Proponents of liquid alternatives (alts) build a strong case for including these assets in defined contribution (DC) plans either as part of a custom solution or as an individual option. Neuberger Berman’s David Kupperman and Scott Kilgallen summed up the key points in a Winter 2015 Journal of Alternative Investments article. They point to several benefits that liquid alts’ inclusion in DC plan menus could provide: 1) another solution for managing a portfolio’s incremental return and risk management, 2) potential to manage volatility more effectively, and 3) potentially greater diversification with a strategy that is less sensitive to the broader equity and fixed-income markets.
Good Idea, But…
Those are the classic arguments for including alternative investments in a portfolio: differentiated returns and reduced volatility. Defined benefit (DB) plans are buying in, according to the CEM Benchmarking that Kupperman and Kilgallen cite from 1997 to 2013. DB plans held 4 percent of their assets in real estate and REITs, 2 percent in hedge funds and 4 percent in private equity. For DC plans that are working to become more institutional, it makes sense to consider liquid alts, says Lorie Latham, Chicago-based Director, Investment Consulting Group with Willis Towers Watson. “We’re not saying everybody should do this; what we’re saying is every plan sponsor is wise to take an opportunity to look out at the landscape, consider the opportunities and say, can I do better?” she says. “Can I migrate my DC plan to be more institutional and focused and how would I do that? And, I think that’s where these alternatives come into play.”
But DC plans aren’t climbing on the alternative bandwagon. “On the defined contribution side, we’re just not seeing meaningful traction,” says Robert Muse, Senior Vice President at SEI Trust Company in Oaks, Pa. “We’re certainly having a decent amount of conversations with managers and they certainly seem to be having a decent number of conversations with plan sponsors.” Despite the expressed interest, “A lot of those conversations never really go all the way to the finish line,” Muse adds.
A broad rule of thumb is that the optimal allocation to alternatives is somewhere between 10 and 30 percent. Allocations below that range aren’t likely to generate much diversification benefit and those above that range also fail to improve the risk-return profile further. Among DC plans adopting liquid alts, however, the allocations are more likely to be in single digits, Muse notes.
What’s the Problem?
Marc Caras, Director and Head of Retirement Plan Network with Pershing LLC in Jersey City, N.J., believes the biggest challenge is raising sponsors’ comfort level with liquids alts, which means educating them about the investments’ benefits for the portfolio. He suspects that struggle will continue until a hedge fund or marketing firm devises a more effective approach to education and demonstrating the investments’ value. Higher fees are another drawback, Latham notes. Liquid alts are often more expensive than traditional asset classes and plan sponsors need to be convinced of the value-for-fee trade-off. When sponsors consider the pros and cons, including alts is not a simple decision, she says.
Poor performance by the funds as a category has also likely discouraged potential adopters. A recent Barron’s article by Lewis Braham cites returns from Morningstar’s multi-alternative funds category. Although some individual funds performed well, over the preceding five-year period the group averaged a 1.6 percent annualized return, significantly underperforming stocks and bonds. The choppy market action in 2016 should have been an ideal proving ground for liquid alts, but Braham reports that the average fund showed a loss of 0.3 percent versus gains for the S&P 500 (+3.6 percent) and the Barclays US Aggregate Bond Index (+3.1 percent).
Potential lawsuits are another consideration causing sponsors to take a wait-and-see attitude and let other plans test the waters, Latham says. These lawsuits are becoming more nuanced; consequently, sponsors are holding off on introducing anything new or complex to their plans. Nonetheless, consultants have a responsibility to stay abreast of new developments and introduce these new ideas to sponsors, emphasizing the value of suggesting plans investigate diversification opportunities beyond the traditional mix. “Whether or not a sponsor is going to adopt them, that’s the big unknown,” she says.