• Some provide a source of excess return (alpha) which can be harvested by those investors who can identify skill and/or who usually need to be tolerant of shorter-term illiquidity. Private equity, emerging market debt are good examples of this type.
  
  
• Some offer a means of diversifying equity risk without reducing return to the levels achieved by bonds/cash. Good examples include real estate, commodities, metals, and absolute return funds.
  
  
• A long/short investment process can be used to enhance returns, and if the strategy is market neutral, these returns should be largely uncorrelated to markets and thus provide good diversification to other investments within a client's portfolio.

To provide an exhaustive list of all the different types of alternatives is almost impossible because (as the name implies) alternative asset classes are generally taken to include any asset class that is not included in quoted equities, quoted bonds, investment grade debt or cash. The list is thus very long. However, they can be loosely grouped into the following categories – the common characteristic is given in brackets:

Of course, not every alternative investment falls neatly into a single category. For example, is forestry a real estate investment or is it an investment in commodities? The broad definition does, however, help to make analysis and consideration easier.

It should be emphasised that while observed correlation between these asset types and equities is usually low, it does not mean that equity risk has been fully diversified. Some may exhibit lagged correlation; most will correlate quite closely with equities over the long term since the success depends on the same type of economic conditions. The obvious exception is hedge funds. However, even here, many hedge funds have either deliberate, unintentional or occasional correlation with equity markets.

Undoubtedly, the use of alternatives by pension plans has increased in most parts of the world but the predicted “wall of money” has yet to manifest itself. In part, this is because of the lack of transparency, the higher cost and the governance problems that alternatives pose.

In Mercer’s view, some alternatives will provide a worthwhile alternative source of alpha and some will provide worthwhile diversification. However, not every plan will benefit from investment in alternatives. Any decision to invest in alternatives must be based on a plan’s own unique circumstances.