Alternative investments are gaining some traction within defined contribution plans, a trend that is expected to continue for the next several years.
That’s according to a report by Hewitt EnnisKnupp, an Aon company. Alternatives work well within 401(k) plans as long as they are included in multi-asset funds, such as target-date funds and diversified core options, which reduces the potential for misuse by plan participants, the report’s authors found.
Hewitt warned that even though the number of alternative options is increasing in the DC space, “investors must still critically evaluate options — a specific fund may be appealing for institutional investors but this doesn’t always imply that the strategy can be modified in a way that makes it equally attractive for defined contribution plans.”
The company evaluated its 10-year capital market assumptions of returns and risk as of the first quarter of 2013 and found that portfolios that included alternatives had both higher-than-expected returns and lower volatility.
It doesn’t believe alternatives should be stand-alone investments within 401(k) plans, but can be beneficial when included in multi-asset funds.
Hedge funds are becoming one of the most successful alternative investments included in DC plans. They offer capital preservation and less risk, their advocates say. Hewitt compared the HFRI Fund Weighted Composite Index’s average monthly return to the S&P 500 from January 1994 through June 2013. While both were in the negatives, the hedge fund performed nearly 3 percentage points better.
Firms that offer hedge funds have made many changes to them to make them more attractive to the DC investor. One way to do this is to create mutual fund structures. These funds have a number of characteristics that provide greater regulatory safeguards, including mandatory independent fund governance, requirements for custody of assets and leverage restrictions, Hewitt said.
Today, the liquid alternative mutual fund universe is more than 300 products, amounting to more than $600 billion in assets. The number of offerings has roughly doubled since 2009 and the growth trend is expected to continue, which is seen also in the larger institutional landscape where alternatives grew at 14.2 percent from 2005 to 2011 compared to 1.9 percent for non-alternatives, the report found.
Real estate is another asset class that could be attractive to DC plans. Many plans already include real estate investment trusts but don’t have any exposure to private real estate.
Things to watch out for:
- Fee levels can be higher for alternative investments. Plan sponsors have an obligation to participants to get the appropriate value for their investments.
- Many alternative investments have more complex incentive fee structures. If companies want to target DC plans, they need to be more transparent with their fee structure, which may mean changing the way fees are structured in the fund.
- Alternative investments are less liquid than traditional investment, which can clash with the daily liquidity provided by most DC plans. This can be handled by offering only the more liquid strategies or effectively managing the fund’s liquidity needs around the other assets, particularly in target-date funds. Plans can also only allow transactions on a monthly or quarterly basis instead of daily.