Public pension funds are upping their allocations to alternative investments such as hedge funds, private equity and real estate in order to generate alpha. This presents a cornucopia of operational and governance issues.

“From the starting point, there are some pretty fundamental areas that need to be assessed,” said Ryan Bisch, who heads up the Canadian alternative asset program for consultancy Mercer. “Many of these investments are illiquid. A conversation must be had around whether or not a pension plan or other pool of capital can invest into illiquid assets.”

“Does the plan have the ability to take a long-term approach and potentially lock up capital for ten plus years? “That’s pretty fundamental to investing in certain real estate strategies, most of infrastructure and most of private equity. Without that ability, your path can change significantly,” said Bisch.

The Metropolitan Government of Nashville’s alternative fixed income program started with a $25 million investment in non-agency mortgages in December 2008. That investment has tripled in value.

“I am proud of our alternative fixed-income allocation that has a 25% annualized five year track record that is the result of the organizational structure and decisions we have been able to make,” said Fadi BouSamra, chief investment officer of the $2.7 billion Nashville Metro plan.

BouSamra stayed away from complex derivatives which imploded following the crash. “We have not fallen prey to investments that we could not understand,” he said.

A spectrum of implementation considerations need to be dealt with in building an alternative investment program. “There are methods of investing in alternatives that can work for every different type of plan sponsor or a trustee or investment committee, regardless of the degree of sophistication or experience with these alternative asset classes,” said Bisch. “That’s an important consideration when you’re thinking about investing.”

For example, there’s a substantial difference between building a portfolio of direct fund manager investments and using an intermediary.

“Investing directly in hedge funds or private equity is quite a bit different than selecting a fund-of-fund provider or an advisor to help you build that portfolio,” Bisch said. “However, the implementation challenges have been reduced as the types of products that have come to market have been a little bit easier to digest and deal with at all levels of sophistication when it comes to plan sponsors.”

Metro Nashville’s assets are managed internally “simply due to the fact that we pick all our beta exposures and find managers to execute them,” BouSamra said. “In some cases, we are looking for additional alpha from the managers, but that does not mean we are acquiescing to other people to decide how to run our pension. In the long run the asset allocation decisions the Investment Committee makes will drive returns not whether we owned stock A or stock B. “

This is not to say that external managers aren’t important. “Managing internally is a big benefit simply because of the large cost advantage,” BouSamra said. “However, in order to execute that properly you need to be able to hire and maintain a certain level of talent. So far we have found it difficult to build staff, and even if we found the resources, I see better ways to get a high IRR than to pick stocks. On the stock side, we know we can replicate what most people falsely call alpha relatively cheaply.”

Building a direct hedge fund program or a direct private equity program requires a different skill set and governance than selecting a fund-of-fund provider or an advisor.

Bisch advises clients to first “get comfortable with the asset class” before taking a deep dive.

“In that initial conversation, implementation options and the path that you’re going to take needs to be discussed,” he said. “It should really fit the level of resources, the level of experience of the asset class.”

BouSamra attributes much of the plan’s success to “our ability to create a cohesive team made up of the consultant, CIO and the Investment Committee as we moved this plan from a plain vanilla portfolio that simply rides the equity market up and down. While the Committee does not micro manage, they are completely in charge. They have set up a framework for the risk and the asset classes we will traverse in and our job is to make the investments.”