Amid the growing popularity of the defined contribution (DC) model, the DC industry continues to look for ways to optimize performance. The outperformance of defined benefit (DB) plans, and the increasing cross-pollination of DB and DC investment staff, has led some DC plans to take a closer look at alternative investments. We examine three broad areas of alternative investments in relation to the DC market: real estate, hedge funds, and private equity. Authors: Sally Haskins, Gary Robertson, Jimmy Veneruso

1. Knowledge. Experience. Integrity.
CALLAN
INVESTMENTS
INSTITUTE
Research
June 2014
Through the Looking Glass
Are DC Plans Ready for Alternatives?
Amid the growing popularity of the defined contribution (DC) model, the DC industry continues to look
for ways to optimize performance.
The outperformance of defined benefit (DB) plans, and the increasing cross-pollination of DB and DC
investment staff, has led some DC plans to take a closer look at alternative investments.
We examine three broad areas of alternative investments in relation to the DC market: real estate,
hedge funds, and private equity.
Alice and the Cheshire Cat:
“Would you tell me, please, which way I ought to go from here?”
“That depends a good deal on where you want to get to.”
“I don’t much care where…”
“Then it doesn’t much matter which way you go.”
“...So long as I get somewhere.”
“Oh, you’re sure to do that, if only you walk long enough.”
― Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking-Glass
Introduction
With scars from 2008 not quite faded, the defined contribution (DC) industry continues to look for ways to
avoid further episodes of financial disruption. Through this soul searching, alternative assets—with their
promise of uncorrelated returns—have risen to the fore. Much like Alice peering down the rabbit hole, plan
sponsors stand poised on the precipice, debating whether or not to take the plunge into a wonderland of
exotic alternative asset classes.
As DC plan sponsors and consultants consider the merits of this expanding selection set, they must use
caution and ensure they understand the inner workings of such products. Imposing daily value and liquid-
ity upon asset classes that do not inherently possess these traits comes at a price. These costs may take

2. 2
the form of heightened correlations to mainstream asset classes, higher fees, and unanticipated volatility.
In this paper, Callan explores the current state of the market and the viability of these solutions, focusing
on real estate, hedge funds, and private equity. It remains to be seen whether the investment thesis for
such products stays intact as they go through the DC “looking glass.”
The DC Market: A Not-So-Mad Tea Party?
A survey of the retirement landscape reveals that arguably the most striking trend is the growth of the DC
model. In 2013 alone, DC assets experienced a growth rate of 22%. Since 2010, DC assets have grown at
an annualized rate of 7.6%, which is more than three times the rate for defined benefit (DB) plans (2.2%).1
Not surprisingly, investment managers that formerly confined themselves to the world of DB and endow-
ments and foundations are now taking a fresh look at DC, supported by these trends:
• The average DC plan has underperformed the average DB plan by nearly 100 bps annually.2
Although
some of this difference is due to fees, a portion may be due to the wider selection universe available
to DB plans, notably in the field of alternatives.
• DB investment staffs have noticed the growth in DC assets and are becoming increasingly involved
in DC plans. These investment professionals are often experienced with, and knowledgeable about,
working with alternatives managers.
Manager and plan sponsor interest is beginning to translate into an increase in alternatives products
tailored to the DC market. For the purposes of this paper, we will define “alternatives” as asset classes
that historically have featured low correlations to both traditional equity and fixed income, as well as being
characterized by both liquidity and valuation complexities (Exhibit 1).
1 Callan DC Index™
2 Ibid.
Exhibit 1
Asset Class
Comparisons
(10 years as of 12/31/13)
Asset Class
Annualized
10-Year Return
Annualized 10-
Year Standard
Deviation
Correlation to
Global Equity
Correlation to
Fixed Income
Global Equity
(MSCI ACWI)
7.7% 18.4% 1.00 -0.20
Fixed Income
(Barclays Agg)
4.6% 3.5% -0.20 1.00
Real Estate
(NCREIF NPI)
8.6% 6.3% 0.22 -0.18
Hedge Fund-of-Funds
(HFRI FOF Composite)
3.4% 7.2% 0.87 -0.25
Private Equity
(Thomson ONE All
Private Equity Index)
13.1% 9.5% 0.84 -0.28
Note: Data reflects 10 years as of 12/31/13 due to the lag in the release of Thomson Reuters data
Sources: Callan, Venture Economics

