The Role of Alternative Investments for Taft-Hartley Plans p 14 MAGAZINE. education research information. Vol. 50 No. 10 October 2013.

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1 Vol. 50 No. 10 October 2013 education research information MAGAZINE reprint MAGAZINE Reproduced with permission from Benefits Magazine, Volume 50, No.10, October 2013, pages 14-20, published by the International Foundation of Employee Benefit Plans ( Brookfield, Wis. All rights reserved. Statements or opinions expressed in this article are those of the author and do not necessarily represent the views or positions of the International Foundation, its officers, directors or staff. No further transmission or electronic distribution of this material is permitted. Subscriptions are available ( subscriptions). PU pdf/913 The Role of Alternative Investments for Taft-Hartley Plans p 14

2 The Role of Alternative Investments for Taft-Hartley Plans by Kenneth Hoffman Alternative investments can help a plan meet its liquidity and funding requirements. But they may have a variety of risks, including a lack of liquidity, and often have higher fees. 2 benefits magazine october 2013

3 In the past, Taft-Hartley plans were restricted by their trust documents to traditional investments such as stocks and bonds, U.S. government bonds in particular. Yet even these simple investments carry inherent risks. Interest rates have declined steadily since the early 1980s, causing fixed income investments to rise in price while equity markets, as depicted by the S&P 500, have seen two significant declines since These drawdowns, peak to trough, are noted in Table I. Over the years, the rules and attitudes regarding Taft- Hartley plan investments have become less restrictive, and many types of alternative investments, such as hedge funds and managed futures strategies used by commodity trading advisors (CTAs), are now commonly used in many Taft- Hartley plans. Figure 1 indicates the flow of institutional investor assets into hedge funds over the last 18 years. Institutional clients have dedicated a larger percentage of their asset pools to hedge funds as well as a greater amount of dollars to the asset class since 2003, as seen in Figure 2. These alternative investments are complementary tools that help a fund manage its risk, and they can play a crucial role in allowing a plan to meet its liquidity and funding requirements. It is important to note that these alternative investments carry different types of risks, are not transparent, are more expensive to manage and may lack liquidity. However, in the hands of an experienced investment consultant, alternative investments can help a Taft-Hartley plan develop a better balance of risk and reward. According to the June 2012 Citi Prime Finance Report, Institutional Investment in Hedge Funds: Evolving Investor Portfolio Construction Drives Product Convergence, institutional investors (including Taft-Hartley plans, endowments, foundations, pension funds and insurance funds) have increased their commitment to alternative investments over the last eight years both in terms of dollars and the percentages of institutions invested in alternatives, as shown in Figure 3. Table I Peak to Trough Drawdowns, Highest Close Lowest Close % Change March 24, 2000 October 9, % October 12, 2007 March 5, % Based on daily closing values excluding dividends. Source: FactSet. october 2013 benefits magazine 15

4 Figure 1 Institutional Investor Flows of Money Into Hedge Funds, Billions of Dollars 1,200 1, $463B $1,028B Year $-248B Figure 2 Institutional Assets Invested in Hedge Funds December 2003 $8.7 Trillion Invested in Total Hedge Funds $211 Billion 2.4% 97.6% Traditional Asset Classes 89.5% 10.5% $179B December 2011 $14 Trillion Invested in Total Hedge Funds $1.5 Trillion Traditional Asset Classes Source: Citi Prime Finance analysis based on Evestment HFN & ICI & Sim Fund data. What Is a Hedge Fund? Hedge funds are private, actively managed investment funds. Hedge funds invest in a diverse range of markets, investment instruments and strategies such as equity long/short, global macro and event-driven. Managed futures funds are unique forms of hedge funds that invest primarily in commodities, although CTAs also trade in foreign exchange markets, energy markets and global stock indexes. Both hedge funds and managed futures funds are alternative investments. In general, U.S. regulations limit hedge fund participation to certain classes of investors based on their liquid net worth. Most Taft- Hartley plans will qualify. Additionally, hedge funds are often open-ended and allow additions or withdrawals by their investors. Increases and decreases in the value of the fund s investment assets and fund expenses are directly reflected in the value of the investment. Most hedge fund investment strategies aim to achieve a positive investment return regardless of whether financial markets are rising or falling. This is referred to as absolute returns. Hedge fund managers typically invest money of their own in the fund they manage, which serves to align their own interests with those of the investors in the fund. In other words, managers often eat their own cooking. A hedge fund typically pays its investment manager an annual management fee, which is a percentage of the assets of the fund, plus a performance fee if the fund s net asset value increases during the year. Most hedge funds are subject to a high-water mark, meaning that until the value of the fund increases above its historic highest level, no performance fee is paid. This is put in place to give managers an incentive to reach new highs year after year. Historically, hedge funds were exempt from some of the regulations that govern other investment funds and managers with regard to how the funds may be structured and how strategies and techniques are employed. Regulations passed in the United States and Europe after the 2008 credit crisis were intended to increase government oversight of hedge funds and eliminate certain regulatory gaps. 16 benefits magazine october 2013

