The Markets February 19, 2014

Sponsors Drawn to Alternative Investments

John Hancock Investments is seeing defined contribution (DC) retirement plan clients add alternative mutual funds to their menu of investment options at a rapid pace.
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“We’re seeing firms use alternatives—either as part of a target-date or asset allocation portfolio or as single additional investments in their DC lineup—to solve for three things,” Todd Cassler, president of institutional distribution for John Hancock Investments in Boston, tells PLANADVISER. “They are looking for non-correlated and diversified sources of return, a way to manage volatility and tail risk and a hedge against some type of future event, such as rising interest rates or inflation.”

Cassler explains that non-correlated or diversified sources of return are investments for which the return does not follow the movement of traditional asset classes—when the market goes down the strategy may go up, or at least drop less significantly. Tail risk is an extreme shock to financial markets—technically defined as an investment that moves more than three standard deviations from the mean of a normal distribution of investment returns.

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Cassler says DC plan sponsors’ interest in alternatives is a result of a combination of lessons from the 2008-2009 financial crisis, current market volatility and anticipation of future volatility and rising interest rates. “It started in 2008 when client portfolios experienced extreme drawdowns. Firms started looking for options that would provide diversification and reduce volatility.”

Each plan is different, so the type of alternative strategy that is best depends on the plan and participants’ needs. Firms are either adding standalone alternative options like absolute return—in a retirement plan menu, absolute return funds can offer participants a way to reduce the effect of market volatility without settling for the near-zero returns of money markets, Cassler says—or adding strategies that offer a complete alternative portfolio. An example is the John Hancock Alternative Asset Allocation Fund, a fund-of-funds that invests in alternative asset classes, including, but not limited to, currencies, global real estate, commodities, natural resources, and emerging-market debt.

"Retirement plan sponsors and participants are finding multiple benefits in this all-in-one approach," says Cassler. "Because the assets are professionally allocated among multiple alternative strategies and managers, participants don't need to worry about being conversant with all the details of all the strategies. At the same time, plan sponsors are able to add this varied alternative asset category in a single, diversified option."

According to Cassler, when selecting alternative investment products for their DC retirement plans, plan sponsors need to know who is being hired, what is the performance blueprint of the strategy, what is its role in the fund lineup or target-date fund, and what are the costs associated with the product. Other questions to ask include whether there are any daily valuation issues for participants or challenging liquidity demands, as well as what is going to be the overall diversification benefit of including the product. Cassler adds mutual funds can help plan sponsors deal with these issues because they offer lower fees, liquidity and more stringent oversight not received from illiquid investments like hedge funds.

Aside from funds’ prospectuses, there are fact sheets and information about strategies and commentary about how products perform to educate plan sponsors as well as participants.

The Markets February 19, 2014

Towers Watson Clients Double Smart Beta Asset Flows

Institutional investors working with Towers Watson more than doubled asset flows moving into “smart beta” strategies last year, reaching $11 billion of inflows in 2013.
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Smart beta strategies don’t have a precise definition, but the term generally refers to investment programs that take advantage of both active and passive investing principals. Generally, a smart beta portfolio uses rules-based investment strategies that do not rely on traditional market-capitalization weighting to set asset allocations within an index-tracking portfolio.

Historically, smart beta strategies weighted a portfolio’s asset allocations by the security issuer’s revenues, earnings or gross domestic product, among other rules. Popular strategies today include equal weighting, fundamental weighting and minimum variance weighting.

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Towers Watson says the strong growth in smart beta strategies among its institutional clients is not surprising, as institutions have long been expressing interest in alternative strategies (see “Institutions Like Smart Beta”) that can provide lower fees. Put simply, smart beta assumes that better diversification and rebalancing rules can generate returns that exceed the capitalization-weighted index without expanded risk or excessive oversight. Like indexed investments, smart beta’s most attractive features typically include low management fees, high transparency and low asset turnover, but great diversity exists in the space.

Data released by Towers Watson shows about $1 billion of the $4 billion that clients invested in real estate during 2013 moved through smart beta portfolios, followed by a third of investments made in direct hedge funds, at more than $3 billion. The firm also saw institutional clients put $2 billion into infrastructure-related investments through smart beta investments during 2013.

The $11 billion in total inflows across over 180 portfolios is up more than 100% from the $5 billion placed in smart beta across 130 portfolios in 2012, the firm says. Towers Watson’s clients globally have now allocated over $32 billion to smart beta strategies in almost 500 portfolios, across a range of asset classes.

“It is no surprise that smart beta strategies are being implemented at this rate, given their inherent relevance for most institutional investors,” says Craig Baker, global head of investment research at Towers Watson. “Interestingly, it has taken some time to get to this point, given that we started developing the concept in 2000 as part of our work on structured alpha, then in more detail in 2002, as beta prime.”

Baker says that, while his firm is satisfied that its clients have been able to benefit from a range of smart beta strategies, Towers Watson is concerned about the proliferation of products now on the market that claim to be smart beta, particularly in the equity area.

The data also show that, last year, Towers Watson’s institutional clients—which include pension funds, sovereign wealth funds and insurance companies—carried out alternative asset class selections worth more than four times as much (over $12.5 billion) as they did five years ago.

Among alternatives, real estate attracted the most interest (over $4 billion), where about 25% is in smart beta, followed by direct hedge funds (over $3 billion) and infrastructure (over $2 billion), where about one-third was in smart beta strategies. In the same period, direct private equity attracted approximately $1.5 billion, while illiquid credit (distressed debt and lending) attracted roughly $1 billion in assets, the firm says.

“Throughout the past five years, the alternative fund managers that we have put into client portfolios have shown their ability to adapt to the changing environment to generate good net-of-fees performances,” Baker says.

Baker predicts that larger institutional funds are likely to continue investing in funds directly for most alternative asset classes, rather than via funds of funds. That’s a result of expanding focus on securing better fee structures, greater transparency and the growth of more advanced smart beta options, he says.

“Indeed, there were only three fund of hedge funds mandate selections in 2013, which demonstrates this point,” he says.

According to the data, bond selections by Towers Watson’s clients in 2013 totaled $22 billion, of which the majority were invested in global (approximately $11 billion) and U.S. (roughly $5 billion) mandates, followed by emerging market mandates (about $3 billion). In 2013, the total number of multi-region bond selections exceeded the combined total of all single-region bond mandates, the firm says.

“These figures confirm a longer-term trend of investors seeking greater efficiency, diversification and diversity in bond mandates, for example, favoring global solutions over a home-market bias, and an increasing acceptance of alternative credit asset classes into the strategic asset mix,” says Baker.

In equities, global mandates totaling approximately $10 billion continued to be the most popular with Towers Watson's clients in 2013, followed by U.S. equity (roughly $3 billion), global ex-U.S. equity and U.S. small- and mid-cap equity mandates (each approximately $2 billion). In total, equity mandate selections last year accounted for approximately $24 billion in assets.

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