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."

Real Estate Investment Trusts (REITs) and ERISA Plans

According to "REITs By The Numbers," published by the National Association of Real Estate Investment Trusts, Inc. ("NAREIT"), real estate is gaining favor with 401(k) investment committees that decide on asset allocation. They write that the last ten years has seen a rise from 5 percent to 30 percent of 401(k) plans that offer Real Estate Investment Trusts ("REITs") as an investment option. Moreover, the market is large at $1 trillion of real estate held in the form of an investment pool.

If you are a member of a 401(k) investment committee, advisor, consultant or individual participant, you will want to keep up with current guidelines and rules. Some of these are described in "Real Estate Investment Trust Valuation Guidelines Published." This blog post by Susan Mangiero includes FINRA and SEC comments about non-listed REITs as relates to items such as illiquidity, valuation and disclosures.

$89 For An Umbrella and No Money To Retire

In between business meetings in Greenwich, Connecticut the other day, it started to rain heavily so this blogger walked a few blocks to an upscale department store (the closest in sight), in search of a reasonably priced umbrella. Since I have so many umbrellas already (but had forgotten to pack one), I figured I would spend a modest $15 or $20 to buy another umbrella to keep me dry. How much could an umbrella cost after all? To my surprise and shock, none of the umbrellas came in at less than $89 (plus tax of course). For some people, that's a tiny price for protection. Certainly this merchant was thriving with designer attire, shoes and jewelry finding its way into shoppers' bags.

However, the reality is that not everyone is going to shell out 89 big ones for an umbrella, no matter what the brand. For a large segment of the U.S. population, money is a scarce resource and confidence in a secure future is low. According to the results of a recent Wells Fargo/Gallup Investor study, optimism is down and pessimism is up. At the same time that 68% of respondents say they have "little to no" confidence in the stock market as a way to prepare for retirement, 80% of investors urge lawmakers to act now so that savings is encouraged.

Unfortunately, most of the initiatives that individuals cite as "must have" elements of a national retirement readiness program are in direct conflict with the political grab to raise taxes. Consider a few examples.

  • Sixty-nine percent of the survey respondents say it is "extremely" or "very important" that politicians encourage every company to offer a 401(k) plan to its employees. Since there is already talk in Washington, DC about stripping companies of the tax benefits associated with offering retirement plans, it is unlikely that employers will realize further tax advantages at the expense of big spenders having to lose tax "revenue."
  • Sixty-six percent cite the need for the government to figure out how Americans who participate in 401(k) plans can get "more quality investment advice." Anticipating increased regulations as relates to investment fiduciary duties, some financial advisors are becoming less generous with information for fear of being sued. As described in "401(k) Lawsuits, Investment Advisers and Fiduciary Breach" (November 18, 2012), breach of fiduciary duty is cited as the top complaint in FINRA arbitration matters.
  • Sixty-nine percent want the government to establish initiatives that will motivate individuals to participate in their employer's 401(k) retirement savings option, assuming that they work for a company that offers benefits. Yet here we are, talking about a fiscal cliff that could impact millions of people with incomes below the magical "rich" benchmark of $250,000.  For one thing, in the absence of inflation indexing, the Alternative Minimum Tax that was enacted decades ago will show up as a nasty spring 2013 surprise for countless tax-paying middle-class households. Then there is the issue of jobs not created because employers will be writing larger checks to the IRS instead as various tax rates go up.

The United States is not alone in having to tackle difficult problems. The list is long and includes (but is not limited to) insufficient aggregate savings, underfunded social programs that are not sustainable safety nets without reform, high unemployment, corporate jitters about parting with cash, uncertain tax and regulatory environment and conflicting interests that make it almost possible to come up with near-term solutions.

There is a way forward to expand economic growth but that will require political courage. Let's hold our policy-makers accountable in 2013.

Computer-Driven Trading Slowing Down?

According to "Traders Exit High-Speed Lane" by Tom Lauricella (Wall Street Journal, May 5, 2011), equity trading has slowed down since last year's market "flash crash." Citing concerns on the part of previously active algorithmic traders and longer-term investors with a stomach for more calm, trading volume has dipped as a result. In turn, volatility has quieted, rendering it difficult for high frequency traders to turn a profit. Lauricella adds that some hedge funds that engage in statistical arbitrage have shut down or entered into fewer transactions if their performance has discouraged investors from sending more money their way. A counter opinion described in the article is that trading volume was artificially high during the credit crisis and that current numbers reflect the norm.

Institutional investors are impacted by the depth and breadth of trading activity in any secondary market in part because risk-takers facilitate liquidity by being the "other side." Having worked on several trading desks and also done research in the area of market microstructure, I know firsthand how aggregate levels themselves can fall short as a guide to what is really going on beneath the surface. Those pension funds and endowments that track short-term dynamics for timing purposes (i.e. market entry or exit) may want to examine the bid-ask spread trends along with price behavior relative to technical indicators in addition to total volume and volatility. For those that have relationships with high frequency trading ("HFT") teams, note that the Financial Industry Regulatory Authority ("FINRA") has publicly declared its intention to scrutinize firms that effect "orders by use of HFT models or trading algorithms" by making sure that "such trading complies with applicable FINRA rules and federal securities laws and regulations, including anti-manipulation provisions." Some assert that high frequency trading litigation may accompany heightened enforcement activity.

Note to Readers: The items listed below may be of interest.