Alternative Investments in Target-Date Funds: Poisoning the Well


report released by ThinkAdvisor cited the recent increase in alternative investments making their way into defined contribution plans. According to Cerulli Associates, a research firm based out of Boston, “alternatives have long been used in defined benefit plans, but they’ve been sneaking into DC plans by way of target-date funds for some time.” We find it particularly interesting that Cerulli chose the word “sneaking” in its name since it seems to suggest secrecy, which we wouldn’t expect anything less from in this particular area of investment management.

This is a crucial topic that we are passionate about since investment authority, Charles Ellis, recently stated that the 401(k) represents, “the most important investment challenge,” the United States has ever faced. As such, it is extremely important that we make decisions that are solely in the best interest of American workers and for nobody else when it comes to tackling retirement readiness.

We have made great strides in recent years in terms of investment regulation, plan design, and overall education when it comes to retirement plans. The Department of Labor has recently issued their “fiduciary rule” when it comes to retirement advisors, which is still receiving pushback from mainstream financial advisors (brokers) who have been hiding under the much weaker rule of “suitability” when giving financial advice. This has subsequently relieved these individuals from much of the liability associated with the advice they give, or stated more precisely, the product that they sold. Investment professionals engaged in retirement plans are now held to the same standard that your physician is when it comes to looking out for your best interest.

Thanks to the advancements we have made in the area of behavioral finance, we now have a better understanding of some of the biases individuals have when making decisions when it comes to retirement. The work done by individuals like Daniel Kahneman, Amos Tversky, Richard Thaler, and as it applies to 401(k) plans, Shlomo Benartzi, we have been able to develop features such as automatic enrollment, automatic match, automatic escalation, target-date funds and a glide path. All of these have the intention of helping individuals overcome some of their behavioral biases in order to save themselves from themselves when it comes to preparing for retirement.  

There has also been a growing body of literature among the academic community and professionals alike, which strongly suggests a passive investment strategy for most individuals. Those recommending active investment strategies for masses are highly suspect since it is mathematically impossible for there to be a successful active investment experience for everyone. You can find an outstanding amount of academic evidence on IFA.com.

So what’s inherently wrong with telling the majority of workers saving for retirement to allocate some of their hard earned resources to alternative investment strategies?

First, alternative investments outside of real assets such as land, buildings and private equity focus on speculation in other types of markets. Whether it is stocks, bonds, or commodities, most alternative investments rely on “expertise” in being able to generate “alpha” in these types of markets. While many hedge fund managers would probably admit that most arbitrage opportunities have a smaller time horizon, a long-term allocation would require a manager’s ability to find and successfully exploit these opportunities many times over an investor’s time horizon. Oh by the way, they are usually charging somewhere in the range of 1-2% annually even though there is no guarantee that they will deliver.

Which brings us to our next point: there is no substantial evidence the alternative asset managers have delivered on their promise. When we mean substantial, we mean peer-reviewed academic research done by professionals who do not have their skin in the game, which eliminates most incentive to skew any conclusions they find. Because alternative investments are a relatively new asset class, there is not a sufficient data sample to draw any conclusions from. Further, because many alternative investment strategies are not regulated like other types of investment companies, they are not required to report their performance figures, leading to many types of biases in the available datasets like back-fill bias and survivorship bias.

Lastly, the stakes are too high to be gambling with retirement savings. Active investment strategies can best be described as speculation, which is just another term for gambling. The expected return from speculation is zero, a conclusion made by Louis Bachelier in his famous The Theory of Speculation. Once we account for costs, the expected return is actually negative. Thus, just like a casino, we are expected to lose more often than we will win, even though we may get lucky at times. At a time when most Americans are underfunded for retirement, it is not only irresponsible, but also downright criminal to give any dollar to something that has an expected negative payoff.

We have made tremendous strides in trying to solve the problem of retirement readiness in this country. Most of the greatest advancements have come from the halls of academia and implemented by outstanding practitioners in our industry. By allowing alternative investments to sneak their way into this progress is, in our opinion, poisoning the well. There is too much at stake when it comes this particular area of our industry. Let billionaries and millionaires gamble with their own money, but not the hard working individuals who need every dollar they can in order to make it across the retirement finish line.