Alternatives and Retail Retirement Account Owners

The prospect of being part of millions of retail retirement plans has some financial advisors and hedge fund managers giddy with excitement. The 401(k) market alone is huge. According to the Investment Company Institute, as of Q3-2012, these defined contribution plans held an estimated $3.5 trillion in assets. In 2011, over fifty million U.S. workers were "active 401(k) participants." This compares favorably to an approximate $2.66 trillion hedge fund market size in 2013, up from $2.3 trillion one year earlier. Private equity, real estate and infrastructure comprise the rest of the alternatives investment sector according to a press release issued by Preqin, a financial research company. See "Alternative Assets Industry Hits $6tn in AUM for First Time" (January 21, 2014).

CNBC contributor Shelly K. Schwartz explains that alternative investment strategies are appearing in the form of 400 plus mutual funds and exchange-traded funds ("ETFs") that employ "complex trading strategies" such as managed futures, long/short trading in stocks and multiple currency exposures. Allocating to leveraged loans, start-up ventures and global real estate are other ways that these relatively new funds seem to be mimicking the approach taken by hedge funds and private equity funds that traditionally have catered to institutional investors and high net worth individuals. Notwithstanding regulatory differences relating to diversification, percentage of "illiquid" investments, redemption, daily pricing and how much debt can be used to lever a portfolio, statistics suggest a growing interest on the part of smaller investors to get in on the action. See "Seeking safe havens? Analysts, advisors point to liquid alternative funds" (November 24, 2013). Also check out "Goldman pushes hedge funds for your 401(k)" (Fortune, May 22, 2013) in which reporter Stephen Gandel describes new funds being offered by various financial institutions, some of which invest in mutual funds that mimic hedge fund investing strategies and others that invest in hedge funds directly.

Not everyone is an ardent fan. In "FINRA warns investors on alternative mutual funds," Reuters reporter Trevor Hunnicutt (June 11, 2013) describes regulators' concerns that "not all advisers and investors understand the risks involved," especially with respect to whether a retail-oriented fund is truly liquid. In its "Alternative Funds Are Not Your Typical Mutual Fund" publication, the Financial Industry Regulatory Authority ("FINRA") cautions investors to assess investment structure, strategy risk, investment objectives, operating expenses, the background of a particular fund manager and performance history.

Given the ongoing search for the next big thing, we are likely to see a lot more activity in the alternative investments marketplace - for both institutional and high net worth clients as well as for individuals with modest wealth levels. PensionRiskMatters.com will return to this topic in future posts. There is much to write about with respect to fiduciary implications, risk management and valuation.

In the meantime, I want to thank ERISA attorney David C. Olstein with Skadden, Arps, Slate, Meagher & Flom LLP & Affiliates for apprising me of a 2012 U.S. Department of Labor grant of individual exemption for Renaissance Technologies, LLC ("Renaissance").  Described as a "private hedge fund investment company based in New York with over $15 billion under management" by HedgeCo.net (September 26, 2013), Renaissance holds a large number of equity positions in stocks issued by household name companies. Click to see a recent list of their transactions. The "Grant of Individual Exemption Involving Renaissance Technologies, LLC," published in the Federal Register on April 20, 2012 makes for interesting reading for several reasons. First, it describes policies relating to important topics such as valuation, redemption and disclosures for "privately offered collective investment vehicles managed by Renaissance, comprised almost exclusively of proprietary funds" and the impact on retirement accounts in the name of Renaissance employees, some of its owners and spouses of both employees and owners. Second, as far as I know, there are not a lot of publicly available documents about proprietary investment products that find their way into the retirement portfolios of asset management firm employees and shareholders. Third, as earlier described, there is evidence of a growing interest on the part of the financial community in bringing hedge funds or hedge fund "look alike" products to the retirement "masses."

Hedge Funds, Private Equity Funds and ERISA Pension Plans

Alternative fund managers and regulators will convene in Washington, D.C. from July 19 through 21, 2011 to talk about pension investing in hedge funds and private equity funds. Over several days, those who present before the ERISA Advisory Council will be asked to address questions such as those listed below:

  • What differentiates a hedge fund from other types of investments?
  • What differentiates a private equity fund from other types of investments?
  • How are hedge funds and private equity funds, respectively, correlated with the returns of traditional equity and fixed income investments?
  • How can defined benefit and defined contribution plan sponsors mitigate "the lack of liquidity that is characteristic of these investments?"
  • How can fee transparency be enhanced?
  • "Are there any unique diversification benefits offered by hedge funds and private equity investments as opposed to a fund of funds?"
  • What is the view of target date fund managers with respect to including hedge funds and/or private equity strategies within their funds?

According to U.S. Department of Labor documents, the aim is to create best practices guidance in areas such as leverage, liquidity, transparency. valuation, operational due diligence, client and asset concentration and offering documents. Click to download "2011 ERISA Advisory Council: Hedge Funds and Private Equity Investments." Click to read the June 22, 2011 U.S. Department of Labor news release about the forthcoming meetings to address hedge funds and private equity investments by ERISA plans.

Interested readers may want to check out the following of many items that are available for further research:

Risk Management, Leverage and Globalization

In "Risk Management Q&A: Risk is a four-letter word" (Perspectives, RBC Dexis Investor Services, April 2010), I talk about meaningful changes in terms of risk management as a result of the financial crisis. My comments about leverage in the same interview are nothing new. Leverage is not necessarily good or bad. Importantly, institutional investors must understand how to properly measure leverage and establish internal controls.

"All leverage is not created equal. A short position in an actively-traded instrument has a different risk-return profile than taking on debt or synthesizing exposure with puts or a combination of derivatives."

To read the full interview, go to page 10 of "The global power shift: New directions for the world economy". I am also quoted on page 8 in the article entitled "Reversal of Fortune: Regulators could push the consolidation trend back a few years" on the topic of reactionary regulation.

Leverage - I Love You, I Need You - Don't Hurt Me

 

If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?