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Considerations for Liquid Alternatives in Your Defined Contribution Plan
By: Brian White, Senior Consultant
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2020 will undoubtedly go down as one of the most volatile years in history on multiple fronts… and it’s not over yet. In the first half of the year we saw the fastest bear market retreat on record, with the S&P 500 losing one third of its value in just 16 trading days. The recovery has also been swift, with the S&P 500 recovering over 48 percent off the market low to finish in positive territory as of the writing of this article on August 4, 2020. It’s been a wild ride for plan participants to say the least.
The subsequent market upswing since the March 23 market bottom seems disconnected from recent grim economic data, with second quarter GDP coming in at an annualized rate of negative 31.7 percent, according to the second estimate from the Bureau of Economic Analysis, and over 16 million Americans still unemployed according to the U.S. Bureau of Labor Statistics report in July 2020. Manufacturing data is improving but still registering in contraction territory through the end of June according to the Purchasing Manager’s Index. Many of you may be wondering if there are asset classes or specific investments that should be evaluated with an objective of providing you with a better chance at reducing volatility on a go-forward basis.
These questions remind us of white papers we’ve written during other times of volatility or concern regarding lower future expected returns. The topic of those white papers: liquid alternatives.
What are liquid alternatives?
There is no universal definition of liquid alternatives, also referred to as liquid alts. We define liquid alternatives as mutual funds or exchange-traded funds (ETFs) which implement hedge fund strategies to mitigate risk. Mutual funds are subject to many federal regulations, including the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Advisers Act of 1940 and the Investment Company Act of 1940 (the “’40 Act”). Hedge funds and other alternative investments avoid the bulk of these regulations in part by making only private offerings to investors who meet the accredited investor, qualified client and qualified purchaser restrictions. Liquid alternative mutual funds attempt to provide hedge fund-like strategies to retail investors by remaining subject to the ’40 Act and other regulations mentioned above. However, investment managers also find their execution of these strategies constrained by the same regulations. Unlike traditional hedge funds which are not valued on a daily basis, liquid alternatives are valued and traded daily.
Historical Perspectives
In our 2019 white paper, “Liquid Alternatives – A Somber Update”, we observed, “Since our initial report on the liquid alternatives universe in 2015, the space has continued to worsen. With persistent underperformance relative to comparable hedge fund indices, poor alpha generation, high fees and modestly rising correlations to the S&P 500 across most Morningstar peer groups, we continue to emphasize a diversified portfolio of hedge funds or a multi-strategy fund of hedge funds as the preferred implementations of a hedge fund allocation.”
Our first articles were geared towards liquid alts in the context of multiple client types, including nonprofit and other trustee directed pools of assets. In that environment, the S&P 500 (large cap U.S. stocks) was consistently one of the best performing asset classes while pretty much everything else lagged. A globally diversified portfolio didn’t seem to track the domestic markets.
For today’s purposes, we will be evaluating the asset class through the defined contribution lens. Given this perspective, we acknowledge that building a direct hedge fund portfolio for a defined contribution plan is not feasible and has structural limitations.
So how have liquid alternatives as an asset class performed in 2020 specifically, in an environment where alternatives are supposed to mitigate risk? Do liquid alternatives warrant a fresh look in the post-COVID world?
Performance Update
Similar to our previous findings, Morningstar’s liquid alternatives peer groups continue to underperform their comparable hedge fund indices across the board (Exhibit 1). Annualized underperformance over the last five years ending June 2020 has ranged from negative 1.2 percent to negative 2 percent across multi-strategies, long/short credit, long/short equity, managed futures and market neutral strategies. When looking at calendar year returns, multiple categories have showed persistent underperformance year after year. Our previous findings highlighted liquid alternative underperformance that ranged between negative 0.8 percent and negative 2.4 percent for the trailing five year period ending December 2018. The most recent five year period has demonstrated a similar underperformance range.
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When controlling for risk, the picture isn’t any rosier for liquid alternatives. After backing out the level of market risk to the S&P 500, none of the liquid alternative categories have generated alpha over the previous five year period. While some hedge fund categories also struggled to produce alpha, such as the fund of funds category (Exhibit 2), each liquid alternative category has fared worse than its comparable index. The same is true with each category’s Sharpe Ratio, which measures excess return (above cash) per unit of volatility.
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What Does This Mean for Your Investment Menu?
The takeaway remains consistent with our initial observations: If your goal is to obtain hedge fund exposure and you have the option to invest in direct hedge funds over liquid alternatives, you should consider doing so. As stated previously, direct hedge funds are not typically an option for defined contribution plans, especially as a standalone option. That being said, for Sponsors looking to add investment menu options with hedge fund-like characteristics, it is hard to make a case for liquid alts based on the data above. Additionally, recent litigation against defined contribution plans has focused heavily on two key areas: poor performance (typically cited versus the S&P 500 Index) and high fees. We know where liquid alternatives have fared from a performance perspective, but in addition, they are often criticized for higher fees than the typical active manager. As noted in our white paper referenced above, the average expense ratios for the liquid alt strategies range from 1.82 to 2.13 percent.
It is natural in a time of uncertainty to question whether something is missing from your investment menu. Rest assured, you are not missing the “silver bullet” investment option or asset class for that matter. Our disciplined approach with clients has always been to implement a thoughtfully diversified core investment line-up of active and passively managed investment funds, anchored by a suite of target date funds.
Should you have questions on your current investment line-up or would like to review a GAP analysis for your current investment menu, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
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| This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. The information contained herein is intended for the recipient, is confidential and may not be disseminated or distributed to any other person without the prior approval of DiMeo Schneider. Any dissemination or distribution is strictly prohibited. Information has been obtained from a variety of sources believed to be reliable though not independently verified. Any forecasts represent future expectations and actual returns, volatilities and correlations will differ from forecasts. This report does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Past performance does not indicate future performance and there is a possibility of a loss.
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