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Why Retirement Plans Are Targeting Alternatives

Fri, 26 Jul 2013

Volatility and changing demographics have target-date fund and defined-contribution plan managers considering alternatives as hedging tools against fixed-income rate risk, says Arden manager Henry Davis.

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Video Transcript

Nadia Papagiannis: Hi, my name is Nadia Papagiannis. I'm the director of alternative fund research at Morningstar, and today I have with me Henry Davis, manager of Arden Alternative Strategies, ARDNX. And Henry just participated with me on the Two Worlds Collide panel at the Morningstar Investment Conference.

Henry, thank you so much for being here with us today.

Henry Davis: Thank you for having me.

Papagiannis: Henry, on our Two Worlds Collide panel, we talked about how the mutual fund industry and hedge fund industry are converging. And that this is not just a short-term trend; it's a very long-term fundamental shift in what's happening in asset management. But why hasn't this happened already? I mean, we've had alternative mutual funds for a few years now. Why haven't we had alternative mutual funds in defined-contribution plans?

Davis: There have been different versions of alternatives as you know that have found their way into mutual funds. But what there have been less of are actual hedge fund managers who are either running their own mutual funds or being included in multimanager programs, for instance the fund of funds program within the mutual fund itself. That just hasn't existed until within the last couple of years, and there are whole host of reasons for that. One of them is most hedge fund managers didn't have a whole lot of incentive to participate in a mutual fund because they were doing just fine with their being quite well-compensated under a 2 and 20 type of fee structure and having large, primarily pension plan clients as investors.

But as they have started to see the same demographic shift that I've described, which is essentially over time a shrinking of the defined-benefit pool generally and a growing of the defined-contribution pool, there has been a willingness on the part of hedge fund managers to figure out how they can participate in a 40 Act, or the mutual fund, type of structure. What do I need to do? What compromises do I need to make? And can I still execute my strategy and deliver the return stream that I need to, given those constraints?

The other part of this is defined-contribution plans are really early in terms of their efforts at diversifying. They have been reasonably satisfied relying solely on stocks, bonds, and cash. But 2008 was a real wake-up call especially in the target-date fund area which is so significant and so impactful as a percentage of total self-directed retirement assets. After those funds experienced drawdowns, there was a real push after 2008 to find out how can I diversify my risk? How can I bring into this fund a return stream that is going to have different characteristics, that's going to be uncorrelated, and that isn't going to draw down severely when markets sell off? That's how the debate began for inclusion of alternatives in defined-contribution-type plans.

Papagiannis: Is there a change in how target-date funds are structured now than how they perhaps used to be at the beginning that would incorporate more of these alternatives.

Davis: Yes. Target-date funds have been incredibly successful. Some people are shocked when I say that because you can look back at how they performed in 2008 and they were not immune to the suffering of the rest of the investment world. They certainly took their hits, but they are successful in the sense that assets continue to flow into them, and in fact, not only at an increasing rate but an accelerating rate. And part of the reason for this is the demographic stuff that I talked about earlier, but also the government is behind it, as well, because there is some legislation that has been passed going back to the Pension Protection Act and other things that basically make it easier for dollars to flow into target-date funds through auto-enrollment and acceleration. There are other technical reasons why the dollars are continuing to flow.

But as target-date becomes an ever-increasing component of the defined-contribution space--and I think some of the management consulting firms have published research on this, including McKinsey stating that out into the future, 2018 or 2020, by one of those dates, half of self-directed retirement assets is going to consist of these target-date funds--these are very significant investment pools going forward.

Until now, there has not been an effort or a push for them to have diversification. But within just the last couple of years and really just in the last, I'm going to say last year, there has really been a growing, there has been a drumbeat of interest in demand from target-date funds to come up with alternatives or some way to diversify the risk in a target-date fund, and maybe surprisingly, not solely risk to equity markets, but risk to rates. 

