The Value of Alts

Art by Katherine Streeter

Investment managers suggest that retirement plans should embrace alternative investments not only to offer participants better diversification but to take advantage of current market conditions.

Principal Funds is confident that a wide blend of alternatives will perform well in the type of rising-interest-rate, higher-volatility environment projected for 2016 and beyond.

“In particular, a liquid basket of diversified hedge fund strategies should be a very compelling investment option in the years ahead, inside and outside DC [defined contribution] plans,” says Ben Rotenberg, a Principal Financial Group portfolio manager in Des Moines, Iowa. He says the traditional 60/40 portfolio of stocks and bonds has had a good run in the last three decades, as bonds have ridden interest rates down over the last 35 years. “But will this continue in the coming decade? Unlikely,” he predicts.

“Frankly, the 60/40 traditional portfolio has been hard to beat,” Rotenberg says. “But we need to ask whether the next 35 years will look like the last 35 years.”

One simply needs to consider globally systemic elements such as slowing momentum in China, emerging-market sluggishness, a still-strengthening U.S. dollar, and lasting European malaise to find compelling evidence for lower global growth over the next decade or longer, Rotenberg says.

The How, When and Why of Alternatives
The most recent data available from mutual fund and exchange-traded fund (ETF) market research firm Strategic Insight (SI), an Asset International company, shows that, at the end of last year, liquid alternative funds held some $240 billion in total assets. 

According to the SI data, international long/short equity products have led the pack, with $9 billion of inflows since the start of 2014. Managed futures and multi-strategy hedge fund products follow in a near-tie for second, with about $6 billion in inflows each during the period. Other growing categories include long/short bond funds ($3 billion), U.S. long/short with long-bias (less than $3 billion) and global macro (about $2.5 billion).

What do the wider market trends mean for retirement plans and individual defined contribution investors? Sirion Skulpone, head of liquid alternatives product strategy for Goldman Sachs Asset Management in New York City, agrees with the sentiment that now is “about as good a time as any for DC plans to consider adding liquid alternatives.”

Like Rotenberg, Skulpone predominantly advocates for a prepackaged, diversified basket of alternative strategies for use within DC plans. As an investment option, Skulpone says, they can be helpful for a loss-averse participant, due to their return-smoothing characteristics and lower correlations with traditional equity benchmarks.

Beyond the very likely prospect of continuing rising interest rates, equity valuations also make a good case for turning to liquid alternatives. Skulpone says valuations have “come down somewhat, due to the volatility of recent months, but they are still relatively high compared with historic averages.” This implies the need for strong earnings growth and other new sources of confidence before broad equity indexes will start to make sustainable gains again—a situation that naturally favors many of the alternative approaches.

“Often, liquid alternatives are thought of as more risky sources of greater potential returns,” Rotenberg notes. “In reality [and especially within the defined contribution plan environment] we see they’re more often relied on as hedging tools to smooth the sequence of returns during times of market corrections or persistent volatility.” 

The Basics About Alternatives Portfolios
Another important point about introducing an alternatives allocation to a defined contribution plan, Rotenberg says, is that it will “have to be 10% of the participant’s portfolio at a minimum to have a real impact.” This is true whether the alternatives are being folded into a target-date fund (TDF)—an increasingly common move among top providers—or being presented as a standalone option, singly or as a pre-diversified mutual fund basket.

In fact, Rotenberg is a proponent of even greater holdings in alternatives. “Is [a] 20% [exposure to alternatives] better than 10%? Yes. Is 30% better than 20%? Yes,” Rotenberg says. “Obviously, you have to take liquidity into account, and the portfolio probably shouldn’t be all alternatives, but we’re strong advocates for including a substantial alternatives allocation in a DC plan portfolio.”

Skulpone agrees, observing that the “vast majority of current institutional users of alternatives are allocating to a group of managers and a bucket of different strategies.”

“From the very beginning, you need to know what you’re getting, from a holistic risk-return perspective,” she says. “There are single-strategy funds out there that are quite unique and quite risky, for example, while other diversified products strive to be very broad-based and stable, so you need to be sure you are pursuing the right alternative approaches. Again, it’s the bucket of diversified alternative strategies that is probably going to be the most appropriate for DC plans.” In terms of what part of the existing portfolio might be reduced to accommodate a new alternatives exposure, Skulpone generally recommends “funding this out of equities.”