3. 3Knowledge. Experience. Integrity.
Real Estate: The King of Hearts?
There are a few key developments and trends influencing the investment in real estate by DC plans. The
most important development is the existence of viable investment choices for access to public and private
real estate, separately or together. Publicly traded real estate investment trusts (REITs) remain the primary
way to access commercial real estate for DC participants. However, REITs have suffered from a high correla-
tion to equities (notably small cap equity). Currently, 70% of target date funds (TDFs) have some exposure
to REITs, and 22% of DC plans offer REITs in their fund lineup.3
Standalone options in DC plans, which must
be elected by participants, may suffer from a lack of participant interest or understanding. Across plans that
offer REITs as a standalone option, participant allocations to them are low—just 1.4%, according to the Cal-
lan DC Index. From a DC perspective, private real estate is a very different—and less DC-friendly—animal.
The Industry Expands
Private real estate products that meet the requirements of DC plans are being developed, and entities
supporting real estate in DC plans are evolving. The Pension Real Estate Association formed a DC Affinity
Group in 2012 as a forum for plan sponsors, consultants, and investment managers to discuss real estate
in DC plans. The National Council of Real Estate Investment Fiduciaries has a defined contribution com-
mittee and is working on a daily valued fund index. Finally, the Defined Contribution Real Estate Council
was formed in 2013 to “promote the inclusion of investments in direct commercial real estate and real
estate securities within DC plans in order to improve participant outcomes by furthering education about,
advocacy for, and best practices of such investments.”4
There are seven contemporary private real estate-based products (defined as those launched since 2006)
for DC plans that are open for investment (approximately $1 billion of total AUM) and others are under
development. Unlike their REIT counterparts, these products are generally marketed to be a component
in a professionally managed solution, such as a TDF or real asset portfolio, versus as a stand-alone in-
vestment option. Typically, they are structured as a fund-of-funds with allocations to the manager’s private
real estate product(s), a REIT component, and cash and/or a line of credit for liquidity purposes. Products
continue to evolve. For example, a manager may have two products with differing allocations across
REITs and private real estate, or it may include real estate debt alongside public and private real estate.
Roadblocks Remain
Still, as a standalone investment option, private real estate is not prevalent in DC plans or within TDFs.
According to Callan’s annual TDF manager survey, just 5% of TDFs invest in direct real estate. Liquidity,
fees, and valuation concerns are frequently voiced by potential investors with regard to private real estate.
Entry queues in the underlying private real estate products represent another potential barrier. Lack of a
long-term track record and experience managing the product in various real estate and financial cycles
may also influence adoption. Straying too far from the basics in terms of product design could prove to be
more confusing than helpful to the buyer, to extent that it introduces more wrinkles with regard to valuation
and liquidity. As a contract, the REIT-only products face none of these issues.
3 Callan DC Index
4 DCREC website, www.dcrec.org
Currently, there are seven
private real estate-
based products for DC
plans that are open for
investment and others
are under development.

