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Hedge Funds and DC Plans: Happy Together?

Large defined-contribution-plan sponsors are beginning to add alternative investments to target date portfolios — or at least asking about them.

The big problem with seeking ever-more exotic asset classes for defined contribution plans isn’t where to find them. It’s where to put them.

In the past couple of years, plan sponsors have become intrigued by illiquid investments like private equity, hedge funds, derivatives and direct real estate, as uncorrelated, diversified counterpoints to the volatile traditional markets. But because it can be difficult to value these complex products — much less explain them to participants who may not even understand a basic equity fund all that well — these asset classes, if its accurate to describe them as such, can’t be part of the regular investment menu. Many managers don’t think they even fit into off-the-shelf target date funds.

So plan sponsors have decided to piggyback onto another growing trend — target date funds that are custom-made for the largest plans.

With a custom fund, “the plan sponsor can control how much of the asset allocation goes into the less-liquid vehicle, and you are in control of the cash flows,” says Fredrik Axsater, global head of defined contribution investment strategy at State Street Global Advisors. Typically, a plan sponsor creates a customized fund-of-funds using mainly the managers already in its defined benefit and defined contribution lineups and then devises an asset allocation tailored to the demographics of its workforce.

One large State Street client has already put “a few percent” of its custom target date assets into a hedge fund, according to Axsater, and about one tenth of the firm’s approximately 200 clients are seriously considering such moves. BlackRock has similar discussions with plan sponsors “a couple” of times a month, and Dagmar Nikles, head of investment strategy for the firm’s U.S. and Canada defined contribution group, expects to implement the first one by year-end. Three Towers Watson clients use direct real estate in their custom portfolios.

With off-the-shelf target date products, movement has been more cautious. J.P. Morgan's target date line includes one pool that invests directly in commercial real estate. BlackRock is studying whether to put illiquid vehicles into its standardized target date offerings, although Nikles says that nothing is likely to happen for at least six months.

Market acceptance is one reason for the slow start among off-the-shelf products, Nikles says. By contrast, with a custom target date fund, the plan sponsor may already have exposure to a certain manager.

Indeed, fund managers are looking for all sorts of ways to help sponsors feel more comfortable with these strange investments. For instance, the illiquids usually constitute only about 5 percent of the entire target date portfolio.

For similar reasons, real estate tends to be the most popular type. In addition to its correlation with inflation and usually steady returns (2008 notwithstanding), “it’s a real asset, it has physical holdings, and that makes it easier to communicate to participants,” says David O’Meara, a senior investment consultant with Towers Watson.

J.P. Morgan looked into other illiquid asset classes, says Daniel Oldroyd, a target date portfolio manager there. However, “to get the full benefit of private equity, you would have to have 7 to 8 percent [of the portfolio], and that would get us above our target,” he says.

The small percentage also helps tamp down two of the biggest concerns, liquidity and valuation.

Luckily, experts say there isn’t usually much demand for cash flow. “Target date investors are not the investors that trade frequently,” BlackRock’s Nikles points out. So J.P. Morgan has been able to meet demand by cashing out assets from the more liquid 95 percent of its portfolios, Oldroyd says.

Nikles also suggests creating a liquidity pool within the fund as a kind of mirror image of the illiquid asset, containing liquid assets correlated to the illiquid part. For instance, the mirror-image pool for a direct real estate pool like J.P. Morgan’s could have equity futures or ETF contracts that use real-estate-related companies. The size of the liquidity pool would depend on how active the investors are, but in a target date fund, Nikles says, it would probably be less than half the size of the illiquid part.

The entire target date fund could also substitute for the illiquid part’s lack of daily valuation. “The target date funds themselves will be open on a daily basis,” State Street’s Axsater says. “Given that the illiquid part is such a small component, you don’t have to force cash flow on a daily basis, and you can just true things up on a monthly basis,” when the illiquids are more likely to be valued.

Exotic assets — as with most collectibles — don’t come cheap. Oldroyd says that fees on the direct real estate portion of J.P. Morgan’s target date fund are more than 1 percent higher than for the rest — although, he adds, returns have been “a little better” than on the fixed-income portion, at about 7 percent. Depending on the type of asset, the fees for illiquids could be up to twice those of a bread-and-butter index fund, Nikles estimates. To some degree, plans can trim costs by negotiating with their existing defined benefit managers.

In the end, illiquid assets are just another form of risk-return tradeoff. Bonds have proved disappointing. Equities have their own risks. “Investors are increasingly seeking more uncorrelated, more diversified asset classes,” Nikles says.

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