Seeking Alternatives
Retirement savers in the global markets have enjoyed a long string of encouraging returns. In the seven years ended in March, annualized returns in the MSCI World Index, net dividends, were 8.63%, and in the Bloomberg Barclays U.S. Aggregate bond index, 3.48%. Along the way, many equity markets have been taken to record highs, and bond yields have been driven to unusual lows. It has been an enjoyable ride, but this strong performance is likely to make investing in traditional assets all the harder for years to come.
“We believe that the markets are in a lower-return world,” observes Nathan Thooft, senior managing director of asset allocation at Manulife Asset Management in Boston. “With stocks fully valued, and fixed income likely to earn its small coupon at best, investors need additional levers to pull.”
To sustain portfolio performance against such challenges, asset managers, plan consultants and advisers all look to investment in alternative assets. These are typically nontraditional asset classes with diversifying performance patterns plus leverage, as well as strategies designed to wring more value from returns on conventional stocks and bonds, often applying leverage as well.
Defined benefit (DB) plans have long turned to investments outside the public stock and bond markets. Private commercial real estate has been a DB staple for decades, and sponsors moved to private equity and hedge funds to repair some of the damage from the tech crash early in the century. Their alternative nature comes from a different set of return drivers: Commercial real estate has a long development and funding cycle, often out of sync with the general economy, and thus offers significant diversification for the patterns of returns. Real estate investment trust (REIT) funds have a history of appearing on defined contribution (DC) plan menus, but because the funds invest in public companies that own properties, rather than directly in the properties themselves, their returns tend to move more in line with the general stock market over shorter periods.
Private equity also has a long time frame and can earn returns above the public markets from the transformation of companies’ operations and financing. Hedge funds invest for the most part in public markets but follow complex strategies. All three alternatives can be illiquid, involve concentrated portfolios and leverage, and call for skilled active management, so the results vary widely across managers and individual funds.
In 2015, large corporate defined benefit plans held an average of 3.0% of portfolio assets in hedge funds, 2.5% in real estate and 2.3% in private equity, according to annual surveys by Wilshire Associates. State defined benefit plans rely more heavily on alternatives, says a 2017 report from The Pew Charitable Trusts, at 25% for fiscal 2016, up from 11% in 2006.
While some of the investment advances in DB plans have been easily grafted onto DC structures, alternative assets have not taken as well. Expectations for DC plans are that participants will be able to buy and sell their plan investments daily, setting the bar high on asset valuation and liquidity. That daily valuation has so far ruled out private equity, although providers keep trying to bring suitable fund vehicles to market.
However, direct real estate has been incorporated into a few collective trust versions of target-date funds (TDFs) for years, notably J.P. Morgan’s SmartRetirement series. And last August, TIAA-CREF fit direct real estate into its mutual-fund-based Lifecycle Fund series.
In the search for diversifying investments, the DC world has defined alternatives more broadly. “Certainly hedge funds, private equity and real estate are what people think of in DB, but, for a DC plan, I like to cast the net a bit wider,” says David O’Meara, senior investment consultant at Willis Towers Watson in New York City. “That includes anything that might not be found in a traditional 401(k) structure. [Such investments] don’t have all of the attributes of the private market assets, or all the bells and whistles of hedge funds, but they are different enough to diversify a conventional portfolio.”
Inflation protection has been the major theme in DC alternatives, through various approaches to “real assets” that shelter participants’ hard-won savings from rising prices. Many target-date funds include a real-asset sleeve that contains a combination of REITs, commodities, TIPS [Treasury inflation-protected securities] or the stocks of infrastructure and natural resource companies.
“We’ve also been seeing an inflation-protection option in the core menu,” notes Jeri Savage, head of DC research and a partner at Rocaton Partners in Norwalk, Connecticut. “That can take various forms and include several asset classes, and [also] be an all-weather type of inflation protection,” she explains. “All else equal, we would rather see our clients offer a multi-asset approach in their core menus,” to avoid the potential volatility of single options. Such multi-asset core menu choices are offered by John Hancock, Franklin Templeton, Principal Investors and Deutsche Asset Management.
Less developed are so-called “liquid alts”—specialized strategies resembling those of hedge funds that invest in long-short equity and credit, market neutral equity, currencies and various multi-alternative combinations. Other alternatives invest in equity factors—aka smart beta—such as value, momentum, quality and carry.
In its newly published whitepaper “2017 Target-Date Fund Landscape,” Morningstar points out that liquid alts are still fairly scarce within target-date funds, and the number of series holding alternatives dropped from 10 last year to seven this year. Moreover, allocations of those including liquid alts are rather small. “Their generally high fees make them a hard sell for the fee-sensitive target-date fund space,” Morningstar writes. However, hundreds of hedge funds have rolled out ’40 Act [1940 Investment Companies Act] versions of their strategies, although adapted to meet mutual fund regulatory requirements.
Judging the success of liquid alts—or any alternative, for that matter—is challenging, concedes Ross Bremen, partner at consulting firm NEPC in Boston. “Alts work, but [having] success at a complex strategy and having the highest possible returns are not synonymous,” he explains. “The reality is that when the market has built products that behave differently from the majority, investors tend to follow the ‘hot dot’ with the highest return. Some products can minimize losses or volatility in a portfolio, but those are not the products the market has gravitated to.”
“Sponsors and advisers need to be mindful of the environment returns are generated in,” notes O’Meara. “A fund may have underperformed equities over the last three years, but if it was behaving as it was designed to, that’s not necessarily a bad thing. The test of alternatives will come when the equity markets aren’t so hot.”
Liquid alternative funds also face an uphill battle regarding fees. “There are reasonably priced liquid alts, but you won’t find any with a fee as low as that on an S&P [Standard & Poor’s] 500 index fund,” observes Matt Rauseo, vice president at AQR Capital Management in Greenwich, Connecticut.
His colleague Antti Ilmanen, manager of AQR’s portfolio solutions group, cautions that sponsors and advisers should look beyond the headline fee of a strategy. “A smart beta portfolio starts with a long-only market exposure, which you can get for zero to 10 basis points [bps], and then combines factor tilts, which can be very valuable, say, worth 30 basis points,” Ilmanen says. “Long-short market-neutral applications are giving you even more. If they were available at 50 basis points, that would clearly be a better deal, because it doesn’t include any of the beta, which is worth very little in terms of management fees.”
Rauseo lays out three crucial points for plan sponsors or advisers to consider in choosing any alternative asset: “They need to understand the concept behind the investment and how it is likely to behave in a range of markets. First, does it clear the bar for risk-adjusted return? Can it enhance return or reduce portfolio risk, or possibly both? Second, it should improve performance in bad times. That is, it should do less badly than the rest of the portfolio, or perform well.
“Third, versus stocks and bonds, will this asset perform better in a broader range of macroeconomic environments?” Rauseo says.
KEY TAKEAWAYS:
- In light of expected lower returns in the equity and bond
markets, defined contribution plans might consider adding fund that invest in
alternatives to their investment lineups.
- Alternatives are difficult to invest in as standalone due
to liquidity issues, so advisers should look for funds that allocate to them.
- Some target-date funds invest in real estate, real estate investment trusts (REITs), commodities, Treasury inflation-protection securities (TIPS) and infrastructure and natural resource stocks.