Posted by on Aug 18, 2014 in Blog, Columns |

By Jason Zweig | 2:29 pm ET Aug 15, 2014
Image Credit: Christophe Vorlet

“Alternative” investments have their place. But where is it?

Many asset managers argue that nontraditional investments belong in your 401(k) or other retirement account. But with giant pension plans like the California Public Employees’ Retirement System cutting their exposure to hedge funds, and the Securities and Exchange Commission examining how alternative funds are managed, retirement investors should open their eyes before they open their wallets.

Alternatives can be just about anything other than plain old stock or bond portfolios: funds that traffic in real estate, commodities, foreign currency or the debt of troubled companies; private-equity operations that buy companies outright; funds that hedge by betting on security prices to go down as well as up.

A fund that seeks to fight inflation can be useful in just about anyone’s retirement account. For most investors, however, there are simpler, cheaper ways to realize many of the goals alternative funds set out to achieve.

So far, the migration of 401(k) plans into alternative funds isn’t a stampede. Industrywide, analysts and consultants say, the percentage of retirement assets invested in alternatives is well below 10%. And most “target date” funds, the 401(k) portfolios popular among employees who expect to retire on a known date in the future, don’t yet hold any alternatives.

But according to Lipper, the fund-research company, the 25 target-date funds with the greatest exposure to derivatives—futures, options and other instruments tied to the performance of stocks, bonds and commodities—have an average of 36% of their assets there. That indirect measure of exposure to alternatives is up from 21% a year ago.

Morningstar, another fund researcher, estimates that target-date funds hold $1.7 billion in alternatives, up more than fourfold from 2010.

Alternative funds, by tapping into techniques that differ from those of traditional stock and bond funds, improve diversification and provide different sources of return, says Eric Friedman, associate partner at Hewitt EnnisKnupp, an investment-consulting firm.

Such a strategy “offers a shock absorber for people’s portfolios,” says David Kupperman, co-portfolio manager of Neuberger Berman Absolute Return Multi-Manager, a mutual fund with $1.6 billion in assets invested with 10 hedge-fund managers as of June 30. “It allows people to stay in the market when they should, because the swings won’t be as dramatic,” he says.

In the fourth quarter of 2012, the S&P 500 stock index lost 0.4% and the Barclays U.S. Aggregate bond index gained just 0.2%; the Neuberger fund grew by 0.4%. When stocks do very well, however, such a fund tends to lag behind; in 2013, as U.S. stocks returned 32.4%, Neuberger was up 9.6%.

David Holmgren, chief investment officer at Hartford HealthCare, a consortium of 17 hospitals and other health facilities in Connecticut, says he is “very much pleased” with how the fund has worked in the 401(k) and other retirement plans he helps oversee.

The Neuberger fund was added to Hartford HealthCare’s retirement menu in January; Mr. Holmgren estimates that approximately $2 million of the group’s $600 million in employee-retirement assets is invested there so far. “The biggest risk that participants will always face is undersaving for retirement,” he says, “and the best protection they have for that is not to have lost money.”

But David O’Meara, a senior consultant at Towers Watson Investment Services, says, “We would strongly caution plan sponsors against adding many of these alternatives as stand-alone options.” For starters, it’s even harder to select good hedge-fund managers than it is to pick winning mutual-fund managers—a task that most experts have failed at for decades.

In addition, many alternative strategies require investors to lock up their money for months or years at a time—and in a 401(k), participants expect to be able to move their money at will.

As a result of all these factors, “we expect that asset growth [in alternatives] will be minimal for most 401(k) plans,” says Sabrina Bailey, an investment-consulting principal at Mercer.

“There’s very much a place for alternatives in investment portfolios,” says Stephen Sexauer, a chief investment officer at Allianz Global Investors, which manages $511 billion. “But that place is endowments, foundations, pension funds, family offices and certain high-net-worth investors—who have very long-term horizons and don’t have to value their assets every day the way 401(k)s do.”

The problem, says Mr. Sexauer, is that many alternative assets seem liquid, or tradable, until there is a crisis. He adds, invoking the remark often attributed to boxer Mike Tyson, “Everybody has a plan—until they get punched in the mouth.”

If your 401(k) does start offering an alternatives fund, find out how well the managers weathered a period when liquidity dried up. Remember that you will pay annual fees of around 2%; that is 10 to 20 times what an index fund might cost you. Many existing options—real-estate and inflation-protection funds, for example—provide at least some assurance much more cheaply.

During the financial crisis in 2008 and 2009, even eminent investors like the endowments of Harvard University and the University of Chicago were surprised by how quickly and severely some of their alternative assets lost value and became hard to trade.

“Even the best and brightest got it wrong,” Mr. Sexauer says.

To believe that alternatives can work broadly in 401(k)s, he says, you must believe that the people running the funds “are better than all the other smart people who’ve thought they had a plan until they got punched in the mouth.”