4. 4
Ultimately, changes must occur—within the DC market and the products offered—if there is to be broader
and faster adoption of private real estate within DC. Accelerants to adoption would include the increased use
of custom funds, greater acceptance of illiquid assets within plans, less focus on costs/fees, and appropri-
ate staffing. DC plan recordkeepers must also be able to handle this additional complexity, and today, most
cannot. Products offered for investment will need to have full transparency with regard to liquidity in various
scenarios. It is critical that investors understand the valuation of all parts of the product, including equity,
leveraged equity, other debt used, and debt investments made. Testing the liquidity and valuation in differ-
ent environments will provide comfort (or not) with the products’ processes, investment thesis, and ability to
improve participant outcomes.
Hedge Funds: The Red Queen?
The primary benefit of a diversified portfolio of hedge funds is as a source of uncorrelated return. Depend-
ing on the strategy mix, hedge funds can have low beta to the S&P 500 Index and negative beta with the
Barclays Aggregate Index. Also, hedge funds’ unconstrained nature means that managers can pursue in-
vestment opportunities across a broad range of markets. Yet a single-manager hedge fund has too many
concentrated risks to justify individual placement in a DC plan.
Vetting a pool of single hedge fund manager options for a DC plan, and expecting participants to pick a
well-balanced portfolio, is beyond the scope of a DC plan fiduciary. Also, traditional private placement
vehicles for hedge funds are too illiquid for DC plans. Hedge funds typically give quarterly liquidity on
60 to 90 days’ notice and some strategies do not have accurate daily valuations, which simply cannot
be accommodated by the typical DC recordkeeper and would be unpalatable to many DC fiduciaries.
However, there are ways for DC plans to access the benefits of hedge funds. They run the gamut from
hedge fund replication indices to the evolving arena of DC-friendly multi-manager hedge fund mutual
funds. As with any investment, DC plans must ensure they have a solid understanding of the risks inher-
ent in hedge fund strategies.
Risks and Fees
Since hedge fund investment strategies are largely unconstrained, and hedge funds in a limited partner-
ship (LP) format are less regulated than traditional asset managers, business risk, operational risk, and
investment risk play a prominent role.
Business risk affects hedge funds in two primary areas: failure to gain critical mass with assets under man-
agement, or a change in leadership. One of a hedge fund’s main selling points is the opportunity to buy
into a portfolio manager’s talent. Hedge fund managers are thought of as the “best in breed” in terms of
investment skill. Losing a key decision maker at any investment fund is challenging, but this risk is greatly
magnified at a hedge fund.
Operational risk is related to a hedge fund’s critical mid- and back-office functions—trade processing,
accounting, administration, reporting—and counterparty exposures. Hedge funds rely on prime brokers

5. 5Knowledge. Experience. Integrity.
to house the securities in the hedge fund portfolio, enable short selling by the hedge fund, and extend
leverage. A failure of the prime broker can severely cripple a hedge fund’s ability to invest properly. For
this reason, it is imperative that plan sponsors understand the fund’s operational risk controls and, more
broadly, its culture of compliance.
Investment risk plays a larger role in hedge funds than traditional asset managers due to the hedge fund’s
unconstrained nature. While a long-only equity manager mirrors the benchmark index return, plus or
minus a few percentage points, a hedge fund manager’s losses can be total. It is important to monitor a
hedge fund’s exposures and risks to ensure the manager is not making lopsided bets that could cause a
total loss of capital.
In addition to an understanding of these risks, DC plans must also have a firm grasp on hedge fund fee
structures. At 2% of assets and 20% of profits, the typical hedge fund fee is well above that of a traditional
manager. Administering performance-based fees is challenging in the DC environment. Both the level of
fees and existence of performance-based fees are sources of fiduciary concern given DC regulators’ focus
on fees. Additionally, the post-2008 environment is providing headwinds to hedge fund performance, cre-
ating a disconnect between the fees charged and return received. Thus far, managers that have launched
DC-friendly products have made concessions on fees and have often dropped performance-related fees.
While the illiquidity premium some hedge funds seek provides a source of additional return, this illiquidity
can affect investors during market disruptions. Hedge funds typically allow redemptions on a set sched-
ule, such as the end of each quarter, and usually require advance written notice, such as 60 days. Also,
hedge funds often reserve the right to “gate” investors (i.e., limit withdrawals) if a certain number redeem
at once, further delaying the return of capital. Although transfer activity is low in DC plans, DC participants
have come to expect instant access to their money, and few plan sponsors are willing to assume the com-
munication challenges of explaining illiquid investments to plan participants. Hedge fund managers have
responded by creating vehicles that offer enhanced liquidity, focusing on liquid hedge fund strategies such
as long/short equity and global macro.
Multi-Manager Funds
While a traditional limited partnership hedge fund faces significant hurdles to even being offered in a DC
plan, a multi-manager mutual fund that meets 40 Act regulatory requirements is a viable option. These
mutual funds invest in the more liquid hedge fund strategies, such as long/short equity, event-driven eq-
uity, and global macro. Strategies that focus on extremely illiquid sectors of the market, such as distressed
debt, are only practical in small allocations. Many hedge fund-of-funds managers avoid this strategy al-
together in their mutual funds. Market neutral equity, which uses large amounts of leverage to generate
returns from offsetting security mis-pricings, also tends to be avoided within 40 Act funds. Restrictions on
performance fees also help make 40 Act multi-manager hedge funds more suitable for DC plans. Cur-
rently, there are 36 such products in the marketplace, with another four in registration.5
These products
account for roughly $17B in assets (the majority of which is through advisor-sold channels).
5 Callan
While a traditional limited
partnership hedge fund
faces significant hurdles
to even being offered
in a DC plan, a multi-
manager mutual fund that
meets 40 Act regulatory
requirements is a viable
option.