The reason why this is so significant is every target-date fund essentially has a glide path, a multiyear and in some cases a multidecade glide path to a date. Whenever it is that you are going to retire, you should receive your principal, you the investor. In order to reduce the risk of the principal being available and delivered to you, these programs all rely very significantly on fixed income as a derisking technique as you approach the target date, so that incrementally fixed income goes up and up and up and up as you approach the date, which makes a lot of sense expect for one thing.

What happens if rates go up? Fixed income declines. You're almost doubling up on the risk, because exactly at the time when you need to derisk--because you cannot afford a drawdown because you're running out of time as you approach the target date, and you don't have the time to recover from a drawdown--exactly at that same moment, you're increasing your allocation to something that is extremely vulnerable to rising rates.

In our instance, an example might be, why would you want to include an alternative? The push to including alternatives in this case is driven by a desire, and it's almost an urgent desire on the part of the managers and the sponsors of these target-date funds. How do I find a substitute for fixed income? How can I derisk using a different type of return stream? And specifically, how can I find a return stream that is not only going to go down when interest rates go up, but ideally, is it possible to create, to engineer a return stream that can in fact go up in a rising-interest-rate-environment? That's when hedge funds come into the conversation because it's possible to create a program that can do that.

Papagiannis: A lot of that the largest target-date fund families don't have in-house alternatives strategies. Are they opening up to outside alternative strategies?

Davis: Yes. Historically, target-date funds have been closed architecture, where whoever the sponsor is, if it's a mutual fund complex, what you have in there is you have the target-date fund, and inside the target-date fund are that same mutual fund complex's own mutual funds. Recently or more recently within the last two years or so, there has been a push, and you can see some of the major mutual fund complexes are now pushing to have open architecture in their target-date funds, so that they're looking to basically hire managers and include mutual funds from outside their own complex. That opens the door for there to be, for instance, an alternative mutual fund that could be embedded in a target-date fund.

And also on the corporate side, there's been a push to create custom defined-contribution and target-date funds. These are custom target-date funds, where you actually take your population of retirees or employees, and you structure a program that really is designed to more closely match their exact age, health, and other demographic characteristics.

Papagiannis: The plan sponsors are in fact asking for these alternatives, as well?

Davis: Exactly.

Papagiannis: Henry, we see the demand side, we see the supply side, why all these liquid alternatives are pretty much here to stay. But do investors really need alternative investments? Why can't they just go to cash? There's been a lot of talk at this conference actually that all you need is stocks, bonds, and cash? What's wrong with cash?

Davis: Nothing is wrong with cash. Cash is actually dry powder. Cash is the ability to capitalize on an opportunity that may happen in the future. But cash also takes discipline because you have to have a methodology or process or willingness to deploy it at the right time. And typically cash doesn't get invested when it really should be. In fact, more cash gets raised. That's the good thing you could say about cash.

The bad thing you can say about cash is really mathematical, which is right now cash is a guaranteed negative real rate of return, and that's tolerable for some period of time. Waiting for something better and preserving your principal in the meantime, those are very reasonable reasons to have cash. Where it becomes problematic is if you have a longer time horizon--for instance, if you're saving for retirement--then your mission is you want to compound your capital at a rate of return that is going to help you achieve your objectives, which is to replace your current income when you're in retirement and you don't have income. But you can't do that, if you're earning a negative real rate of return.

Papagiannis: Cash is something that is maybe tactical and most people are very good at tactically using cash. Alternatives give potential real-return opportunity that is not a stock, that is not a bond, that could help diversify and help people reach their retirement goals.

Davis: Yes. You could use a balanced, well-structured, pool of alternatives to produce a return stream that has some premium over cash, and when you get into talking about hedge funds, there are so many different strategies, it's very hard to generalize. But to use a balanced low-volatility pool as something to use, instead of having to rely so much on a guaranteed negative return that you're going to get from cash, is a reasonable approach.

Papagiannis: All right. Thank you so much, Henry.

Davis: Thank you.

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