Should 401(k) Plans Embrace Alternative Investments?

New Ideas The fund industry's trade publication, Ignites, reports that a startup is providing 401(k) plans with a difference. (No link, paywalled.) Rocket Dollar's offering "enables you to invest beyond traditional stocks and bonds." Rocket Dollar 401(k) plans enable their owners to buy cryptocurrency, rental properties, and venture-capital funds. Perhaps they wish to make small business loans. When it comes to possible investments, "the sky's the limit" for those who board the Rocket Dollar...rocket.

Well, sort of. The company's website carries the warning that the investments must be "allowed by the IRS." That eliminates collectibles, including gold coins. Missing is another caveat: Many of Rocket Dollar's suggested investments are, by SEC regulations, private placements for accredited investors. Rank-and-file employees need not apply.

But never mind that. Assume for the moment that the investment sky is indeed the limit--which it may well become, with the current Washington administration seeking financial deregulation. Would that be beneficial? If that answer is "Yes," will 401(k) participants avail themselves of the opportunity?

Basic investment math indicates that Rocket Dollar is on to something. Harry Markowitz earned his Nobel for demonstrating that portfolios are not built on expected returns and risk alone. How the holdings interact also matters. The less they sing in harmony, the better. Clearly, Rocket Dollar's suggested investments offer excellent diversification--better than is normally available in 401(k) plans. Its menagerie quacks, barks, and howls.

At What Cost? Now come the drawbacks.

The first problem is that the rent is too damn high. When two professors at the Air Force Academy (William Jennings and Brian Payne) examined how diversifying into nonstandard asset classes would work in practice, as opposed to the cost-free assumption that is used in theory, they concluded that "Fees Eat Diversification's Lunch." They write, "We show that the fees on diversifying asset classes can be astonishingly high [the authors' italics] relative to their diversification benefit." Often, they find, the extra costs of exotic securities fully consume their advantages. The profits are reaped by the investment managers, not the shareholders.

The authors are particularly wary of hedge funds, private-equity funds, global bonds, and "narrow mandates in public equity" (that is, sector funds or style-constricted funds, such as small-company value). They are somewhat more sanguine about emerging-markets equity and real assets, although even in those areas only a "subset" of investments were attractive.

Not Transparent A second concern is that even if Rocket Dollar's customers have access to appropriately priced options--the company's website is currently mum on the details--they won't necessarily be positioned to make sound investment decisions. Nonpublic securities are exactly that: nonpublic. Third-party reports on such securities are scarce at best. For the most part, the prospective buyer must rely on the word of the issuer.

This, as any experienced investor realizes, is an obstacle. It is not that 401(k) participants should be wary of Wall Street bearing gifts, but rather that they should be prudent. As Ronald Reagan advised, "Trust but verify." (Upon further thought, that approach is too generous. The investment motto should be instead, "Don't trust until you have verified.") However, for many of Rocket Dollar's plan options, verification will not be possible. They must be purchased on faith.

To summarize, having access to exotic, nonstandard investments makes perfect sense … in a laboratory. Elsewhere, it is problematic. This is no fault of Rocket Dollar's. The 401(k) plan provider does not set its offerings' prices, nor does it give investment advice. Rather, it serves as a conduit, by connecting buyers (company employees) and sellers (investment-management firms, bitcoin owners, those seeking loans, and so forth).

Specialized Tastes Happily, I believe the answer to my second question--"Will 401(k) participants avail themselves of the opportunity?"--addresses much of these concerns. For the foreseeable future, Rocket Dollar will appeal to a small clientele. It will not reach the mainstream.

To explain: 20 years ago, open brokerage platforms for 401(k) plans were the rage. As they became more experienced at investing, it was believed, employees would not longer be satisfied with off-the-rack 401(k)s and would instead seek to customize their holdings. That did not occur; few 401(k) participants opened brokerage accounts.

Indeed, most employees found the idea distinctly unappealing. They did not seek greater complexity. On the contrary, they wished for things to become simpler. Thus, employees voted with their feet to do less with their 401(k) plan, not more, by gravitating toward target-date funds. Target-date funds were off-the-shelf, as opposed to being customized, but they had the blessing of being easy to select.

(In 1998, I paid $150 to open a 401(k) brokerage account, so that I could avail myself of more than 10,000 stocks and mutual funds. Those trades never happened. One thing led to another, and inertia took hold. Just as well. My $150 expenditure was a pittance compared with my potential losses, had I bought the stocks that caught my eye.)

Of course, there are always exceptions. Per Ignites, Rocket Dollar's founder, Henry Yoshida, was inspired to start the firm after talking with a 28-year old Lyft driver who had invested $100,000 in alternatives, outside of a 401(k) plan. (Count me impressed--When I was 28 years old, my net worth was negative.) That driver, clearly, is Rocket Dollar's target market.

Generation Gap Perhaps other millennials will be, as well, when they accumulate enough assets and become old enough to take retirement planning seriously. Perhaps for them, the distinction the older generations make between conventional investments (stocks, bonds, and mutual funds) and "alternatives" such as cryptocurrencies, real estate, and unregistered funds will seem artificial. Perhaps the costs for alternatives will decline, and the available information will rise.

Perhaps. But if so, it will be a slow build. Few 401(k) participants will own bitcoin in their plans anytime soon.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.