Use of Liquid Alts in Defined Contribution Plans is on the Rise

Use of Liquid Alts in Defined Contribution Plans is on the RiseTraditionally, a defined benefit pension was seen by most Americans as an important component of the American Dream. Workers would begin with an employer right out of high school or college, with every intention of working with the same firm until retirement, at which point they’d receive guaranteed retirement benefits.

Global realities started catching up with the American Dream in the 1970s, and the shift towards defined contribution plans – such as the 401(k) – accelerated in the 1980s and 90s. Unlike defined benefit plans, defined contribution plans guarantee contributions to a retirement account, but they do not guarantee future retirement benefits if the account’s investments don’t perform.

Today, defined contribution plans are the norm in the United States, while defined benefit plans are being closed and are slowly declining in their overall availability to employees. There are pros and cons to each kind of plan, but up until recently, defined benefit plans had a distinct and unfair advantage in that they could invest in alternative investments, whereas defined contribution plans were largely restricted to traditional stock and bond investments. Thankfully, liquid alternatives have provided a solution to this disparity.

Alternative Funds as DC Plan Options

Back in February, John Hancock Investments issued a statement saying its defined contribution clients were “adding alternative mutual funds to their menu of plan options at a rapid pace.” Between 2012 and February, 2014, more than 400 plans added John Hancock’s alternative strategies, including the John Hancock Global Absolute Return Strategies Fund and the John Hancock Alternative Asset Allocation Fund.

According to Todd J. Cassler, President of Institutional Distribution for John Hancock Investments, retirement plan sponsors are finding multiple benefits in the “all-in-one approach” of investing in multi-manager alternatives funds, rather than individual alternative investments. “Because the assets are professionally allocated among multiple alternative strategies and managers, participants don’t need to worry about being conversant with all the details of all the strategies. At the same time, plan sponsors are able to add this varied alternative asset category in a single, diversified option.”

The Endowment Approach

John Hancock Investments isn’t the only firm touting the expansion of alternative investments in defined contribution plans. Last week, the Alta Trust Company and ETF Model Solutions announced the launch of the Endowment CIF (Collective Investment Fund), which is designed to emulate the strategies of endowments, pension funds, and defined benefit plans. But instead of investing in illiquid alternatives like limited partnerships and private placements, the Endowment CIF will use alternative ETFs and mutual funds to obtain its alternative allocations.

Collective Investment Funds (CIFs) are pooled investment vehicles that are only available to qualified investment plans, but they’re otherwise similar to open-ended mutual funds. ETF Model Solutions says the Endowment CIF offers reduced portfolio volatility due to its inclusion of alternatives, which have little correlation to the stock and bond markets. The fund is designed to have roughly 40% of its assets allocated to global stocks, 20% to global bonds, and 40% to liquid alternatives.

The Alta Trust Company, which sponsors the Endowment CIF,  has selling agreements with most retirement-plan platforms, which means that most advisors will be able to offer their clients exposure to the Endowment CIF through existing platform relationships.

Alternatives in Target Date Funds

According to T. Bondurant French, a CFA with Adams Street Partners, target-date funds are the largest growing segment of the defined contribution plan market today, and they are a good fit with alternative investments. “I don’t see most individual participants having enough expertise or education to make choices on a monthly or quarterly basis between high yield, global fixed income, global equity, hedge funds, commodities, real assets and private equity. But those options do make a lot of sense in a professionally managed strategy like a target-date fund.”

A 2014 PIMCO survey found that 98% of consultants support or strongly support use of alternatives within target-date strategies.

Mr. French participated in an August 5 round-table discussion on the use of alternatives in defined contribution plans, along with Robert Capone of BNY Mellon and David Skinner of Prudential Real Estate Investors. The three gentlemen all projected increased use of alternatives within defined contribution plans, with Mr. Skinner saying, “Alternatives are becoming attractive to plan sponsors who are seeing the potential to deliver better outcomes in the long run by addressing the three key themes of dampening volatility, protecting the downside, and reducing the potential impact of inflation.”

  • Brad Case, PhD, CFA

    To me the most important point made in the August 5 round-table discussion is Mr. French’s point that “the true measure of the value of alternatives will be the net-of-fee return, and the potential improvement in risk-adjusted performance of the portfolio.” I’m surprised that this article didn’t even mention it.
    Unfortunately, that’s where the most prominent segments of the alternative investments spectrum have historically come up short. Most of the independent research on the actual performance of private equity suggests that investors in private equity have done poorly on a net risk-adjusted basis. For private equity real estate the historical record is much worse: more than 35 years of woefully bad returns. For hedge funds the record is decidedly unclear, so let’s not get ahead of ourselves by assuming it’s good.
    Until the net risk-adjusted performance of alternative investments is shown to have improved relative to low-cost listed assets, there’s no reason to cheer any growth in the use of alternatives in DC space.

    • I agree with your two points that the addition of any investment whether traditional or alternative to a portfolio should add value either from a return enhancement or risk reduction perspective, net of any costs.

