Aurora Borealis
1 April 2015 CFA Institute Journal Review

The Case for Liquid Alternatives in Defined-Contribution Plans (Digest Summary)

  1. Robert H. Kaplan

Comparing the performance and asset allocations of defined contribution (DC) and defined benefit (DB) plans, the authors find that DC portfolios underperform DB portfolios and that DC portfolios underweight alternative assets. They conclude that increasing the DC portfolio allocation to alternative assets would improve risk-adjusted portfolio performance, reduce volatility, and enable plan participants to pursue incremental risk and return opportunities.

What’s Inside?

The authors’ primary objective is to demonstrate that increasing the allocation to alternative investments—specifically, liquid alternative investments—can improve the risk-adjusted investment performance of defined contribution (DC) plans. They present evidence revealing the underperformance of DC plans relative to that of defined benefit (DB) plans and compare the historical average DC asset allocations with those of DB plans to highlight their underweighted position.

The secondary objective the authors pursue is to explain the motives behind the growth of the liquid alternative market, liquid alternative investment vehicles, and methods of implementing liquid alternative strategies in DC plans.

How Is This Research Useful to Practitioners?

DC plans are the primary retirement savings vehicle for most US employees (69% of private sector workers have access to DC plans, whereas only 7% have access to DB plans). The widespread use of DC plans provides a large audience interested in optimal DC portfolio construction—namely, DC plan participants, DC plan sponsors, investment advisers to DC plan participants and DC plan sponsors, and managers of liquid alternative products.

The introduction of alternative strategies via mutual funds creates an opportunity for DC plan sponsors to add hedge fund strategies to their platforms, thus enabling DC plan participants to pursue incremental risk and return opportunities, diversification, and volatility management goals that are unavailable through traditional asset classes.

Notable findings supporting these assertions include observations that during January 1990–September 2014, the Hedge Fund Research, Inc. (HFRI) Fund Weighted Composite Index outperformed broad equity markets on a risk-adjusted basis by 76.5%, cumulatively, during periods when the VIX (Chicago Board Option Exchange Volatility Index) closed above its historical average.

During the same period, when the MOVE Index (the fixed-income equivalent of VIX) closed above its historical average, the HFRI Fund Weighted Composite Index outperformed by 47.6%, cumulatively. During periods of high market volatility and/or market declines, the addition of liquid alternative strategies has, at least over these selected time periods, reduced drawdowns and improved risk-adjusted performance.

How Did the Authors Conduct This Research?

The authors use a variety of existing commercial, governmental, and academic research material as sources for their analysis. The centerpiece of their analysis is a comparison of the average asset allocation and performance of DC and DB plans over the period 1997–2011, which indicates that DC portfolios underperform DB portfolios. The authors concede that some portion of the DC/DB performance disparity might be attributable to factors that are unexamined in this analysis—for example, fees, poor portfolio construction, and market timing by participants. Furthermore, wide dispersions in the performance of alternative managers can occur, which might further contribute to widely varying individual outcomes. Additional data provide evidence of the growth of liquid alternative assets and methods for managing their incorporation into DC plans.

The authors are employees of a major investment manager with significant interests in DC and DB plans and alternative advisory services.

Abstractor’s Viewpoint

The relatively short track record of liquid alternative assets makes obtaining the quantitative data necessary for return attribution and simulation of DB and DC portfolio performance difficult. Consequently, identifying the reasons for DC plan underperformance relative to DB plans is a challenge. Nevertheless, the authors’ research, although limited by data availability, suggests reasonable conclusions. Given the economic importance of the topic for a wide audience, the research deserves further consideration.

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