Investment Research: Alternative Investments in Defined Contribution Plans Mari Tsagareishvili Investment Analyst, Cammack Retirement Group The financial crisis of 2008 sparked investors interest in finding opportunities for investing outside of traditional asset classes. Recent increased correlation among traditional asset classes, significant drawdown in the equity market during volatile periods and low interest rates in global bond markets led investors to seek untraditional strategies, such as liquid alternatives. The term liquid alternative covers a diverse array of investment strategies using complex, unconventional methods that hold the prospect of better diversification and higher returns. Alternative investment strategies, executed in hedge funds, have been recently introduced to the mutual fund industry, marketed as liquid alternatives. Liquid alternatives are a natural extension of hedge funds, packaged as mutual funds or as ETFs, typically with significantly lower minimum investments and no lock-up period requirements. Previously, hedge funds were available to only private, high net-worth individuals or large institutional investors, such as Defined Benefit (DB) plans. According to Morningstar the alternative category group enjoyed the highest organic growth rate of all asset categories in 2015, just as it had in 2014. The assets under management of alternative mutual funds increased from less than $100 billion in 2008 to $765 Billion, with 677 liquid alternative investment strategies mutual funds across 15 unique subcategories. 1 ALTERNATIVES DEFINED With no standard definition of the term, alternative generally refers to any asset class that has different risk characteristics than traditional equity or fixed income asset classes. In fact, precisely which asset classes are considered alternatives changes over time. As an asset class becomes more readily available in the market, and more widely held and better understood, it often moves into the mainstream and ceases to be considered an alternative. Exhibit 1 highlights some of the asset classes currently considered to be alternatives. Note that the list is not exhaustive and continues to expand and evolve. In 2016, Morningstar has added new categories, including Long-Short Credit and Options Volatility. EXHIBIT 1: Liquid Alternatives Alternative Asset Classes Multi-Currency Real Estate Commodity Single-Currency Infrastructure Liquid Alternatives Alternative Investment Strategies Multi-Alternative Managed Futures Global Macro Bear Market Equity Market-Neutral Long-Short Equity Non-Traditional Bond Private Equity 1 Goldman Sachs: liquid alternative Investments MAPS 1
Alternatives are divided into two broad subcategories: alternative asset classes and alternative investment strategies. Alternative asset classes provide exposure to alternative risk and returns, driven by different economic factors than traditional asset classes. Alternative investment strategies are active strategies that give exposure to unique management strategies. Due to this factor, the success of each fund is highly dependent on the skill of the portfolio manager, more so than traditional investment strategies. Alternative asset classes, such as commodity and real estate, are widely used in the industry and readily accepted in Defined Contribution (DC) plan menu design. The role of real estate as a strong enhancer of risk-adjusted returns in an investment portfolio is widely accepted. Historically, alternatives as an asset class play a different role in a portfolio; traditionally, hard assets such as gold and commodities have provided protection in periods of high or rising inflation. Given lower capital market return expectations of traditional assets, private equity can also play a role in providing higher returns in a portfolio. Real Estate Real Estate can be an attractive asset class for DC plans; however, illiquidity poses problems. DC plans tend to use real estate investment trusts (REITs) as an investment menu choice for participants. However, demand from investors seeking the high yield REITs provide has made this asset class fairly expensive. Some funds invest directly in real estate property, but will need to include a cash buffer or REITs to provide liquidity in the retirement portfolio. It is common to have a liquidity wrapper of 20%-25% of assets, but these features dilute the full potential of the asset class. Long-Short Equity In an effort to enhance returns, long-short equity investment strategies buy long equities that are expected to increase in value, while selling short equities that are expected to decrease in value. Investors are more inclined to establish long positions and, therefore, short positions may be less efficient. Providing the opportunity to invest long and short can help achieve alpha. LIQUID ALTERNATIVES Although liquid alternatives employ the same investment strategies as hedge funds, there are significant differences in how they are structured. Leverage is limited in