5 As of April 2013, total capital invested in the global hedge fund industry was $2.375 trillion, according to the HFR Global Hedge Fund Industry Report, boosted by an increase of $122 billion in the first quarter. Why Include Alternative Investments in an Investment Portfolio? There are several reasons why portfolio managers/investment consultants add hedge funds and other alternative investments to a more traditional portfolio of stocks and bonds, including their proven ability to: Improve the risk/reward structure of the investment portfolio Diversify the portfolio Decrease portfolio volatility Increase overall returns Capitalize on tactical investment opportunities. As more investment managers include hedge funds in their portfolios, it is important to understand how these investments interface with a more traditional portfolio of stocks and bonds to accomplish the positive attributes noted above. This can be seen with the help of Figures 4 and 5, which illustrate the efficient frontier. The concept of the efficient frontier was developed by economists Harry Markowitz and Bill Sharpe, who received their Nobel Laureates in economics in Their modern portfolio theory is a concept in finance that attempts to maximize a portfolio s expected return for a given amount of portfolio risk, or equivalently minimize risk for a given level of expected return, by carefully choosing the proportions of various assets. The efficient frontier represents a set of optimal portfolios that offers the Figure 3 Institutional Investors $ Invested and % of Institutions Investing in Hedge Funds Billions of Dollars % Year Source: Citi Prime Finance analysis based on evestments HFN data. Figure 4 Efficient Frontier Expected Returns 15% 10% 5% 0% C D E A 100% Bonds 43% 60% 5% 15% 20% Risk (Standard Deviation) B 100% Equities highest expected return for a defined level of risk or the lowest risk level for a given level of expected return, or any combination thereof. Figure 4 shows that mixing different asset classes allows for a unique combination of risk and reward. Point A is an all-bond portfolio, and point B is an all-stock portfolio. Historically, stocks are more volatile than bonds, but they provide a higher rate of return. On the other hand, by mixing stocks and bonds together an investor can both lower its risk and increase its return, as seen in point C. This october 2013 benefits magazine 17

