Alternative investments have made little headway in getting on retirement plan menus

Company-sponsored plans, viewed as the holy grail of asset management, is still a segment some argue is most in need of more options

Oct 9, 2016 @ 12:01 am

By Jeff Benjamin

A more than doubling of the U.S. stock market since the 2008 financial crisis has presented a persistent hurdle for most proponents of alternative investment strategies, but it has yet to derail their efforts.

A raging bull market is probably not what managers of alternative strategies envisioned in the wake of the 38% stock market nose dive that triggered the worst recession since the Great Depression.

But whether you call it tilting at windmills or just missing the point, the alt bulls are not giving up the battle for a toehold in the retail investment universe.

For perspective, consider that at the end of 2006 there were just 132 liquid alternative mutual funds managing a total of $32.6 billion. That compares with 484 liquid alt funds today managing $171.6 billion, representing a 434% increase in assets.

Clearly, the broad swath of strategies specifically designed to target niche categories, hedge risk and boost performance are gaining some traction, but not nearly enough according to the most dogged alternative investment advocates.

The area where alt strategies have made the least headway — and which is still viewed as the holy grail of asset management — is company-sponsored retirement plans, a segment that some argue is most in need of alternative investment options.

(Related read: Special report: alternative investment)

“The biggest pool of money most people have is what they're saving for retirement, and they're being told by the government and the fiduciaries that they can't manage their money the right way,” said Ed Butowsky, managing partner at Chapwood Capital Investment Management.

According to Mr. Butowsky, over any 12-month period, a standard portfolio of 60% stocks and 40% bonds will generate a return in a range between a 19% decline and a 33% gain.

Alt funds starting to decline
Source: Morningstar
Note: Figures for 2016 are through August

“In 2008, when the S&P 500 lost 38%, my average portfolio went down 4% because I had alternatives in there,” he added. “It is mathematically impossible to have a properly allocated portfolio without using alternatives.”

While the number of advisers who are fans of alternative strategies is growing, as is witnessed by the growth in funds and assets, it is still a small slice of the overall industry. And when you look past financial intermediaries to the actual company-sponsored retirement plans, alternative investments barely show up.

Brooks Herman, head of data and research at BrightScope Inc., said that of the 60,000 employer-sponsored plans managing more than $4 trillion, he sees alternative investment options making virtually no inroads.


“You might find an alternative strategy inside a sleeve of a target-date fund, but even counting REITs and commodities, it's less than 1%,” he said. “Alternatives are usually not even available to plan participants unless they have access through a brokerage account.”

“If you're going to see retirement plans add alternatives, it's going to happen with the jumbo plans first because they set the trends, and we're not seeing alternatives yet in the big plans,” Mr. Herman said. “It takes years for these kinds of changes to happen because these plan sponsors move at glacial speeds. At this point, you don't even see gold ETFs on plan menus, and you don't even see a lot of commodity products or smart beta strategies.”

From most perspectives, the bottleneck when it comes to alternative strategies starts with education, and within the education challenge reside the issues of higher fees, shorter track records and a growing fear of lawsuits tied to fiduciary duties.

(Related read: Texas regulator bans adviser from selling alts, including nontraded REITs)

With the number of liquid alt funds increasing by 266% since 2006, it would be difficult to deny the reality of shorter track records, especially given the extended bull market for stocks. Alt strategies usually show their value during market downturns.

There have been short periods of opportunity during which alternatives proved their worth. For example, amid the immediate market fallout from the late-June Brexit vote, a traditional 60-40 portfolio fell 2.7% between June 24 and June 27. Over the same period, the Goldman Sachs Liquid Alternative Investment Multistrategy peer group fell by just 80 basis points.

Norm Boone, founder and president of Mosaic Financial Partners Inc., acknowledges the recent strong stock market performance has hurt the case for alternatives, but he remains committed to reducing his clients' correlation to macro market risks.

Alt assets hit plateau
Source: Morningstar
Note: Figures for 2016 are through August

“If you separate the S&P 500's returns over the past 25 years into five-year periods, you'll see that alternatives have outperformed in three of the five periods, with a fourth one being close, and over the past five years alts” haven't performed well, he said. “We're believers that alternatives can provide some non-correction aspects and boost performance, but you've got to be willing to invest in things that don't get as much attention.”