      When you are investing in the illiquid private equity and real estate markets you have to make sure that the manager has ranked in the top quartile on a consistent and long term basis, as there is some value in past performance being a decent predictor of future returns. If you look at some of the broader market averages like the Cambridge Private Equity Indices or the NCREIF Indices for private real estate, you will find that these do better than the pure publicly traded equity indices.

      As a matter of fact, we have created a Liquid Endowment Index that mirrors the average asset allocation of 800 Endowments in the country. This Index has done better than your plain vanilla stock and stock/bond indices both on an absolute and risk-adjusted basis, since its inception in July-2000. I am more than happy to share with you further details on this Index, if you are interested. You can email me at [email protected].

      Thanks for your comment!

      • Brad Case, PhD, CFA

        Thanks for your thoughts.
        (1) What you said regarding the NCREIF Indices is absolutely false. Since the inception date of the NCREIF Property Index at the end of 1977, the average gross total return has been 9.18% per year, compared to 12.90% per year for listed equity REITs. Institutional investors pay about 1% per year on average to invest in core properties, so their net returns averaged about 8.18% per year; for investors in listed equity REITs the expense ratio for a broad-based ETF are closer to 0.12% per year, so their net returns would have averaged about 12.78% per year. Similarly with open-end core private equity real estate funds: according to the NCREIF ODCE, their net total returns averaged 7.45% per year over the same period. That means an investor who put an initial $10,000 into core private equity real estate funds at the end of 1977 would have had a portfolio worth just $137,532 at the end of June 2014 whereas the same initial investment in listed equity REITs would have had a portfolio worth have been worth $801,304–that’s nearly six times as much! The NCREIF/Townsend Value-Added Funds Index did even worse over a shorter time period (1988Q2-2013Q3): net total returns averaging 5.84% per year compared to about 10.63% per year for listed equity REITs, implying portfolio wealth of just $42,526 for so-called “value-added” private equity real estate compared to $141,963 (more than three times as much) with listed equity REITs. The NCREIF/Townsend Opportunistic Funds Index showed average net total returns of 8.22% per year (1988Q4-2013Q3) compared to 10.69% for listed equity REITs, implying portfolio wealth of just $72,006 with “opportunistic” private real estate compared to $136,781 (nearly twice as much) with listed equity REITs.
        (2) Perhaps you could provide a similar comparison for the Cambridge Private Equity Indices. Don’t forget to use NET returns, not gross, because the costs of active management are dramatically higher than for passive management, especially in illiquid private assets. I can share the results of several empirical studies by independent academic researchers, if you haven’t done the research yourself.
        (3) Investors who believe they can predict which managers will provide top-quartile returns (whether in private equity or in pivate equity real estate) are deluding themselves. Harris, Jenkinson, Kaplan & Stucke [2014] found that since 2000 there has been no persistence in private equity returns at all. Korteweg & Sorensen [2014] reached the same conclusion; so did Braun, Jenkinson & Stoff [2013].
        (4) Finally, it is important for investors to understand that the reported returns of private equity managers (and private equity real estate managers), to a very great extent, ARE the top-quartile performance! Very few institutional investors make any investments in private equity funds or private equity real estate funds without hiring investment consultants–at great expense–to research the possible funds and identify the ones that will perform best. The fund managers who are not selected as the top-quartile performers simply don’t get capital, so their performance doesn’t get measured by the available indexes. So when the best-performing private equity and private equity real estate managers underperform passive investments in public markets through low-fee index ETFs and index mutual funds, that’s a pretty damning result!

        • You forced me to take another closer look at the underlying data for NCREIF Property and Wilshire US REIT TR Index. You are absolutely correct, that Wilshire US REITs have returned 12.62% since Jan-1978. That compares to 9.2% for NCREIF.

          However, this analysis is one dimensional as it only considers returns and does not factor in the Risk dimension, which could be proxied by Volatility and/or Maximum Drawdown. When you factor in these two metrics, NCREIF Property beats it hands down on a risk-adjusted basis. In our business, it is all about generating the best risk-adjusted returns and not just relative returns in a vacuum. As a matter of fact, the US REITS had a massive drawdown of 68% during the recent financial crisis of 2008, which compares to NCREIFs of 23.8%. Also, the annualized volatility for NCREIFs is 4.3%, which is a fraction of the Wilshire REIT index at 19.5%.

          As Asset Allocators, our job is to produce the best risk-adjusted returns in a globally diversified portfolio. We believe that the Endowment approach of asset allocating accomplishes this objective really well. We do believe that DC Plan participants should have the opportunity to invest in Alternative strategies that can help broaden the investment universe and potentially perform better than two dimensional stock-bond allocations.

          Let’s leave the Private Equity discussion for another day!

