What’s the Alternative?

When one hears “alternative assets,” hedge funds might come to mind. But alternative investments nowadays are that and much more. With assets in ’40 Act liquid alternative funds expected to double to nearly $500 billion by 2018, according to Strategic Insight, these funds are likely to appear on many retirement plan menus. Alison Cooke Mintzer, editor-in-chief of PLANSPONSOR and PLANADVISER, spoke with Rob Capone, executive vice president and head of BNY Mellon Retirement for BNY Mellon Investment Management, about the growth in such alternative investments and what plan sponsors need to know.

PS: How have defined benefit (DB) plan investment trends affected the defined contribution (DC) plan landscape?

Capone: There are two major areas. One of the big investing trend differentials is diversification. Greenwich Associates in 2012 did a study on the average DB asset allocation and, comparing that to the Callan DC Index around the same period of time, found that the average DB allocation is 60% weighted toward U.S. equity and U.S. fixed income. Yet, the average DC allocation, as measured by Callan, is 80%. That 20% difference reflects the better diversification that DB plans have around alternatives, real assets, international equities and emerging markets.

Since 2006, Callan has stated that the average DB plan has outperformed the average DC plan by 180 basis points. Now, there could be some reasons and rationale behind that, over and above the differences in the underlying asset-class exposures, but I happen to think that diversification goes a long way toward explaining the performance disparities. That’s one area.

The second area is professional management. DBs have always had the benefit of a corporate treasury team or dedicated investment team managing the plan. In DC, however, you’ve never had that, per se. The advent of the target-date fund (TDF) is really the first we’ve seen in DC that can at least attempt to look like DB-style investing.

PS: Can you describe the growth that has been happening both in traditional alternatives and liquid alternatives?

Capone: In DC plans, anything beyond those traditional style boxes, I always say, are alternatives. That’s not the general view of what an alternative is.

Historically, DC was a plan that was designed to maximize return. Since the crisis of 2008, the goals of the plan have had to change. Talking to sponsors now, there are a few key themes: the need to manage volatility, manage downside risk and, frankly, address the potential impact of inflation.

When we try to broadly diversify, the one goal is to add asset classes that specifically address those issues. When I look at alternatives, anything that is global—as an example—could be, potentially, an alternative within a DC plan. If you’re trying to reduce home-country bias or equity risk with truer diversification, look at global or emerging market strategies. If you’re trying to hedge against inflation, to protect participant purchasing power, then you want some exposure to real assets. Real assets could be Treasury inflation-protected securities (TIPS), real estate investment trusts (REITs), commodities, natural resource equities—any of those.

Then, if you are looking to achieve more diversification within the portfolio with strategies that are less correlated to equities, that gets into liquid alts. That’s your exposure to something that could be absolute return strategies or hedge fund replication.

Those types of alternatives are more prevalent now than ever, due to the shifting global markets and shifting global economies. 

PS: What’s the opportunity for DC plan sponsors and advisers to help put this in place?

Capone: Sponsors are trying to get more comfortable, for instance, with absolute return strategies as potentially stand-alone options. I don’t have as much comfort or faith that our industry can move that quickly and en masse. I think target-date funds are probably the best conduit to provide these types of strategies as a percentage allocation toward the overall allocation. If the main purpose of a global real return fund is for diversification—broadening the current global tactical asset allocation (GTAA) within a target date—then I think you have to embed it. That’s a natural fit and a natural opportunity to use the target date to provide components of alternatives—nontraditional as well as liquid alts as the best way.

PS: Why is it the best way?

Capone: Well, it’s less daunting to participant education. It provides a diversification that can be controlled. In other words, that percentage allocation can be limited within an overall allocation. It’s an opportunity to start using the vehicle as a way of introducing these strategies and adjusting the percentage allocations as momentum and asset utilization take more shape. It’s the easiest place for sponsors to begin to change their allocations in a more diversified way.

And, if you add it to a lineup, these are all new asset categories, so they don’t really replace anything. Most likely, if you’re ever trying to do something stand-alone, it sits there and you hope that, by education and information, participants get the gist that this is a diversifier and a hedge against inflation, and think: “Gee, I’d better invest in it.”

Again, you’re trying to move people; you’re trying to get them to make decisions; you’re trying to force action. As we have seen over the years, that is very hard to do.

