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By Nadia Papagiannis, CFA | 06-14-2013 04:00 PM

Why Retirement Plans Are Targeting Alternatives

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.

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.

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