          • Brad Case, PhD, CFA

            Thank you for looking again at the data on returns.
            You should know, however, that the NCREIF Property Index is practically useless for the purpose of measuring volatility, and so should NEVER be used to evaluate risk-adjusted returns (or correlations). The NPI measures returns using appraisals, which fail in measure volatility in four ways:
            (1) Appraisals are typically performed only once a year–and once every three years was standard until recently–which means that most of the appraised values used to produce the index in any given quarter are stale.
            (2) Appraisers suffer from the behavioral bias known as “anchoring,” which means that they tend to place too much weight on a previous known value and too little weight on the current unknown value. Empirically, the NPI suggests that appraisers put about 80% weight on the previous appraised value and only about 20% on the current actual value.
            (3) Appraisal-based indexes such as the NPI measure, in effect, the average value of an asset over the course of the quarter, whereas indexes of listed assets, such as the Wilshire US REIT Index, measure the value of the asset as of the last trade on the last day of the quarter. In order to compare accurately the volatilily of an appraisal-based index and a listed index, you should do something along the lines of averaging the values of the listed index across all the trading days in the quarter.
            (4) Finally, appraisals are notoriously inaccurate–not because appraisers aren’t good at what they do, but because what they try to do is very difficult. The average appraisal error in the NPI databased is more than 10%.
            NCREIF also publishes an index based on actual transaction prices for properties in the same data base. The volatility of the NCREIF Transaction Based Index (NTBI) is exactly the same as the volatility of an index of listed equity REIT returns after eliminating the effects of leverage to make them comparable. And that’s before averaging the REIT index across trading days–if you also do that, REIT returns appear to be substantially LESS volatile than private real estate.
            What that means is that private real estate investments have provided dramatically lower returns over very long histories, with equal or even greater volatility compared to listed equity REITs. Private real estate has been dismal even on a risk-adjusted basis.

          • Brad-

            Your depth of knowledge and mastery of your data sources in the real estate and equity arena are excellent, and I appreciate the dialogue.

            As we both know, all indexes have their strengths and weaknesses, and it’s the prerogative of each manager/investor to determine whether or not the characteristics of a particular index are useful for their own needs. For instance, a particular investor may invest in several private properties near his hometown. The only way for him to measure his own portfolio’s result in an objective manner (outside of a “goals-based” measurement process) in an “apples to apples” comparison is an index such as Wilshire US REIT TR or
            FTSE NAREIT Equity REITs TR. It probably won’t matter to him whether there is bias in the index or not because the appraiser of his properties will have a bias. (As a matter of fact, my home was recently appraised by the city and I can assure you that the appraiser had a positive valuation bias!). The exercise of whether or not the investor should have made an investment in a publicly-traded REIT rather than in his private properties isn’t an issue to him/her. Perhaps he/she had IRR forecasts for the property that were favorable, or perhaps he/she felt they could make improvements that would generate a higher return than a passive investment in a publicly-traded security. In the end, this just doesn’t matter-
            he just needs an appropriate measuring stick.

            Incidentally, I do share your enthusiasm for publicly-traded REITs. We use them in our private client portfolios, our Endowment Collective Fund, and public REIT indexes occupy two slots in our Endowment Index. As an asset class, we value them very highly for their ability to generate returns for our clients, generate income, and provide for an inflation hedge.

            Back to alternatives, specifically liquid alternatives, which was the author’s original point- many investors have become too focused on liquid alts and that trend is finally starting to be seen in the DC space. I suggest that this is just a start, and there will be tremendous
            growth in the use of liquid alts in the DC space. Liquid alts have seen tremendous growth in the past few years as investors reflect upon the past and look for solutions beyond the stock and bond only portfolios that have failed them in the past. Investors are seeking more out of their investments than high costs and associated hassles of illiquidity, high minimums, K-1 tax reporting, scandals (Madoff), lack of transparency, and ineffective price
            discovery/valuation in the private equity and hedge funds space. These investors were supposed to get a return premium for their effort, but, as you mention, in many cases, that has not occurred. Even CalPERS is moving away from their private hedge funds.

            Enter liquid alts. They offer the potential to improve investor risk-adjusted returns, net of fees compared to their private-investment counterparts. In addition, they offer many additional features: liquidity, price discovery, regulatory oversight, 1099 tax reporting,
            low minimums, no limitation as to investor accreditation, and others.

            As you said, the true value of alternatives will be the potential improvement in risk-adjusted performance of the portfolio, as measured in the net-of-fee return. And exactly how will one measure those results? I would propose that the Endowment Index might be a perfect solution!


          • Brad Case, PhD, CFA

            Very good, Prateek. I will be very interested in seeing the development of this market, and it’ll be great if the Endowment Index enables investors to realize better portfolio outcomes. My concern is that investors who haven’t looked at the actual empirical data–or, worse, have looked at empirical data that has been misleadingly presented–are under the misconception that the main categories of alternative investments (private equity, private real estate, and hedge funds) have actually provided strong net total returns, low volatilities, and diversification benefits when the truth is that they generally have not. To the extent that they are misled about the actual performance of illiquid alternatives, they may make the decision about investing in liquid alternatives on the basis of faulty information. Still, the more reliable data we have about actual performance in all assets, the better we can hope investment decisions to be made. And certainly the Endowment Index gives me hope along those lines.
            Thanks for the back-and-forth.