The Alternatives Route
Sponsors of defined benefit (DB) plans have utilized alternative investments as a diversifier for years. Is it time for defined contribution (DC) participants to do the same?
“Many of these alternatives strategies in the defined benefit world are trying to make their way over to the DC world,” says Scott Rubin, director of research at consultant Portfolio Evaluations Inc. in Warren, New Jersey. The industry is trying to determine “the best way to get these exposures into plans.”
Adoption of alternative investments as DC menu options has been modest so far, according to the 2013 PLANSPONSOR Defined Contribution Survey. Last year, 28.2% of plans offered a real estate/real estate investment trust (REIT) fund, up from 12.1% in 2009, while 5.5% provided such alternative options as hedge funds or private equity, up from 2.3% in 2009.
Current Usage Trends
For sponsors that want to offer a real estate option on the core menu, a REIT fund makes sense because of its liquidity, high streams of dividend income and more conservative performance compared with other alternative investments, says Gary Handler, senior vice president, investments, and senior institutional consultant at Raymond James Institutional Consulting in Beverly Hills, California. “With REITs, if you exclude the financial crisis, it’s a bit more predictable, because commercial, industrial, office properties and apartment real estate prices tend to increase over time, which gives investors the potential for growth and higher streams of income,” he says.
Investors also like the Internal Revenue Service (IRS) requirement that REITs pay 90% of their profits as dividends, he says. And both sponsors and participants often feel more familiar with real estate than they do with other alternative investments, Rubin says.
Plans have also been adding Treasury inflation-protected securities (TIPS) funds to their lineups in recent years, says Ross Bremen, a partner at investment consultant NEPC LLC in Boston. About one-quarter of 401(k) plans now provide them as an option, he says. “Sponsors are looking for ways to [help] participants not only diversify their portfolios but combat inflation. TIPS have been the inflation-protection choice,” he says. “[They] have been an easy decision for committees—many of these products are index-like, so there are low costs. And they are guaranteed by the federal government.”
Other alternatives strategies such as private equity or hedge funds have complex investment strategies and characteristics that can present liquidity, transparency and other challenges to defined contribution plans. “While there is opportunity to add value, there has not been, by any stretch, universal adoption of these options,” Bremen says. “Unfortunately, many sponsors feel anything you do that increases complexity is potentially a move in the wrong direction.”
The fees for alternative investments also can dissuade sponsors, Rubin says. “Some of these strategies may have an all-in expense ratio of 250 basis points [BPS],” he says. “Many plan sponsors see that and there is sticker shock.”
Alternatives offered as core menu options tend to appeal to a niche of relatively knowledgeable investors, Handler says. “It’s traditionally the more sophisticated investors, and they might put 5% to 10% of their assets in the REIT sector.” How much a participant should invest in alternatives depends on that person’s risk tolerance and feelings about the risk/return trade-off, he says.
Still, the unlikelihood of participants making big bets on alternatives has, so far, limited their use as core menu options. “[They do] have potential within DC plans but really within the context of asset-allocation funds such as target-date funds [TDFs],” Rubin says. Such funds would be run by professional investment managers who would control the exposure to between 5% and 7%, for example, Rubin says.
The first significant wave of target-date funds investing in alternatives came after the 2008/2009 market crisis, when the TDFs started allocating to real-asset funds and emerging-market debt and equity, says Bob Jenkins, global head of research at Lipper in Boston. Many target-date funds suffered from their heavy allocations to traditional asset classes, including equity allocations, but fixed-income holdings also contributed to unexpectedly large losses for some funds, Jenkins says. “[Managers] had a desire to really diversify beyond that.”
Future Growth Potential
Some large-plan sponsors with both defined contribution and defined benefit plans have begun utilizing their DB alternative investments within custom target-date funds in their DC plans, Bremen says. Using the investments in master trust arrangements, these target-date funds get exposure to alternatives, such as private equity, that they otherwise would lack, he says.
“The unitized structure of the master trust arrangement allows participants to invest in illiquid pools,” Bremen says, “and the inclusion of true illiquid securities can be very impactful.” These longer-term investments can have a so-called “illiquidity premium” that enhances returns, and a better-diversified portfolio also lowers downside risk for participants. These sponsors see the target-date fund approach as a way to more safely give participants exposure to a broader array of alternative investments, without the risks of offering those exposures as core menu options.
