The Markets January 25, 2016

How Are Investors Responding to Volatility?

Experts suggest many long-term investors have absorbed central lessons about volatility and trading—especially among more sophisticated segments of the investing population. 
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“Volatility Doesn’t Shake Investor Optimism for 2016,” a survey published by AMG Funds of investors with over $250,000 in household investable assets, shows most active-mutual fund owners (90%) plan to maintain or increase their allocations to active funds this year.  

According to AMG Funds Chief Marketing Officer Bill Finnegan, this segment of affluent investors also widely anticipates an ongoing rise in interest rates and “moderate to high volatility,” amid modestly increasing inflation. Importantly, Finnegan notes, the survey sample represents a different segment of investors than a general survey with no wealth limit or investing style filter. Given their larger pools of resources and stated interest in active funds, it’s fair to say these are more engaged investors than the norm in many workplace retirement plans.

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Even so, Finnegan says it is encouraging to see this group’s willingness to stay invested and even increase investment amid significant market volatility—understanding there are real opportunities and pockets of fundamental strength amid the global turbulence. In this way, individual affluent investors are looking more like their large-scale institutional counterparts, for example pension plans or endowments. Even with major market swings occurring nearly weekly since Q3 2015, these highly sophisticated investors are not widely turning off risk.

In fact, according to new data published by BlackRock compiling the investment outlooks of 170 of the firm’s largest clients ($6.6 trillion in combined assets), large institutional investors “expect to embrace active management in 2016 to combat macro-economic trends, anticipated market volatility and divergent monetary policy.” The data further shows institutions increasingly embracing illiquid assets, including private credit and real assets, as a way to meet their long-dated liabilities.

Mark McCombe, senior managing director and global head of BlackRock’s institutional client business, explains investors are “attempting to look past the current market environment and find alpha generating opportunities that match their liabilities.” Individuals may only have limited access to investment strategies in private credit and real assets—depending on their own wealth level and pathways of investing—but the ripple effect from recent price swings is causing all sorts of investors to “more actively manage risk and seek alternative sources of returns,” BlackRock finds.

NEXT: How allocations are changing

Amid the recent volatility, the sector that has seen the largest increase in investor interest has been long-dated illiquid strategies, led by private credit strategies, with more than half of institutional investors indicating an increased allocation, “closely followed by real assets (53% increase / 4% decrease / +49% net), real estate (47% increase / 9% decrease / +38% net), and private equity (39% increase / 9% decrease / +30% net).”

Taken all together, clients are “clearly expressing demand for the return premium offered by illiquid assets,” BlackRock finds. Specific to U.S. and Canadian institutions, the shift toward illiquid assets is occurring as institutions slightly reduce their allocations in equities. 

Despite the muted returns in 2015, allocations to hedge funds remain fairly steady globally, BlackRock finds. When asked how they plan to manage their modestly scaled-back equity exposures, BlackRock’s data shows 25% of respondents plan on increasing their allocations to active managers, compared to 16% looking to increase index-based allocations. Within fixed income, institutions are anticipating modest reductions, “with the majority of that ... coming from their core allocations.”

Plugging for AMG Fund’s own active investment products, Finnegan predicts 2016 will provide a complex environment for both institutions and individuals, in which the more strategic/contrarian nature of high quality active mutual strategies “has more room for advantage over indexers.” Specifically, active strategies that focus on limiting the potential of large losses on the downside should be popular among both individuals and institutions—even at the expense of a few percentage points of potential return when markets are up.

NEXT: Who volatility really hurts

“There is a lot of evidence showing long-term investors will do better in this type of product over time, one that limits shocks to the downside, even though they may miss out on the top of the upside,” Finnegan explains. “Dalbar, for example, has data that shows this over a 30 year period—it is freakishly consistent that the investment always does better than the investor. This is because people, over this long of a time period, cannot help but to get really scared by volatility and pull out of their investments at least once at the wrong time, for the wrong reason, and with no rational plan to get back in.”

Finnegan likes to summarize the point this way: “Volatility generally does not hurt the investment, but it can hurt the investor.” The AMG survey data supports this, he notes, as a solid majority (58%) of affluent investors say large swings in the stock market “make them very uncomfortable.” The problem is not necessarily the discomfort, Finnegan notes. It’s when discomfort translates to ill-timed trading actions.

“Pulling out of funds prematurely is even more detrimental for investors that have already taken the step of going active to limit volatility,” Finnegan warns. “When an investor reacts to volatility and actively trades in and out of active products, this is essentially attempting to actively manage an active manager.” It’s not a winning proposition from the fee and portfolio efficiency perspective, not to mention the problems with attempting to time the markets.

Reading further into the data, Finnegan says the firm “always finds that wealth preservation is a top goal for clients across age cohorts and wealth segments. My message here is that, if you want to preserve wealth, there are definitely strategies out there that can reduce the amount of volatility you’re exposed to.” Investors have to find the strategies that fit, and they have to stick with them.

