Key Takeaways

  • Pension funds have significantly increased their allocations to alternative assets, with U.S. public pension funds nearly tripling their exposure over the past two decades. However, this shift has been highly uneven across funds and geographies.
  • Shifts in beliefs about the risk-adjusted performance of alternatives appear to be the central driver of this trend, transmitted through three channels: investment consultants, past market experience from the 1990s boom-bust cycle, and peer effects.
  • Other explanations, including reach for yield, volatility smoothing incentives arising from agency problems, and supply-side growth of private capital markets, consistently fall short in explaining the wide cross-sectional variation in alternatives adoption across funds.

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Summary

Motivation: Since the early 2000s, pension funds around the world have significantly rotated out of public equities and into alternative assets, with U.S. public pensions holding ~40% of risky assets in alternatives compared to just 14% in 2001. However, adoption has varied widely across funds and geographies, with the 10th-to-90th percentile spread in the U.S. widening from 26 to 40 percentage points. This paper examines four possible explanations to understand what is driving both the aggregate trend and wide variation in the adoption of alternative assets across pension funds.

Methodology: The authors study a comprehensive panel of U.S. public defined benefit pension funds from the early 2000s through 2021, tracking each fund’s ‘alternative-to-risky share’, defined as alternative investments as a share of total risky assets (excluding fixed income and cash). They test four hypotheses for the rise of alternatives: 1) belief shifts about the risk-adjusted returns of alternatives relative to public equities; 2) reach for yield, using funding ratios and return targets as proxies; 3) agency problems and return-smoothing incentives; and 4) supply-side growth of capital markets. The analysis employs panel regressions, variance decompositions, cross-sectional regressions, and instrumental variable methods to identify key drivers and assess causal effects.

Findings:

  • Belief shifts are the main driver of the observed rise in alternatives, supported by three independent channels. Investment consultant identity alone explains ~20% of the cross-sectional variation in pension alternatives allocation, and moving from the 5th to the 95th percentile consultant is associated with pensions shifting from 8% to 51% alternatives-to-risky share.
  • Consultant capital market assumptions for alternatives became increasingly optimistic over the sample period, with the median perceived alpha relative to public equities rising ~70 bps; funds advised by more optimistic consultants also tended to allocate more to alternatives.
  • Past market experience provides a second, independent belief channel: pensions that moved into public equities later during the 1990s boom-bust cycle (and thus more exposed to the bust) subsequently allocated more to alternatives in the 2000s and 2010s.
  • Peer networks also helped propagate the shift towards alternatives: pensions allocate more to alternatives when nearby peers do, consistent with learning and belief transmission. Across institutions, alternative-to-risky shares rose even as overall risky shares diverged, suggesting beliefs shape portfolio composition more than aggregate risk appetite.
  • The reach-for-yield explanation has weak empirical support, as there is virtually no cross-sectional relationship between a pension’s funding ratio, spending needs, or return targets and its alternatives allocation.
  • While agency problems and return-smoothing incentives may contribute to the aggregate trend, they cannot explain the wide variation across funds. Supply-side private capital growth faces the same limitation, failing to explain why pensions continued to increase allocations to alternatives even as their weight in global investable markets plateaued following the GFC.

Q&A Highlights:

  • Reverse causality: A natural concern is that pension funds inclined toward alternatives may select more bullish consultants; however, the instrumental variable results suggest the relationship is mostly causal, not simply driven by matching.
  • Alternatives are not one homogeneous bucket: Similar patterns appear across sub-asset classes, but fees, access, and implementation can differ sharply within categories like private equity and infrastructure.
  • Agency frictions: incentive misalignment cannot be ruled out at the consultant level, where OCIO-style firms that both advise and manage assets may have an interest in steering clients towards alternatives.
  • Fee transparency: while consultant return assumptions are generally intended to be net of typical manager fees, conventions are not standardized across firms and lack transparency.