A More Cautious Take on In-Plan Alternative Investments

Investment menus are contracting and being trimmed of “unnecessary” options, says Brian O’Keefe, director of research and surveys for Asset International, who manages the PLANSPONSOR Defined Contribution (DC) Survey among a number of other large annual research projects.  

“I think most people would agree that alternative investments will not be understood by the overwhelming majority of participants,” O’Keefe says. All things considered, he feels plan sponsors will be driven more in the coming years by their interest to streamline and simplify investment menus than their interest in adding the diversification benefits that alternatives can confer, adding it’s more likely that those participants who do understand them and do want to invest in them will be sent to a self-directed brokerage window.

O’Keefe notes the last PLANSPONSOR DC Survey shows alternative investments—including private equity funds, hedge funds, and other alternative approaches packaged as liquid securities—are in place in just 4.6% of all DC plans. Mega plans are the likeliest to have alternatives on the menu, at 6.0%, implying the reach of alternatives touches more participants than the topline single-digit figure suggests. Interestingly, micro plans appear to use alternatives more often than large plans, at 5.1% versus 3.0%, respectively.

An important note is that the survey segregates real estate and real estate investment trusts (REITs) from the alternatives category, with take up of these investment options looking much stronger than the other types of alternatives. In fact, more than one-quarter of all plans (26%) offer some type of real estate investment. 

Perhaps the most important storyline in all this, O’Keefe says, is that some target-date fund (TDF) managers are starting to incorporate alternative investments into their asset allocation strategy products, “but we have yet to see how this will play out and/or whether it is a sound investing strategy or a poor one.”

NEXT: Alternatives marketing is taking off 

Providers have in the last several years been arguing alternative holdings can help with diversification and improve participant outcomes, especially during times of rising interest rates and higher global volatility.

“It makes sense why target-date fund providers are moving down this path,” O’Keefe explains. Alternative funds are by their nature more exotic and unique from the customer’s perspective. Thus, a target-date fund that folds in a novel type of alternative investment approach is more easily distinguishable from the competition and generally more marketable and profitable to provide.

“Additionally, most target-date funds have very similar glide paths, so providers are happy to take a little extra risk in hopes that it will translate into higher return that can then be marketed against other TDFs,” O’Keefe concludes. Fund providers are comfortable taking the added risk because “most assets won’t move out of the TDF even if the fund under-performs the market.”

This highlights some of the positive and negative aspects of the highly influential qualified default investment alternative (QDIA) regulations that came into effect under the Pension Protection Act—passed nearly a decade ago. The QDIA rules got a lot more people involved in retirement planning, but it’s still a difficult fact for the industry to confront that the majority of TDF participants have been defaulted into their investments. Thus they have both a wide variety of investing skill levels and a wide-range of investment risk profiles. 

Taking it all together, O'Keefe feels it's unlikely that it's participants themselves who are driving the marked interest in alternatives from the grass roots. Rather, investment managers and advisers are framing alternatives usage as a developing best practice of diversification, generating increased interest from the top down.

NEXT: Alternatives are an adviser opportunity 

Other survey data shared with PLANADVISER by AMG Funds seems to echo many of O’Keefe’s points, but the firm interprets the balance of forces somewhat differently—framing investor’s lack of understanding of alternatives more as an opportunity than a hindrance, especially from the perspective of advisers.

Most affluent investors admit to knowing little or nothing about alternative investments, according to the firm’s new report, “Investors Confident in Active Management in 2016.” Just one in 10 of affluent respondents feels highly confident in selecting these investments without the guidance of a financial adviser—an informative fact for the general investing population given that affluent investors are likeliest to be interested in long-term financial planning products.

“More than half (54%) indicate that alternatives are a ‘mystery,’ but nearly the same number (47%) of investors wish they knew more,” the report says.

Important for advisers and investment providers alike to note, 77% of current investors in alternative products say that an adviser played a key role in the purchase. At the same time, 54% of advised investors say they have still not discussed alternative investments with their adviser.

While an adviser or provider will not help investors, affluent or otherwise, by suggesting overly complicated or expensive products that do not fit their individual needs, the report concludes it should be no surprise that conversations are building around alternative investing. Against the backdrop of recent market volatility retirement plan participants and pretty much all other types of investors are feeling ill at ease, creating a lasting opportunity for advisers to provide education on these themes and products.

Asset International is the owner and publisher of PLANADVISER.