liquid alternative mutual funds, whereas hedge funds can use unlimited borrowing to magnify their returns. The requirement that 85% of mutual fund or ETF holdings offer daily liquidity changes how liquid alternatives can be invested. Due to this, hedge fund strategies have not translated clearly in mutual fund classifications. EXHIBIT 2: Liquid Alternative Mutual Funds Compared to Hedge Funds Liquid Alternative Mutual Funds Hedge Funds Liquidity 85% in liquid, easier to sell assets Monthly or quarterly; some may impose lock-ups Pricing valuations Daily Typically monthly Short Selling 33% limitation on short selling, and covering the full value of short sales by holding equivalent amount of Unlimited collateral Transparency Quarterly disclosure of holdings Public disclosure of holdings not required Regulation Investment Company Act of 1940 Registration with SEC depending on the number of clients and asset size The different characteristics of the two make it more challenging for liquid alternative mutual funds to replicate, and limits the implementation of, the full hedge fund strategy. Whether or not an investment strategy closely tracks its hedge fund counterpart depends on the investment strategy chosen. Event-driven (seeking to exploit pricing inefficiencies that may occur before or after a corporate event) and relative-value hedge fund strategies cannot 2
completely be replicated in a liquid alternative. Event-driven strategies usually are classified as equity marketneutral, which take long and short positions and seek to eliminate all market exposure. Relative value hedge fund strategies can be categorized either as non-traditional bond or equity-neutral strategies; in general they both are trying to benefit from market price discrepancies. Equity market-neutral investment strategies have underperformed their hedge fund peers due to their limited ability to magnify returns through more leverage and less liquid investments. According to Goldman Sachs research, the equity long-short, global macro and multialternative categories have historically performed somewhat more in line with their hedge fund counterparts. 2 Different Flavors of Liquid Alternatives Each liquid alternative category exhibits various risk and return characteristics and behaves differently, depending on market conditions. Additionally, each exposes an investor to the risk of sustained underperformance due to the strategy s style or manager s uncompensated risk. Due to the inconsistency in returns across liquid alternative categories from year to year, selecting the top-performing category in a given year let alone selecting top performing managers is challenging. EXHIBIT 3 Hedge Fund Strategies Morningstar Category Strategy Potential Benefits Risk/Unfavorable Environment Equity Long/Short Equity Long/Short Seeks to generate returns on both the long and short side Lower volatility than long-only and ability to provide downside risk mitigation Stock market risk as it can have increased correlation with long-only equity; typically lags bull market returns Hedge Fund of Funds Multi-Strategy Allocates across a broad range of liquid alternatives strategies Diversification across strategies, avoiding highs and lows of each category Higher fees Equity Hedge: Short Bias Bear Market Dedicates large allocations to short positions to take advantage of anticipated market or stock declines Protection in down markets Underperformance in strong up markets Macro/Tactical Trading Managed Futures Seeks to generate positive returns by capturing price trends across major asset classes Offers a good diversification during market stress Can lag in absence of market trends Event Driven /Relative Value Market Neutral/ Non-Traditional Bond Seeks alpha from market price discrepancies while controling market factors Control on market factoers and greater focus on generating returns through market/sector mispricing Low returns in periods of low liquidity and low dispersion Equity Hedge: Neutral Market-Neutral Achieves market neutrality by matching long and short positions Control on market/ equity risk, and greater focuson stock selection Can lose money on both sides 2 Goldman Sachs: liquid alternative Investments MAPS 3
To eliminate each strategy s unfavorable risk exposures, many liquid alternatives are offered as multi-strategy funds. These funds allocate across a broad range of liquid alternative strategies to avoid the highs and lows of any given year or any given strategy. Multi-alternative funds will typically employ sub-advisors and invest in a variety of funds. Therefore, these multi-alternative funds tend to have an additional layer of fees and may be relatively expensive. EXHIBIT 4: Liquid Alternatives Performance (%) Morningstar Category Average 2015 2014 2013 2012 2011 2010 2009 2008 Multi-Strategy -2.58 1.81 4.16 3.87-2.79 5.51 14.2-22.14 Managed Futures -0.94 9.04-0.95-7.39-6.92 3.77-5.8 8.33 Long-Short Equity -2.02 2.92 14.62 5.15-2.81 4.13 10.46-15.4 Bear Market -5.05-17.48-34.36-23.7-10.85-24.28-33.88 29.95 Equity Market Neutral -0.25 0.76 2.92 0.18-0.3-2 -1.18-0.33 Non-Traditional Bond -1.41 1.24 0.29 7.5-1.29 5.44 19-16.76 Key Considerations for Liquid Alternatives in Defined Contribution Plans Costs are generally higher among liquid alternatives strategies than among traditional investment strategies. Manager fees also vary, depending on the investment strategy chosen, as well the manager selected in each category. Much as with traditional hedge funds, manager selection is especially critical to the success of a liquid alternatives fund. The dispersion of returns among managers is significantly higher than traditional investments. Many alternative strategies are inherently more dependent on portfolio manager expertise, as the larger component of returns are derived from active manager decisions, not market returns. Additionally, the short track record of these liquid alternative strategies makes them more difficult to assess and complicates the analysis. The various liquid alternative strategy funds have been around less than five years and have not been tested in periods of high volatility. Alternative asset classes are usually included as an asset class in a target date fund or a custom model solution. They can be particularly beneficial to DC plan participants as they approach retirement. Real assets in a portfolio also provide protection in inflationary periods. For example, inflation has not been a headline issue for some time, but inflation risk can be significant for those close to, or in, retirement. Participants need investment strategies that help protect their purchasing power. Incorporating liquid alternative investment strategies in DC plans is still in the early stages of development. The greatest opportunities for liquid alternatives in DC plans are within target date funds or custom solution portfolios with ongoing monitoring and oversight. Including liquid alternatives strategies in a portfolio can minimize the effect of a drawdown and provide a better risk/return profile. For plans considering incorporating liquid alternative investment strategies into the plan lineup it is important to outline clear goals for the investment strategy in the plan investment menu. Research has shown that in order for a liquid alternative strategy to make a marginal difference in the portfolio, an allocation of approximately 15%-20% is necessary 3. This allocation entails higher expenses, complexity, and certain trade-offs. As these strategies might lag in strong up-markets, an allocation of 5%-10% in the portfolio can negatively affect performance in strong bull markets. Cammack Retirement acknowledges that liquid alternatives can diversify portfolios and mitigate risks. However, as a stand-alone asset class the participant usage may need to be capped by the recordkeeper to a maximum allowable amount, much like employer stock. The better solution might be to incorporate liquid alternatives into a target date fund. A small allocation might not make an appreciable effect on mitigating risk; therefore, a 15%-20% 3 BlackRock: Alternative Path: Is it Time for Alts in DC? Cammack Retirement 2016 All Rights Reserved Confidential Information 4
allocation to alternatives may be more appropriate. In order to compensate for fees that are higher than traditional asset classes, some custom target date funds have examined their risk budget. For example, a shift to indexing in a more efficient asset class, such as large cap equity, can allow the manager to alleviate the higher expenses of liquid alternatives and potentially improve the risk/return profile. With interest rates near record lows and stock valuations elevated, some consideration of alternative strategies should be given, as they may potentially reduce volatility, enhance returns, and deliver lower correlation with traditional assets. Plan sponsors should be careful, as most of the alternative investment strategy funds lack a long-term track record, have inconsistencies in their performance, and exhibit high disparity among managers. They also have higher expenses and have not been tested in full marked circles. These factors complicate due diligence for a retirement plan sponsor. ABOUT CAMMACK RETIREMENT Cammack Retirement Group is a leading provider of investment advisory, consulting and actuarial services. We work with the nation s leading academic and research institutions, healthcare providers, coprorations, non-profit organizations and public sector employers to help them manage fiduciary risk. For more information on our services, please contact Mike Volo, Senior Partner, at 781.997.1426 or mvolo@cammackretirement.com. Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Investment products available through Cammack LaRhette Brokerage, Inc. Investment advisory services available through Cammack LaRhette Advisors, LLC. 100 William Street, Suite 215, Wellesley, MA 02481 p 781-237-2291 Cammack Retirement 2015 All Rights Reserved For Plan Sponsor Use Only 5