“We think about alternatives as a tool to reduce risk and improve risk-adjusted returns, so it makes sense to fund from the equities side of the portfolio, from that perspective,” she says. “This could change, however, given what we have said about a new environment that’s emerging. If you’re bearish on fixed income going forward, you can consider funding from that portion of the portfolio. But alternatives are not less risky than diversified packages of bonds, so you may actually be increasing risk and potential volatility if you fund from the fixed-income portion of the portfolio.”

Rotenberg agrees that alternatives allocations should probably come out of the equity portion of the existing portfolio, but “it all depends.”

“Hedge funds and alts have lower risk than equity, but they are more risky for the most part than high-quality fixed income, so keep that in mind,” he says. “Alternatives will boost the return profile over bonds, but [they] will also boost the risk profile.”

Look to DB Leaders for Guidance
Data from Towers Watson shows that defined contribution plans, even with their rapidly increasing attraction to alternative investments, actually lag far behind their defined benefit (DB) plan counterparts. According to the consulting firm, the global financial crisis of 2008 and 2009 added serious momentum to the shift to alternatives, and by last year U.S. pension funds held upward of 29% of their portfolios in nontraditional assets, up from 13% in 2002 and just 9% in 1997.

At the same time, data from the 2015 PLANSPONSOR Defined Contribution Survey show only 4.8% of all defined contribution plans have alternative offerings on the investment menu. The survey segregates real estate investment trusts (REITs) from other alternatives—finding a more robust 27.8% of plans overall use REITs.

Part of what has held DC plans back is the basic fact that individuals in that plan system maintain control of their individual investment accounts and, therefore, must either choose to proactively invest in alternatives or be automatically routed into such funds via an automatic enrollment or re-enrollment action sanctioned by plan officials. Beyond this serious hurdle, concerns about the scalability and liquidity of alternative investment funds have made plan sponsors hesitant to bring them onto investment menus.

Accordingly, defined benefit plan holdings are already invested in a wide variety of asset classes that can be considered alternative or nontraditional—hedge funds, direct real estate and commodities, just to name a few. There are even hedge funds that invest in conventional stocks and bonds—but they use more strategic and highly active strategies that attempt to beat the broader markets on one measure or another.

Like Skulpone and Rotenberg, Towers Watson researchers highlight the key importance of “knowing upfront what you’re buying” when it comes to selecting alternatives. Whatever a given plan sponsor’s goal in investigating alternatives, there should be plenty of early-mover examples out there to learn from and potentially emulate.

Prudence will remain incredibly important in this domain during the next few years, agrees Rich Fulford, head of PIMCO’s U.S. retirement business, which manages about $16 billion in alternatives for defined contribution plan clients out of Newport Beach, California. He describes a variety of categories of alternatives emerging in the qualified retirement plan domain: The first is “pure” illiquid alternatives, most prevalent in defined benefit plans; these alts are not necessarily packaged into mutual funds, potentially making them difficult for defined contribution plans to access given the Employee Retirement Income Security Act (ERISA)’s liquidity requirements. 

Second are funds “investing in nontraditional assets with limited correlation to stocks and bonds,” such as commodities, Treasury inflation-protected securities (TIPS) and REITs, he says. Third are liquid alternative products akin to hedge funds, pursuing strategies such as global tactical asset allocation, long/short equity and unconstrained fixed income. The second and third types both can be fashioned into ’40 Act [1940 Investment Companies Act] mutual funds or exchange-traded funds (ETFs) permitted by ERISA for use in DC plans, Fulford explains.

“Not every hedge fund strategy will translate well into a daily liquid vehicle, but most can,” Skulpone says. “It’s hard to see how something like a distressed debt strategy, which is in a category that tends not to be very liquid, could be packaged for a DC plan. But strategies like equity long/short or managed futures, where the underlying instruments are very liquid, will translate very well.”

Rotenberg agrees and concludes that most defined contribution plan sponsors that have increased the availability of alternatives have done so via custom target-date funds. “We haven’t seen much usage from a standalone perspective, but we can argue they should have that tool in their tool belt. Where we have seen standalone alternatives taking off is in the diversified real asset portfolio, which has been used quite frequently as a standalone in DC plans, in part because it is so diversified.”

Key Takeaways:

• Alternatives perform well amid volatility.
• Liquid mutual funds or TDFs are best-suited to DC plans.
• Exposure should be at least 10%.