In a low-return environment, the appetite for pension plan sponsors to increase allocations to a wide range of investment alternatives is rising.

True diversification across multiple asset classes with differing objectives and return patterns is essential for all long-term portfolios, regardless of their type or industry, Ashlee Moehring, director at Sellwood Consulting, told Markets Media.

“Alternative investments can be a powerful diversifier for pension portfolios; however we believe it is critical that alternatives selected provide unique exposures, not just replications of traditional stock and bond exposures in an illiquid vehicle,” she said.

Pension plan sponsors must also recognize that alternative investments in many ways demand greater research attention than traditional investments. Sellwood has organized its research efforts to address these special challenges: fees, liquidity, special risks, and blowup risks.

Fees for alternative investments are not only substantially higher, but also less transparent than for traditional investments, Moehring said. “We seek to understand and explain an investment’s total fees, not just those that are most apparent.”

As for liquidity, “we seek to understand expectations for liquidity with any alternative investment, both in “normal” as well as stressed scenarios,” Moehring said. “A complete understanding of liquidity of the individual investments as well as the portfolio as a whole informs the structure of the alternative investment portfolio we would recommend.”

Certain alternative investments carry risks that are not captured in the optimization modeling that characterizes most consultants’ analysis. “Risk is more than simply volatility of reported returns, and for alternative investments especially, an inspection of historical returns does not identify the most meaningful risks inherent in an investment,” Moehring said.

Fraud and blowup risk are prevalent in hedge funds. “We believe that the best way to mitigate these risks is to invest through highly skilled alternatives advisors (typically, funds of funds),” said Moehring. “When evaluating these types of advisors, we place a premium on the advisor’s ability to monitor the operational risks of underlying investment managers.”

Smaller pension plans sponsors can be challenged in that they are not able to enjoy the efficiencies of internal staff and money management, lack fee negotiation leverage with external investment managers, have limited access to some alternative investments, and may not have sufficient assets to engage customized strategies or advisors.

However, small size needn’t be a deterrent from taking on alternative investments. “Overall asset allocation remains the primary driver of long-term success, and the same modeling tools are available to pension plans large and small,” Moehring said. “The key is ensuring the asset allocation strategy is customized to your plans’ unique liability profile, risk tolerance, and liquidity needs.”

The prevalence of index options provides opportunity for fine-tuning the exact exposures sought at a very low cost even without burdensome investment minimums. Smaller plans are able to selectively pursue active management without concerns of overwhelming active manager capacity or needing to adopt portfolios with a large number of securities holdings in order to get the sheer volume of assets invested.

“Smaller mandates often have greater flexibility in seeking higher active share managers,” Moehring said, “ensuring that the active-management fees the plan is paying are for truly active management.”