Considering the Hedge?
Summary paragraph: The fast-growing world of liquid alternative investments
Perhaps the best way to get a handle on the growth of liquid alternative investments-mutual funds or exchange-traded funds (ETFs) that use hedging and leverage techniques-made by employer-sponsored retirement plan participants is simply to review some of the projected numbers.
In a recent study released by mutual fund industry research firm Strategic Insight, an Asset International company, researchers predicted the assets in '40 Act liquid alternative funds-those of the type sold to defined contribution (DC) retirement plan participants and other individual investors-could double by 2018 to reach nearly $500 billion.
Michael Sapir, CEO of Bethesda, Maryland-based alternative-ETF firm ProShares, calls that a conservative estimate. "Some of the large brokerage firms are creating allocation targets for alternatives as high as 20% or 25% for the average investor," Sapir says. "If those numbers get realized, the actual figure could be significantly higher."
What makes the growth even more significant is where the influx of capital is expected to come from, and it is not from the institutions or the high-net-worth individuals that have previously led interest in alternative investments. Instead, sources say, the boom will likely come from employer-sponsored retirement plans and other individual investment platforms, such as individual retirement accounts (IRAs).
However, plan sponsors should not just add these funds to a defined contribution plan fund menu, sources say. For Sapir and a number of other alternative and '40 Act fund specialists, the staggering growth potential must be met by a concerted effort by fund managers and third-party advisers alike to educate plan sponsors and participants about what these funds actually are and what they are meant to accomplish.
While not all '40 Act liquid alternative funds can be classified this way, many are set up to offer a hedging strategy while maintaining certain liquidity, diversification and redemption standards, as required by federal regulations for financial products sold to nonaccredited investors.
Unlike a traditional hedge fund, a '40 Act fund must register with the Securities and Exchange Commission (SEC), according to the Investment Company Act of 1940-hence the name.
These products are often rolled into an employer-sponsored retirement plan, either within an actively managed fund-of-funds, such as a target-date fund (TDF), or as a stand-alone option. Managers then take dollars paid into the registered fund-of-funds and invest in dozens of underlying funds, which may or may not be SEC-registered.
The likeness of '40 Act liquid alternative funds to other mutual funds is both good and bad, says Andrew Klausner, founder and principal of New York-based AK Advisory Partners LLC. Good because it is easier to explain how purchasing and maintaining a '40 Act fund generally works; bad because many use strategies that are very different from traditional stock and bond funds. Thus, it takes skill to determine whether they are actually a sound investment.
The remarkable percentage growth of '40 Act liquid alternative funds makes sense when you look at recent market history, Klausner says. In recent years, many investors turned away from bonds and shifted towards equity strategies to bolster growth. Adding a hedge to this type of portfolio makes sense, Klausner says.
One key misunderstanding among plan sponsors and participants is that, in many cases, adding '40 Act funds that mimic various hedging strategies is not so much a way to increase overall returns in up markets as to protect portfolios in down markets. That explains why so many alternatives underperform in years such as 2013, when market performance improves.
"You really have to understand what you're getting [with alternatives], or you will go in and out at just the wrong time," Klausner says.
Jonathan Schonberg, who heads distribution efforts at event-driven investment management firm Water Island Capital in New York, points to the financial crisis of 2008 and 2009 as a major catalyst in the growth of liquid alternatives.
"There has always been a contingent of people buying the illiquid stuff, going for real estate, timber partnerships and various other areas," Schonberg says. "A lot of those people couldn't get access to their money after '08, because of lockups and gates. These new products don't typically have that problem."
Scott Garsson, managing director of product strategy and business intelligence at J.P. Morgan in Manhattan, says his firm expects strong growth in the need for liquid alternatives. He credits rising doubts among asset managers that the historic returns given from a portfolio actively balanced between equities and bonds will continue over the long term.
"That's where alternatives may now start becoming an integral part of almost every asset-management conversation," Garsson says.
Getting the Most Out Of '40 Act Options
Investment research firm Morningstar tracks more than 300 alternative-based '40 Act funds available to employer-sponsored retirement plan participants. New funds launch every week.
As in other areas of finance, key to adding liquid alternatives to an employer-sponsored 401(k) plan is research and understanding.
Adam Patti, CEO of IndexIQ, an asset and investment management firm headquartered in Rye Brook, New York, warns plan sponsors to be sure of what they are offering plan participants before they add liquid alternatives.
Patti, whose firm focuses on liquid alternative strategies, says he believes many investors look at hedge funds and the '40 Act products designed to mimic them "as something made to 'shoot the lights out,' performance-wise."
"But that's just not the case," he says. "Hedge funds are called hedge funds because they are designed to hedge. The 'normal' hedge fund is designed to bring in 3% or 6% regardless of the market volatility."
Patti suggests that plan sponsors should examine '40 Act funds that take on a diversified strategy when first entering the space, as funds with more specific hedging strategies will be harder for participants to understand.
Schonberg offers a similar suggestion. "If you just cherry-pick one of these funds and throw it in next to the large-cap growth fund option, it's going to cause more confusion than anything," he says.
Including Alternatives In a Packaged Solution
Meghan Jacobson, a retirement insights program manager for J.P. Morgan, says many of the conversations her company has had with plan sponsors on the subject center around adding liquid alternative options within existing target-date funds.
"I think J.P. Morgan would argue that's the most prudent way for a sponsor to add this kind of option to a DC plan," Jacobson says.
This is because target-date funds are typically managed in an active, multi-approach fashion by a professional asset manager. To support the point, Jacobson pointed to a recent J.P. Morgan plan sponsor survey in which only about one-third of respondents felt that their plan participants were capable of appropriately allocating assets.
"Of course it's important to ask about liquidity, pricing and fees," Jacobson says. "But most important is, 'How are my participants actually going to use and understand these products?'"