6 Figure 5 Efficient Frontier Expected Returns 15% 10% 5% 0% F Risk Reducers has a lower risk profile and a higher return than the all-bond portfolio, point A. Point D, which contains more stock than point C but less than point B, is also superior to point A It has the same risk level as point A but a higher expected return. Points C and D are efficient as they both lie on the efficient frontier. Portfolios that lie below the efficient frontier are suboptimal because they do not provide adequate returns for a given level of risk. In other words, if those portfolios did lie on the efficient frontier they would offer a higher expected rate of return for the same level of risk or a lower amount of risk given the same expected rate of return. For example, point E on Figure 4 is suboptimal. It has the same risk level as point D but a lower return, and it has the same return level as point C, but with a higher level of risk. The solid blue line in Figure 4 takes into account only two traditional asset classes: stocks and bonds. The dotted green line in Figure 5 indicates what happens when an additional noncorrelated asset class, such C Return Enhancers G D E A 100% Bonds 5% 15% 20% Risk (Standard Deviation) as hedge funds or managed futures funds, is added. Note that the efficient frontier shifts up and to the left, which theoretically gives the investor a higher return with the same risk (return enhancer), the same return with lower risk (risk reducer) or a combination of the two. Return enhancers are alternative investments that carry a higher risk/reward relationship than the traditional portfolio and are designed to improve the overall portfolio return. Depending on the risk level of the alternative assets, they are designed to improve the risk/ reward profile of the entire portfolio. (See point G in Figure 5.) Risk reducers are alternative investments designed to diversify the investment portfolio and reduce overall risk. This offers a better riskadjusted return than the portfolio that excludes alternative investments. (See point F in Figure 5.) For an additional asset class to improve the risk/reward relationship of B 100% Equities the portfolio, it should have as low a correlation to the other asset classes as possible. This relationship is measured by the correlation coefficient, a statistic that compares the returns of different data series and ranges between +1 and -1. Two asset classes that are perfectly correlated to each other will have a correlation coefficient of +1, while those that are negatively correlated will have a coefficient of -1. A correlation coefficient of 0 indicates that the two data series are not correlated with each other. An example of two data series that are highly correlated to each other would be the Dow Jones Industrial Average (DJIA) and the S&P 500. Both are comprised of large-capitalization domestic stocks, though the S&P is a much broader index. When one goes up over time, the other usually increases over time as well. An example of negatively correlated stocks would be oil stocks and airline stocks. Fuel is a major cost for the airlines, and when fuel costs skyrocket it is generally good for oil companies but bad for the airlines. One industry benefits at the expense of the other. Table II outlines the correlation matrix among several major financial indexes. As noted in Table II, there is little historic correlation between managed futures funds and hedge funds and the S&P 500. This would indicate that their returns are independent of one another. When the S&P drops, the other two indexes can go up or down. In a difficult equity market, they can provide a valuable offset to declining stock prices. Various index returns can be seen in Table III, which outlines the annual returns over the three best and the three worst years for the S&P since benefits magazine october 2013

7 These broad data series indicate that hedge funds and managed futures funds can perform well in strong equity markets, such as in 2003, and they have also done an excellent job of protecting investors in difficult equity markets. For example, in 2008 the S&P 500 dropped by 37%, and a well-quoted international index, EAFE (Europe, Asia, Far East), dropped by 43%. Yet during this year the managed commodity index actually went up by 14.1%, and the hedge fund index increased by 4.8%. Furthermore, in the three worst performing years for the S&P 500 since 1999, both the hedge fund and CTA indexes had positive returns in each year. This speaks volumes to the main reasons for investing in alternative investments, which again are to: Improve the risk/reward structure of an investment portfolio Diversify the portfolio Decrease portfolio volatility. By understanding the nature and style of the hedge fund/cta manager and how these managers correlate with traditional stock and bond assets, the portfolio should be able to adjust the overall risk and reward structure to be in line with the client s goals. Note that these results cannot be guaranteed and will usually vary the most over a short time horizon. The longer the time horizon, the greater the chances that the portfolio will perform as structured. What Are the Negatives of Hedge Funds? Hedge funds potentially have several negatives, some of which are outlined below. The investment consultant should be aware of the following issues and select funds that would avoid most of them: Table II Correlation Matrix of Various Indexes Versus the S&P 500 Monthly Returns, March 1997-March 2013 Traditional Asset Classes Alternative Investments Asset Stocks: Bonds: HFRI Class/ S&P Barclay s Barclay Macro Index 500 US Agg Hedge CTA (Total) S&P Barclay s US Aggregate (0.04) 1.00 Barclay Hedge CTA Index (0.12) HFRI Macro (Total) Index Source: Morningstar, Inc., Zephyr. Table III Annual Returns by Asset Class for the Three Best and Worst Performing Years for the S&P 500, Traditional Asset Classes Alternative Investments HFRI S&P Barclay s Barclay Macro Year 500 US Agg Hedge CTA (Total) Three Best Years (0.1) (1.7) (0.1) Three Worst 2008 (37.0) Years 2002 (22.1) (11.9) << bio Source: Morningstar, Inc., Zephyr. Kenneth Hoffman is managing director and partner at HighTower s HSW Advisors, where his responsibilities include investment strategy, asset allocation and portfolio design. For 18 years he was with the Private Banking and Investment Group at Merrill Lynch and previously was with Lehman Brothers and E.F. Hutton. Before entering the private client advisory business, he served as a corporate strategist for two publicly traded U.S. companies and as a research economist for the Central Bank of Israel in Jerusalem. Hoffman has a B.A. degree in anthropology, an M.B.A. degree from New York University and a post-master s degree in econometrics from the NYU Stern School of Business. He also completed doctoral work in economics and finance at NYU and Hebrew University in Jerusalem. He is a certified investment management analyst and a certified investment strategist. october 2013 benefits magazine 19