Where target dates are the qualified default investment alternative (QDIA), where there’s auto-enrollment, where folks are investing in them more than ever, you almost have a passive way of getting them involved, if that makes sense. They’re already investing in it, versus them trying to take action.

If it’s for their benefit to more broadly diversify, to try to solve for these issues of volatility and downside risk, as well as inflation, it’s a lot easier for them to take action in that respect than it is to look at something as stand-alone, be educated and then be convinced that they need to take action.

PS: With all this in mind, what trends do you predict for investment menu diversification, specifically in DC plans, for next year?

Capone: The trends will be on a global theme: global equity income, global real estate, global real return, this notion of consolidating U.S. equity and international equity into global equity. I see the biggest trend, of course, being that these will be part of or added to target-date funds in a more customized way.

A few things are going on there. There’s a trend toward more customization of these target dates, and that customization manifests itself around these nontraditional/alternative strategies.

You may see a more unconstrained fixed-income approach, as well as absolute return strategies, with these liquid alts becoming part of the components within target dates to improve diversification through noncorrelation.

This is going to take time. It will happen or begin to happen next year, but by no means do I think there’s this groundswell that the industry is turned upside-down in a year. It’s going to be slow, but I think there’ll be steady movement toward these strategies. We have to get influencers and decisionmakers—sponsors, consultants, advisers—to buy into these notions, and it’s going to take time. That’s a big shift in DC plan investing. You’re trying to solve for participant outcomes now—you’re not just trying to grow a pile. You want a stability of returns.

The DB plan mentality is that, at the end of the day, you’re going to have an outcome—that’s an approach that DC plans are now focusing on. 

PS: Which plan sponsors are most receptive to this conversation?

Capone: Sponsors that are most open to this approach are more “progressive” and are trying to harmonize their DC plans to their DB plans. If they are more progressive fiduciaries and are seeking uncorrelated return streams, both to a current asset-allocation program and to the rest of their portfolio, they’re going to look at these nontraditional strategies as solutions for diversification.

PS: Do you think it’s easier, too, if you have a DB plan because you’re used to dealing with these topics?

Capone: Yes, I very much do. DC sponsors have historically been benefits professionals, and obviously, as fiduciaries, they’re concerned about all facets of the plan design, not only the investment side, which is paramount, but also the plan’s operational design and its efficiency. Whereas DB sponsors, historically, have been investment professionals, and the plans themselves have been managed professionally by the Corporate Treasury or by an investment committee. They’ve gone out of the box a lot earlier, diversified more truly; their portfolios are much more noncorrelated.

On the DC side, there’s a slow evolution toward sponsors becoming more finance- and investment-savvy.

Now you’re beginning to see a little more investment sophistication and a willingness to potentially move away from the strict investment policy statement (IPS) mandate approach and adopt a more DB-plan investing mentality. It’s a huge advantage to those plans that already have that in place because they’re much further along in their thinking and, therefore, much further along in their execution. Lastly, they’re much further along in convincing their own board.

Why can’t we just harmonize that over in DC to DB, recognizing that the plans are different, and you, participant, need to make decisions? Then again, if we put these strategies within the target date, the participant doesn’t have to make a whole lot of decisions, because, frankly, it’s auto-deferral and auto-enrollment. It’s just an allocation.

I’m oversimplifying it, but when you think of the trends, believe it or not, they advantage historical DB investing.

PS: How do you make DC plans take some of those good things away from DB to make them more palatable?

Capone: I think it’s a very exciting time to be in this business because of the nature of these new investment options. No, I take that back. They’re not new. It’s the utilization that would be new. A lot of us in this business get caught up in product development: “We’ve got to build this panacea. We’ve got to come up with the lifetime-income product. We’ve got to come up with the solution to everybody’s issues.” Well, if participants don’t save enough, I know of no product that solves for that.

But the fact is you do have products out there that have been in existence for years that can solve certain things. A liquid alternative or an absolute return strategy helps you diversify through noncorrelation. A real asset strategy helps you hedge against inflation. Emerging markets help you reduce your equity bias, home equity and home currency risk. Those aren’t new strategies. They’re newly used, but they’re not new.

We in DC have to balance the need for brand-new products versus the need to utilize those that exist that can solve current asset-allocation shortcomings within the plans.

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