“It doesn’t help that a lot of investors, according to our surveys, still have faulty beliefs about their portfolios,” Finnegan concludes. “For example, in our last survey it is apparent that nearly half of investors think simply owning a lot of different stocks will guarantee you have a diversified portfolio. Sophisticated investors know you can limit the downside a whole lot just by investing in a truly diversified portfolio that takes asset classes and correlations into consideration.”

Compliance January 22, 2016

ERISA Breach Case Hinges on SunEdison Company Stock

A former SunEdison employee is suing the company, a raft of its directors and State Street Bank for continuing to offer SunEdison stock in the retirement plan.
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Alexander Y. Usenko, a former SunEdison employee and participant in the company’s defined contribution (DC) plan, has brought suit against SunEdison for losses incurred by investing his retirement plan assets in SunEdison stock.

Usenko has named as defendants SunEdison Inc., its board of directors, the company’s investment committee, State Street Bank & Trust Co., and SunEdison’s chief executive (Ahmad R. Chatila) and senior executives and members of the operating committee: Emmanuel T. Hernandez, Antonio R. Alvarez, Peter Blackmore, Clayton C. Daley, Jr., Georganne C. Proctor, Steven V. Tesoriere, James B. Williams, Randy H. Zwirn, Matthew Herzberg). One defendant is identified only as John Doe.

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The notion of company stock as a potential liability in a retirement plan is cropping up more frequently, with plan sponsors backing off company-issued stock as a plan investment. Some say it can still be offered, as long as there is a prudent, documentable process in place.  

According to the complaint, the defendants permitted the plan to continue offering SunEdison stock as an investment option to retirement plan participants, even after they knew or should have known that during the time frame (August 6, 2015 to the present) the stock had a number of troubling issues. It was artificially inflated; SunEdison—which bills itself as the world’s largest global renewable energy development company—was in extremely poor financial condition; and SunEdison faced equally poor long-term prospects.

These factors made SunEdison stock an imprudent retirement investment for the plan, the complaint says. As fiduciaries of the plan, the defendants were empowered to remove SunEdison stock from the plan’s investment options but didn’t. Neither did they act in any way to protect the interests of the plan or its participants, in violation of their legal obligations under the Employee Retirement Income Security Act (ERISA).

NEXT: A breach of the “prudent man” standard

The complaint says that the value of SunEdison shares in Usenko’s account diminished as a result of the defendants’ breaches of duty. According to the complaint, Usenko is no different than the thousands of other SunEdison employees who entrusted their retirement savings to the defendants/fiduciaries of the plan.

According to the complaint, the inclusion of the stock amounts to a breach of the “prudent man” standard under ERISA. The defendants breached the duties they owed to the plan, to Usenko, and to the proposed class members who are also participants by, among other things, retaining SunEdison common stock as an investment option in the plan. A reasonable fiduciary using the “care, skill, prudence, and diligence that a prudent man acting in a like capacity and familiar with such matters would use,” as required by ERISA, would have done otherwise.

Usenko is seeking a jury trial; the complaint states that once discovery begins, it’s likely that additional people or entities engaged in wrongdoing will be revealed, and that more instances of wrongdoing will be uncovered. In that case, Usenko will seek to amend the complaint, adding new parties or new claims (or both).

The complaint cites the Supreme Court’s decision regarding Fifth Third Bancorp v. Dudenhoeffer as a precedent, in which plan participants challenged the plan fiduciaries for failing to remove company stock as a plan investment option. The plan’s fiduciaries were found to have violated ERISA when they continued offering an imprudent plan investment option—and the U.S. District Court considers this case similar to Fifth Third.

NEXT: No presumption of prudence 

The gist of the allegations of breach of the duty of prudence and breach of the duty of loyalty is that the defendants allowed the company stock to continue as a plan investment during the period specified in the complaint—despite knowing that the investment was imprudent as a retirement vehicle. The complaint says defendants certainly should have known it was unsuitable by the beginning of that specified period.

According to the complaint, SunEdison stock was artificially inflated during the period specified in the suit, while the plan was making purchases. Second, the company materially misrepresented the strength of its financial condition and prospects, thereby inflating the stock’s value. As a result, SunEdison stock, and subsequently the plan’s assets invested in it, lost substantial value once the truth emerged.

This claim—that a company’s stock is imprudent based on the stock price being artificially inflated, and that the fiduciaries should have understood the overvaluation because of nonpublic information of which they were aware—is squarely endorsed by Fifth Third.

Second, the lawsuit claims the company was also an imprudent choice during the specified period in light of circumstances demonstrating SunEdison’s perilous financial condition, which included a sea-change in the basic risk profile and business prospects of SunEdison.

The suit suggests several factors—SunEdison’s overwhelming and unserviceable debt and high debt management risk, and the defendants’ failure to properly investigate the continued prudence of SunEdison Stock and/or employ a reasoned decision-making process in evaluating company stock—all represent the kind of “special circumstances” that the Supreme Court recognized in Fifth Third.

The case was filed in U.S. District Court for the Eastern District of Missouri. The text of the complaint is here.

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