John Hancock Advocates for Liquid Alts in DC Plans

John Hancock Advocates for Liquid Alts in DC PlansJohn Hancock’s Head of Investments, Leo Zerilli, has authored a new white paper titled Deepening diversification in defined contribution plans: the rise of liquid alternatives. Mr. Zerilli’s advocacy for liquid alternatives within defined contribution (DC) retirement plans adds to the growing consensus that individual investors can benefit from having an allocation to alternatives, much in the same way that institutional investors and high net worth individuals have done for many years.

The Tortoise and the Hare

Zerilli uses the folk tale of the Tortoise and the Hare to describe the differences between a diversified portfolio including alternative investments (the tortoise) and long-only stock-and-bond investing (the hare). The tortoise takes a slow, plodding, and methodical approach to reaching his goals. The hare, by contrast, moves more speedily, but that goes for both directions – gains and losses. The hare (long-only) will outperform the tortoise (diversified with alts) during bull markets, but the tortoise will outperform the hare during bear markets.

In general, the tortoise’s approach limits volatility, and this can have an enormous impact on long-term returns – after all, 100% gains are required to make up for 50% losses. The popular perception is that alternative investments add risk to a portfolio in pursuit of outsized gains, but this isn’t normally the case, according to Zerilli. He says that investments should be evaluated within the context of the investor’s existing portfolio, and that the low correlation between alternative and traditional assets can result in dampening the portfolio’s overall volatility.

Fiduciary Duty

The U.S. Department of Labor (DOL) agrees with Zerilli. Officials from the agency have offered guidance for financial fiduciaries, telling them to “consider each plan’s investment as part of the plan’s entire portfolio.” The DOL also acknowledged that the higher fees charged by some alternatives “may be for access to special investments that can smooth returns in uncertain markets, and may be worth it.”

The Employment Retirement Income Security Act (ERISA) of 1974 set forth the fiduciary mandate for those who oversee employee benefit plans to act in the best financial interests of their clients. Zerilli argues that the scarcity of liquid alternatives within DC plans is tantamount to plan fiduciaries falling short of their duties, since alternatives have such attractive volatility-dampening features.

Institutional investors have been investing in alternatives for decades, and as of 2013, more than half of all endowment assets were invested in alternative strategies. Why should the allocations of individual investors look so different from institutions and endowments, which are generally regarded as prudent investors?

Endowment allocation to alternatives

Rise of Liquid Alts

Of course, for years most alternative assets were inaccessible to most individual investors. Hedge funds got their start in 1949 and exploded in popularity in the 1980s – but only for the wealthy. The 2008 financial crisis and subsequent stock-market crash helped usher in the era of liquid alts: High-net worth investors had a difficult time getting out of their illiquid alternatives during the crisis, and retail investors saw the value of “hedging their bets” ahead of the next financial crisis. Since liquid alts, such as mutual funds pursuing alternative strategies and/or alternative assets, are regulated by the Investment Act of 1940, they have the same transparency and liquidity as other mutual funds.

Below is a chart showing the growth of liquid alternative funds from 1985 through 2014. Even as the S&P 500 has set more than 40 new all-time records in the first ten-and-a-half months of 2014, the crash of 2008 is still fresh in retail investors’ minds:

Growth of liquid alternative funds

Conclusion

Deepening diversification in defined contribution plans: the rise of liquid alternatives also examines the role of target-date mutual funds, which gradually adjust allocations over time to become more conservative as the account holder nears retirement. Assets under management of such funds have ballooned from $15 billion to $618 billion since 2002, and the number of funds has proliferated from 25 to nearly 500.

“In our view, the most appropriate way to approach alternative investments is with an asset allocation mindset,” Zerilli says. Instead of viewing liquid alts as idiosyncratic investments, investors and other allocators should consider liquid alts within the context of their existing portfolios, and how liquid alternatives could potentially benefit them.

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