Monday, April 7, 2014

Would You Let Plan Participants Invest in Hedge Funds?

by Jeff Briskin
President, Briskin Consulting

If you're like most advisors or plan sponsors, your answer to that question is (hopefully) "Certainly not."

Yet, I recently received an email from the Center for Due Diligence (CFDD) promoting a new microsite they've created to serve as an "educational" clearinghouse for information on "liquid alternative funds available for DC plans." View it here. 

Now, I have a lot of respect for the CFDD. They're a great resource for information on issues of interest to plan sponsors and advisors. I've even served as a panelist at their advisor conference. But, for the life of me, I can't figure out how posting a list of 40 Act alternative funds serves the best interests of anyone other than the fund companies that created them.

The CFDD's list is divided into two categories: fund families and fund categories.These categories run the gamut from "bear market" to "managed futures" to "multicurrency" to "long short equity."

DC Plan investment selection processes must comply with ERISA's fiduciary guidelines, which require that: 
  • Funds evaluation and selection reflect a prudent investment process that carefully weighs risk/return characteristics;
  • Fund costs must be "reasonable";
  • Funds chosen for the plan must represent the best interest of the plan and its participants; and
  • Participants need to receive appropriate educational materials to help them undestand the funds' investment and risk characteristics. 
But, after looking at the CFDD's list of mostly negatively performing, high-risk, high-fee, unrated funds that invest in everything from derivatives to junk bonds and currencies, I have to ask myself: What in the world makes any of these funds a prudent choice for a defined contribution plan?

In a non-1940 Act setting many of these kinds of funds are available only through private placements to "qualified investors" with at least $1 million in investable assets. All 1940 Act funds are legally required to funds maintain certain levels of liquidity and must conform with SEC-specified auditing and reporting requirements. But just because these "liquid alternative" funds are a little less risky and a little more transparent than their hedge fund cousins doesn't make them appropriate choices for DC plans, where they would be available to novice investors who might choose them without fully understanding what they're getting into.

Caveat emptor may be appropriate in the defined benefit and high net worth space, but an industry where most participants still don't understand basic investment principles, plan sponsors and advisors should think thrice about letting these hedge-funds-in-mutual-fund-clothing into their plans.