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401(k) Plans Turn to Alternatives, As Volatility, Inflation Fears Persist


Got downside protection? That's the question many 401(k) plan sponsors and investors are now asking.

While 401(k) plans have been transformed dramatically in recent years by target-date funds and automatic enrollment, the next phase for innovation is likely to come from alternative investments, such as inflation-sensitive assets.

That's the word from Maddi Dessner, executive director and portfolio manager with J.P. Morgan Asset Management's Global Multi-Asset Group.

While '40 Act hedge funds-of-funds aren't likely to ever make their way into 401(k) plans, Dessner spoke with Money Management Executive about the types of alternatives she believes do make sense and why she believes they should be an option for QDIAs (qualified default investment alternatives).

 

MME: Have you been witnessing a significant increase in demand for alternatives among plan sponsors?

Dessner: We absolutely have. Investors in general, in this volatile market environment, are looking for innovation. We are seeing very disappointing market returns, including yesterday's [Sept. 22] 391-point drop in the Dow Jones Industrial Average. The three- and five-year returns for most of the broad, traditional equity indices are currently solidly in the negative territory.

So you really have to be creative about finding growth. More broadly diversifying 401(k) investors' portfolios through greater levels of asset classes is critical.

It's not good enough to put participants in high levels of equities to prepare them for retirement. That's not the end of the story.

 

MME: What types of alternatives are sponsors looking for?

Dessner: In some cases, plan participants-prompted by fears over inflation and market volatility-are prodding their employers to add Treasury Inflation-Protected Securities (TIPS), commodities and real estate investment trusts (REITs) to their investment line-up.

In fact, we are seeing a great deal of interest among DC sponsors in inflation-sensitive asset classes. That's certainly a hot topic right now.

Many plan sponsors think TIPS will save their participants from inflation, but TIPS can be derailed by an unexpected rise in real interest rates, and their longer duration makes them somewhat risky.

Our findings suggest that a diversified basket of inflation-sensitive assets that can perform well in different inflationary environments outperforms a single bet on any one inflation-sensitive asset over the long term.

Thus, besides TIPS, commodities and natural resources equities can also provide protection against inflation and should be part of that basket.

We have found that some asset classes that are thought of as inflation-sensitive will lead inflationary periods, such as commodities. Other asset classes correlate with the Consumer Price Index. Thus, when we start to see rising inflation, TIPS correlate very well with this trend.

But beyond this, inflationary environments tend to be cyclical and episodic, which is why we recommend a broad basket of securities.

 

MME: What is J.P. Morgan Asset Management's outlook right now on inflation?

Dessner: We certainly are concerned. We are concerned about the potential for inflation associated with all of the quantitative, accomodative policies we have seen across the world.

Ultimately, we think it is important to focus on both the effects of inflation on your portfolio and, generally, negative real return.

If you look at the past 40 years of economic history, while there has repeatedly been a great deal of discussion around the issue of inflation, inflation actually occurs in relatively limited periods of time.

More often, what an investor needs to worry about is negative real return, that is, bear markets combined with low inflation. That actually will give you negative real returns, as well.

So, from our perspective, it is best to think about all those different environments and build a portfolio that will hold up well against various market and economic scenarios, because inflationary environments change very quickly.

 

MME: What other types of alternatives are your clients interested in?

Dessner: The alternatives camp includes anything that is not traditional equity or fixed income. When you start to get away from the traditional equity markets, like large-cap and international, and from the traditional bond markets, like the core fixed income indices-that is what we would consider alternatives.

Alternatives can range from traditional asset classes, like real estate or hedge funds, to extended asset classes, like emerging market debt, emerging market equities, high yield, as well as products that replicate the return patterns of some of the more traditional alternative investments, such as long/short equity funds and market-neutral funds.

 

MME: You have said that one myth about alternatives is that the best way to invest in them is through standalone options. Is it always better to own alternatives in a diversified portfolio?

Dessner: It really depends on the alternative that you're talking about. Certainly, there are some alternative asset classes that are difficult to incorporate into a basket or mutual fund construct, such as hedge funds or directly held real estate, both of which we think are great asset classes to include in portfolios from a diversification perspective. However, they are difficult to incorporate from a liquidity and transparency perspective-and thus they aren't likely to make their way into most retail or 401(k) portfolios.

Lack of liquidity and transparency are risks associated with a number of alternative asset classes that investors need to be concerned with-particularly if they are going to be presented in a standalone construct.

Participants need to be given some educational guidance along with those allocations so that they don't misuse them.

 

MME: How difficult do you anticipate it will be to educate investors about alternatives in 401(k) plans,?

Dessner: It is a challenge, but we think simple communications about the specific components of the investment strategy that are relevant to the investor's portfolio, are critical.

Another way to go is to ensure that these asset classes are included in the plan as one of the QDIAs.