yield-oriented instruments, such as subordinated debt.

The board of investment oversees two principal pension funds: its Basic Fund, which held $22.5 billion in retirement assets of active public employees as of September 30; and its Post Fund, which had $22.7 billion to tap for paying monthly pension benefits to retirees.

Alternative investing at pension funds got a big push in the late 1970s, after years of bearish stock markets. The Minnesota State Board of Investment began putting money into the private equity, real estate, and resources sectors in the mid-1980s. It got into yield-oriented instruments in 1994.

Generally, the board has tiptoed into these fields. Such investing promises higher returns than traditional investments in stocks or bonds, but the risks are higher, too.

As the fall of 2006 began, the board still had far more money in each of three more traditional categories—domestic common stocks ($22.2 billion), international stocks ($7.1 billion), and bonds ($10.7 billion)—than in alternatives ($4.4 billion).

But the board wants to close the gap somewhat by boosting the share of alternatives to 15 percent of the Basic Fund’s assets and to 12 percent of the Post Fund’s assets. Three years ago, it moved the Post’s target up to 12 percent from 5 percent. Yet currently, only 10.7 percent of the Basic and 8.7 percent of the Post are in alternatives. One restraining factor is that it can be hard to find good deals, particularly with so many institutional investors chasing them.

Alternative investing is complicated. In mid-2005, the Minnesota State Board of Investment had 32 investment firms managing $20.1 billion of domestic common stocks. At the same time, almost as many firms (31) managed just $3.5 billion in alternative investments.

Statutory law limits the board’s flexibility; it requires that there be four other investors besides the board in any single fund. The board can’t take more than a 20 percent stake in any one fund. The four different categories of alternative investments do give the board the opportunity to diversify significantly within its alternatives portfolio, but Bicker notes that “there is, indeed, less historical data than for stocks or bonds.”

Because of that, “risk is very hard to measure in these [alternative] asset classes,” Richard Mich-aud, president and chief investment officer at New Frontier Advisors, LLC, recently told Pensions & Investments. “It’s really just a true bear of a problem,” added Mich-aud, whose Boston-based research and advisory firm specializes in asset allocation issues.

Perhaps Michael Troutman, who chairs the Minnesota board’s Investment Advisory Council, put it best when he commented on alternative investments at the board’s December meeting. “These returns have been great,” he said, quickly adding this warning: They aren’t likely to remain that great.

Troutman says a reasonable expectation would be that over a decade, the returns from alternative investments would top those of public equities by 300 basis points, or three percentage points. That’s pretty good, but far below the spectacular performance of alternatives in recent years.