Mr. Boone recommends that his clients have 20% to 30% exposure to alts, while Mr. Butowsky suggests 30% to 35%.

On the fee issue, it is difficult to dispute that alternative strategies have some work to do.

According to Morningstar Inc., the average expense ratio on liquid alt mutual funds is 1.823%, which compares to 1.179% for the average large-cap growth fund. That gap of 64 basis points, even across broad categories, is not lost on an investor and adviser universe that has become increasingly focused on fees and expenses.


“I don't see why the liquid alt funds have to be so expensive,” said Jason Kephart, alternatives analyst at Morningstar.

He added that the asset management industry will often respond to criticism of the higher fees by pointing out that hedge funds are still charging 2% management fees and 20% performance fees.

It's hard for investors to swallow the huge fees.—Jason Kephart, alternatives analyst at Morningstar

“It's hard for investors to swallow the huge fees,” Mr. Kephart said. “People aren't comparing them to hedge funds anymore; they're comparing them to everything else out there. If they could start dropping the fees it would make their case more compelling, but you kind of need someone to come out and do what Vanguard did with mutual fund fees by offering some cheap options to put pressure on everyone else.”

Then there's the fiduciary factor, representing perhaps the biggest and sturdiest obstacle standing between alternative strategies and retirement plan menus.

(Related read: The top FAQs on the DOL fiduciary rule)

“There's always been a challenge in the defined contribution space to try and go beyond the plain vanilla investment options, because plan sponsors don't want to take the risk of employees picking the wrong investments,” said Chris Brown, principal and founder of Sway Research.

Mr. Brown is currently tracking 43 lawsuits involving retirement plans, and the list of defendants includes financial services companies, universities and employers.

Eight of those lawsuits were filed in August and relate to expenses inside 403(b) plans.

“When you have lawyers coming after companies for putting certain investments in the plan, that will dissuade plan sponsors,” he said. “I do think there's a role for alternatives in model portfolios such as target-date funds, but the recent lawsuits may be quelling interest and slowing the adoption.”


Mr. Boone of Mosaic Financial Partners acknowledges both the real fears and the “unknowns,” but still believes investors will be better off with more access to alternative strategies.

“It will take people getting used to alternatives and seeing them work, and the last four years have confirmed their fears,” he said. “The sponsors are erring on the side of caution, and for some legitimate reasons, because the police are out there looking, and when employees get upset they're bringing suit.”

Marty Beaulier, executive chairman at Altegris, which manages nearly $3 billion worth of alternative investments, cited education and regulatory issues as the two main things keeping alternatives off retirement plan menus.

“We definitely haven't had the regulatory wind at our back, but you have to remember it took years before target-date funds became widely accepted,” Mr. Beaulier. “You really have to get financial advisers to embrace alternatives first, and many of them still don't understand it.”

I think getting alts onto retirement plans will happen, but it will take time because we have to get to the point where the complexity no longer outweighs the benefits.—Stephen Scott, managing director at Longboard Asset Management

Brandon Thomas, co-founder and CEO of Envestnet PMC, said the focus has to be at the plan sponsor level, particularly at smaller companies where the person in charge of the plan might have limited financial expertise.

“Plan sponsors, most of the time, aren't investment people and they're not familiar with the investment merits of alternatives, but they can see that the fees look too high and the track records look too short, and they don't know how to classify them so participants can know how to use them,” he said. “In 2009 there was a lot of demand for alternative strategies, but the market has done a nice job of just marching higher and people have forgotten about the need for alternative strategies.”

Short of a major and prolonged stock market pullback that would shine a light on those alternative strategies that truly are earning their fees, the alternatives camp will have to keep banging the drum of diversification as broad market valuations climb higher.

(Related read: Nuveen Investments expands access to alternatives for financial advisers' wealthy clients)

And that message will first have to resonate with financial professionals, according to Stephen Scott, managing director at Longboard Asset Management.

“We're spending a lot of time attempting to empower advisers to get a better understanding of how to use alternatives, because the nature of alternatives is so different, even within the same category,” he said. “I think getting alts onto retirement plans will happen, but it will take time because we have to get to the point where the complexity no longer outweighs the benefits.”


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