Despite the current trend toward simplifying investment menus for participants, Jenkins does see potential for growth in alternatives as a core defined contribution menu option. “The next phase is the use of alternatives as more of a risk diversifier, as opposed to a pure return enhancer,” he says.
The recent growth of alternative strategy mutual funds makes this a more viable option for plans, Jenkins says. (See “‘Liquid Alt’ Mutuals Gain Momentum,” below.) “Increasingly, there are some good standalone options,” he says. Sponsors may add alternative funds that focus on minimizing volatility for investors, particularly on the downside, he says. Strategies that could line up well with that goal include absolute return, long/short equity, market neutral and managed volatility, he says.
“A lot of these funds have a hedging component,” he says. For investors, “that’s where we see a lot of the attraction.”
But for alternative strategy mutual funds to have more potential as a core menu option, participants need to be educated about how to utilize them effectively and what to expect, Jenkins says.
“Our sponsor clients realize there really is a hill to climb, in terms of getting participants up to speed,” Rubin agrees.
Still, Jenkins believes, “If you can educate investors as to what the investment is here for, and adjust their expectations accordingly, then people will start to use them in the right way.”
‘Liquid Alt’ Mutuals Gain Momentum
Retail investors are beginning to invest in alternative strategy mutual funds. Their motive: to avoid a repeat of the decline in their portfolios that many experienced in the 2008/2009 equities downturn, theorizes Josh Charlson, director of manager research for alternative strategies at Morningstar Inc. in Chicago.
“[The move] has also been facilitated by the increasing number of options out there,” he says. The quantity of alternative strategy mutual funds—also called “liquid alt” mutual funds—has risen steadily from 215 in 2008 to 442 this year, according to Morningstar. Total net assets in the funds has jumped from $49.6 billion at year-end 2009 to $139.4 billion in 2013.
“Although there are institutional flows coming into these funds, it’s primarily a retail-led phenomenon,” Charlson says. He has also heard of defined benefit (DB) plans investing in long/short liquid alt funds, rather than investing directly in hedge funds that utilize a long/short strategy. “If they can find a similar strategy in the ’40 Act [Investment Company Act of 1940] space, they prefer the daily liquidity and transparency,” he says.
But alternative strategy funds also can differ from typical equity and fixed-income funds, he says. For example, an alternative strategy fund may use leverage by borrowing money from a bank that the fund then invests, in hopes of generating higher returns.
As for performance, Charlson says, “It’s very hard to generalize, because they’re in different categories. ‘Alternatives’ is a catchall, and you have to look at performance or benchmarks relative to the category.”
For example, amid the rise in equities, managed futures funds recently have performed poorly as a category. But some long/short equity funds have done quite well in the same environment, he says. “In general, the average beta [for alternative strategy funds] is around 0.5, so you would expect about half the volatility and half the return of the S&P [Standard & Poor’s] 500.”
A Money Management Institute study released in May gives a sense of retail investor interest in these strategies. “Distribution of Alternative Investments through Wirehouses,” produced in collaboration with Dover Financial Research, found that, in 2013, wirehouse-based assets in liquid alternative investments surpassed assets in traditional alternatives such as hedge funds. According to the study, a handful of “blockbuster” funds saw three-quarters of net flows from wirehouses last year: the MainStay Marketfield Fund, Goldman Sachs Strategic Income Fund, J.P. Morgan Strategic Income Opportunities Fund, BlackRock Strategic Income Opportunities Fund and BlackRock Global Long/Short Credit Fund.
The study also notes that, among alternatives strategies, the nontraditional bond category had the most wirehouse-based assets last year. “In the bond market, everybody is looking for alternative sources of income,” says Jean Sullivan, a managing principal at Dover in Westwood, Massachusetts. Long/short equity had the second-largest assets.
“A large part of that is driven by good returns,” she says. “The other piece is that advisers are trying to incorporate these products [to] develop a portfolio for clients that is less volatile. These funds can limit downside risk and hedge other investments, and they also are liquid.”