6. 6
As with private real estate, hedge funds—even 40 Act hedge funds—are not generally viewed as viable
standalone DC offerings. Beyond the reasons cited here, communication challenges abound when it
comes to explaining these complex products to unsophisticated DC investors. Inroads into TDFs, mean-
while, have been mixed: according to Callan’s data, 14% of target date funds incorporate absolute return
strategies, 12% include managed volatility, and 9% have allocations to long/short equity strategies.
Private Equity: The Cheshire Cat?
Private equity DC products remain in their infancy. To date, Callan is only aware of one DC product that
is actively seeking funding. The product is structured as a commingled vehicle, allowing for participation
from multiple plan sponsors.
Manager Insights
In order to better gain insight into this space, Callan recently conducted an informal poll of nine large,
global, private equity fund-of-funds managers to see if they were actively working on products for the
DC market, and to get input on their views toward the DC marketplace. Four of the managers are private
equity groups within large asset management complexes that have a public security presence in the
DC market.
Of the nine managers, only two were actively working on products for the DC marketplace. One firm was
modifying an existing open-end private equity vehicle, and expected that a launch would occur relatively
soon. The other manager was developing a private equity-related product, but indicated it would be public
market-based and liquid. A general sentiment across the managers polled was that any relatively illiquid
private equity product would be limited to being a modest to moderate portion of TDFs, and would not be
viable as a standalone investment option.
All of the remaining seven private equity firms stated that they are actively researching the area. They are
attending DC conferences, discussing product design, monitoring plan sponsor interest, and developing
related white papers. Some said that an attractive product for the DC market was considered to be the
“Holy Grail.” One firm hired a consulting firm to conduct a market feasibility study, but most are not dedicat-
ing capital and human resources to formal product development.
Several firms had approached, or unsuccessfully attempted to approach, some of the large, proprietary
DC TDF and recordkeeping platforms to discuss the concept of private equity in TDFs. The private equity
managers felt that non-proprietary or sub-advised allocations were not of interest to the large proprietary
TDF providers. The possibility of the large DC platforms eventually developing proprietary products for
their TDFs was also raised.
Looking Ahead
The general consensus was that the most likely prospects would be DC plan sponsors with custom TDFs,
but that broad adoption and growth in scale would be very slow to develop. One manager has one client
with a private equity allocation in its TDFs, but the allocation is implemented by an in-house staff at the

