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

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.