8 takeaways >> Most Taft-Hartley plans qualify to participate in hedge funds, which U.S. regulations limit to certain investor classes based on net worth. Alternative investments such as hedge funds and commodities futures strategies may help an investor manage risk while improving liquidity and funding. Most hedge fund investment strategies aim to achieve a positive investment return whether financial markets are rising or falling. Government oversight of hedge funds has increased in the United States and Europe since the 2008 financial crisis. Among the potential negatives of alternative investments are lack of liquidity and transparency, high fees, volatility and the possibility of fraud. learn more >> Education Investments Institute March 3-5, 2014, Clearwater, Florida Visit for more information. Liquidity. Alternative investments are often subject to lockups that can be as long as a year or two. As opposed to most stocks and bonds that have daily liquidity, alternatives typically have quarterly or annual liquidity. Notification must be given, usually days in advance, in order to liquidate. High fees. Alternatives will generally have two fees: an annual administrative payment (usually 1% to 2%) plus a percentage of profits (typically 20%; subject to a high-water mark). Lack of transparency. Little data is available as to the makeup of the portfolio. Volatility. Some hedge funds will employ significant levels of leverage, which can amplify returns. In an up market this can create exceptional returns, but in down markets this can create significant losses. Reporting delays. Given the sometimes complex strategies of a hedge fund, it may take days or weeks to calculate the fund s net asset value at the end of the month/quarter. Potential fraud. Since the exposure of the Madoff Ponzi scheme, several hedge funds have also been revealed as Ponzi schemes. This can be minimized by proper operational due diligence. Allowance for gating. Gating is the practice of not allowing the client to liquidate assets as requested. In , as investors sold financial assets at any price, some hedge funds prohibited liquidations as they believed that prices were too low or that the financial transactions were too complicated to unwind. Not all hedge funds allow their managers to gate. Potential underperformance in strong financial markets. Given that hedge funds are often hedged to provide risk controls in down markets, they can underperform in strong equity markets. Insufficient regulation. Although many hedge funds were historically unregulated, more hedge funds are coming under the jurisdiction of regulatory bodies such as the Securities and Exchange Commission, the Financial Industry Regulatory Authority and the Commodity Futures Trading Commission. Summary Alternative investments, such as hedge funds and managed futures funds, have been a growing asset class for institutional investors, including Taft-Hartley plans. Hedge funds, in particular, are able to improve the risk/ reward structure of investment portfolios while also diversifying portfolios, decreasing portfolio volatility and increasing overall returns. Accordingly, a growing number of institutional investors rely on alternative investments in their portfolio makeup. There are potential risks associated with this asset class, and not all hedge funds are created equal as they have different strategies. However, in the hands of an experienced investment consultant, alternative investments can help institutional investors develop a better balance of risk and reward. The ability of an investment consultant to select the appropriate alternative investments and understand how they interface with the entire investment portfolio allows the consultant to create investment portfolios that are more in line with the risk/reward profile of the client. 20 benefits magazine october 2013