7. 7Knowledge. Experience. Integrity.
plan sponsor that also manages the TDF’s specific liquidity requirements. Another key issue the managers
cited was a belief that there was not enough DC plan sponsor interest to make the required “early-mover”
capital investment for product development worthwhile.
Amid caution on all sides (including perceived headline risk on the part of plan sponsors), several of the
firms surveyed recognized the difficulties of bringing a true DB-like offering to market. Larger issues that
need to be addressed include:
• Liquidity (both daily and remitting large balances)
• Accurate and equitable daily valuations
• Necessity of gating mechanisms
• Achieving par on termination, asset transitions, or liquidations
• Comparatively high fees
• Ability to get invested quickly
• Product design that generates a return comparable to DB private equity allocations
As with hedge funds, there was a general recognition that solutions to these issues either compromised
the available rate of return, or created product characteristics that would be less than palatable to plan
sponsors, and that could occasionally penalize participants. Callan will continue to analyze private equity-
related DC/TDF offerings as they come to market. We believe that the products will be derivative in nature
relative to traditional DB private equity portfolios and will have specific merits and disadvantages. System-
atic due diligence will be critical for plan sponsors to truly understand product features and make informed
decisions on new private equity-related DC products.
Exhibit 2
Key Features of Select
Alternative Investments
Relative to the DC
Marketplace
Real Estate Hedge Funds Private Equity
State of DC Market Mid Stages Mid Stages Infancy
DC AUM $1 billion $17,000 mm $0
Number of Products 7 36 1
Standalone Offered
No, only as a component of
TDF or multi-asset fund
No, only as a component
of TDF, multi-asset fund, or
multi-manager fund
No, only as a component of
TDF or multi-asset fund
Alpha Enhancer Yes Yes Yes
Risk Diversifier Yes Yes Yes
Daily Liquidity Yes Yes Yes
Daily Value Yes, appraised Yes, marked to market Yes, appraised
Source: Callan

8. 8
Conclusion: Don’t Lose Your Head
As DC plans mature and become more institutional in nature, we see both product innovation and height-
ened interest in alternative asset classes (Exhibit 2). This new wonderland of options presents both op-
portunities and challenges. Plan sponsors and consultants must understand the methodologies used for
marking a daily value to asset classes that, by construction, often lack a clear observable daily valuation. As
with other alternative investments, the performance impact due to heightened liquidity, reduced leverage,
and increased transparency could mute their investment raison d’etre.
As alternative DC products establish longer track
records, it will become possible to judge the ex-
tent to which they are true looking glass versions
of flagship strategies, with allowances for plan
sponsors’ specific requirements. If alternatives
have a place within DC plans, it is most likely
as diversifiers of target date funds. Standalone
alternatives options could face implementation
issues and communication challenges. An addi-
tional, significant concern is the potential for DC
participants—known for performance chasing
and market timing—to put their retirement at risk
due to an inappropriate use of alternatives.
The Door and Alice:
“Why it’s simply impassible!”
“Why, don’t you mean impossible?”
“No, I do mean impassible. (chuckles) Nothing’s impossible!”
― Lewis Carroll, Alice’s Adventures in Wonderland & Through the Looking-Glass
For More Information
To learn more about topics in defined con-
tribution, hedge funds, and private equity,
read our quarterly newsletters: DC Observer,
Hedge Fund Monitor, and Private Markets
Trends. The fourth quarter 2012 DC Observer
features a related essay, “Making Alternatives
Mainstream?” You can find these on our web-
site at www.callan.com/research/publications.
To learn more about the DC Index, visit www.
callan.com/research/dcindex.

9. 9Knowledge. Experience. Integrity.
Authors
Sally Haskins is a consultant in Callan’s Real Assets Consulting group. She is responsible
for strategic planning, implementation, and performance oversight of plan sponsor clients’
real assets portfolios. She heads manager due diligence and strategy research for Asian
real estate markets and investment products. Sally is a shareholder of the firm.
Gary Robertson is manager of Callan’s Private Equity Research group. Gary is respon-
sible for alternative investments consulting services at Callan. He is currently Secretary
of Callan’s Client Policy Review Committee and is a shareholder of the firm.
James Veneruso, CFA, CAIA, is a defined contribution consultant in Callan’s Fund
Sponsor Consulting group. He provides analytical support to Callan’s DC clients and
consultants including investment structure evaluations, fee analyses, and target date
fund research. Jimmy is a shareholder of the firm.

10. 10
Certain information herein has been compiled by Callan and is based on information provided by a variety of sources believed to be
reliable for which Callan has not necessarily verified the accuracy or completeness of or updated. This report is for informational pur-
poses only and should not be construed as legal or tax advice on any matter. Any investment decision you make on the basis of this
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About Callan
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