DC Plans Need Private Investments, Neuberger Berman Says

As defined contribution plans “look to provide more of a ‘DB experience’ to their participants, we believe including alternative exposure within their asset allocation offerings is a natural progression,” according to Michelle Rappa, managing director at Neuberger Berman and a DCALTA board member who contributed to the paper.

Although the study’s findings favor the advantages of including private investments in diversified and time-varying portfolios, they also suggested that the “extent of the benefit depends on the type of private investment,” Neuberger Berman said. Therefore, the research paper was designed “not only to illustrate potential return characteristics and diversification benefits, but also to offer allocation strategies to guide investment decision making,” the firm said.

For the study, DCALTA and IPC used a sample of more than 2,500 U.S. private equity funds to create a hypothetical simulation of historical performance for diversified portfolios that include allocations to private fund assets.

DCALTA and IPC conducted historical simulations where part of the public equity portfolio was replaced with allocations to private equity funds, according to the paper. They used actual private fund cash flows and rebalanced public assets on a quarterly basis back to target allocations for equity and fixed income, the paper pointed out, adding: “All aspects of our simulations are feasible and do not rely on making secondary market transactions in private funds.”

DCALTA and IPC then examined the risk and return characteristics of the portfolios that included private fund allocations, “paying careful attention to the fact that returns of the portfolio are artificially smoothed by the lack of observed price data,” the paper said.

There were three main results of their actions, according to the paper: (1) “Returns are consistently higher for portfolios that incorporate private equity funds.” (2) “Risk is consistently lower for portfolios that include buyout funds. In contrast, [venture capital] funds tend to increase portfolio risk but much of this risk is related to positive skewness in returns and thus represents “upside” risk. In addition, Sharpe ratios are consistently higher for portfolios with buyout funds and with a combination of buyout and VC funds.” (3) “It is challenging to hit specific allocation targets in all years with only primary commitments to private equity funds. We estimate a simple parametric model that improves asset allocation for dynamic strategies such as target date funds.”