Are Hedge Funds Too Complex for the 401(k) Market?

Investors get access to hedge fund managers who previously only worked with the wealthy; funds get a lucrative new market. And the SEC is watching

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Liquid alternative mutual funds are growing faster than any other segment of the $15 trillion mutual fund industry, according to Morningstar research.  Assets rose to $285 billion in the first quarter of 2014. There are more than 500 alternative funds competing for investors’ retirement money. To put their nascence in perspective: over half of those have been created since 2008.

Alternatives have been a staple of the Defined Benefit component of US retirement industry for decades. Massive private and public sector institutional funds deploy alternatives, a category that involves a vast array of investment strategies, as a way to add diversification and hedge against risk to enhance portfolio performance.

A recent purvey conducted by Pimco’s DC practice probed 49 consulting firms that serve 7,800 clients with aggregate DC assets in excess of $2.8 trillion. Nearly all of the consultants surveyed (98 percent) support or strongly support the use of alternatives in custom target-date funds. What those consultants are saying is clear: the biggest risk in alternatives is in not accessing them.

Loosely defined, alternatives are those asset classes that fall outside of stock and bond categories that have shared allocation, along with cash, in traditional 401(k) plan structure. Hedge funds, private equity, commodities, private real estate and inflation protected fixed income like TIPS all fall into the alternative designation.

Harmonizing DC Plans in the Age of Uncertainty

Aggregate data through multiple market cycles over the past 20 years shows that Defined Benefit plans outperform Defined Contribution plans, when compared annually, the far majority of the time. This, in spite of DC plans having larger exposure to equities. The advantage is one of diversification and correlation. DB plans are structured to protect against volatility. By incorporating hedge funds, international equities, long/short positions, and liquid and illiquid assets alike, DB plans are better able to produce in turbulent markets because their performance is less dependent on one index, like the S&P.

At the largest plan sponsor level--those employers that manage both DB and DC plans--there has been dissonance in strategy. Typically, it is the company’s same investment committee applying two different approaches, one complex, nuanced and diversified through many investment vehicles and many managers for DB pension plans, the other a far more basic approach for the self-directed enrollees in a sponsor’s DC plan.

By harmonizing the two approaches, proponents of alternatives argue sponsors can align performance of their DC plans with those of DB plans.  This, says the argument, is an obvious net-benefit to what is the dubious state of the country’s current retirement landscape.

Liquid Alternatives—“If You Don’t Understand It, Don’t Invest in It”

With interest rates having nowhere to go but up, the traditional protections of passive bond allocations in 401(k) s is questionable, putting it mildly. Passive fixed-income holdings will lose value as interest rates rise, potentially adding risk to the products most retail investors have used to preserve principal. This has never-before-seen ramifications for the 401(K) industry. Shifting weight to stocks was as sound of a strategy last year as it was as poor of one in 2008. These massive fluctuations in equities have driven home their risk to investors approaching retirement. 

But alternatives? Hedge funds and private equity? Isn’t this the opaque world of Bernie Madoff, credit default swaps and financial jury-rigging that spawned idioms like Occupy Wall Street and the New Normal?

“There’s a murky side to the world of hedge funds, but there is also massive diversity in approaches,” says Jim Dilworth, founder and managing partner of Simple Alternatives, an based alternative fund company. “And yes, a lot of misunderstanding. But it’s natural that DC enrollees get access to the options of DB plans. Education at the sponsor and enrollee level will be vital.”

Dilworth oversees the management of the S1 fund, a liquid alternative long/short, equity mutual fund that is a part of the movement working to prove its value in the DC space. 

Funds like S1 give investors access to hedge fund managers who previously only worked with accredited, high net-worth individuals or institutions, while hedge fund managers get access to a massive new market. And it puts those strategies in the context of the Investment Company Act of 1940, subjecting them to regulations traditional hedge funds are not beholden to. Hedge fund managers are proving eager to adjust their high compensation structures to access the lucrative mutual fund industry. Alternative funds like S1 delivered 66 cents of every new dollar of assets brought into hedge funds last year.

That has caught the eye of the SEC. Last week they announced they’re testing a select group of liquid alternative funds to see if they are indeed liquid, not over-leveraged while also being compliant with disclosure protections established in the ’40 Funds Act. The SEC will look at number of hedge fund structures, including long/short equity funds similar to S1. (The SEC did not disclose which funds they will be testing. The S1 Fund was recently given a five-star rating by Morningstar.)

“This is fantastic news, exactly what the SEC needs to be doing,” says Dilworth, who describes his long/short fund as “vanilla.” 

“There are a lot of alternatives using leverage, and complicated off-shore vehicles as a part of their compensation structure. When the SEC is out there actively protecting the investor it is good for us, and good for everyone.”

Dilworth is hoping the relative complexity of alternatives can satisfy the time-honored wisdom he says investors of all levels should abide by. “If you don’t understand it, don’t invest in it.”

Barriers to Plan Sponsors

Research from McKinsey & Co. suggests the market for liquid alternatives will grow to represent 8-10 percent of the mutual fund industry by 2017. How open plan sponsors will be to their adoption is less clear. ERISA claims brought by the DOL and private class action have made fees paramount in the minds of fiduciaries. When alternatives tap the world of hedge fund managers, they often create multi-levels of management that all have to be compensated. Actively managed liquid alternatives will be more expensive than passive index funds.

What’s more, sponsors are going to have to actively engage their enrollees on the nature of the alternative options, whether they are folded into a target-date fund or offered to employees in their own basket of options. 

There is a cost to that, to say nothing of unpredictable fiduciary liabilities that may arise from the movement of alternatives. 

Those costs call into question plan sponsors’ incentive to offer higher fee products that will also require some investment in enrollee education. Sponsors are incanted to invest in the management of their DB plans because they occupy huge chunks of liability on company balance sheets. With self-directed DC plans, performance outcome liability falls on the individual enrollee. 

“Where is the upside for an investment committee picking great options,” wonders Jennifer Eller, a principal at the Groom Law Group, a Washington DC-based employee benefits specialist firm. “The upside is they don’t want bad options—high fees, volatility, these are real fiduciary risk factors. When a committee performs really well for their employees, there’s no monetary benefit to the committee. Does it make sense to expose participants to additional risk, even if there is a possibility of greater returns, when there is no reward?”

Those questions cut to the philosophical core of the societal shift from Defined Benefit to Defined Contribution plans.  Warren Buffet has succinctly said risk comes from not knowing what you’re doing. The risk for alternatives going forward?  Maybe it’s in motivating sponsors to help their enrollees know what they’re doing.

Originally published on BenefitsPro. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

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