Hedge Funds in 401(k) Plans: A Toxic Mix

By Gregory Porter, Bailey & Glasser LLP’s Washington, DC office

Participants in 401(k) plans should be worried, very worried, about hedge funds infiltrating their retirement plans. Bailey & Glasser partner Gregory Porter recently filed a class action lawsuit against Intel Corp. because its investment committee put more than $3 billion of retirement plan savings in hedge funds and private equity investments. The New York Times wrote about it here.

As a result, Intel’s employee savings plans have lost more than $600 million dollars as compared to what they would have earned in basic index funds. But Intel may not be alone. Over the past several years, Wall Street has been pushing “Liquid Alternatives” on 401(k) and IRA investors. Liquid Alternatives are hedge funds and private equity funds repackaged as mutual funds and ETFs.

Why? Because, like bank robbers, Wall Street knows where the money is. The Investment Company Institute estimates about $14.2 trillion in combined defined contribution plan (401(k) plans are the dominant form of defined contribution plan) and IRA assets. Trillions more are held in retail investor accounts at brokerages. That’s just too much money to ignore, especially when many institutional investors, the traditional hedge fund clients, are rethinking their hedge fund investments.

For example, the California Public Employees’ Retirement System, CalPERS, an industry giant and trendsetter, is pulling out of hedge funds because of poor performance and high fees. As reported in Forbes, CalPERS is pulling $4 billion in investments from hedge funds because the high fees are not justified by the investment returns. Recent reports by the American Federation of Teachers and the Utah legislature show public pension plan investments in hedge funds have caused huge losses.

The New York Times editorial board recently opined that this data “raises serious doubts about the benefit of hedge funds for big investors with a long-term perspective.”

So hedge fund managers are looking for new targets to expand their assets under management. That’s where 401(k) plans, IRAs, and individual investors with investment brokers come in. For example, a presentation by Citigroup shows the industry practically salivating over selling Liquid Alts to individual investors.

Even though the general trend in 401(k) plans over the past several years has been toward lower-cost index funds, Liquid Alts are gradually capturing more market share. That should worry retirement savers a lot. CitiGroup reports growth in mutual fund hedge funds from less than $50 billion in 2008 to nearly $300 billion in 2014, a compound annual growth rate of 43 percent. For all Liquid Alts, which includes ETFs, the same report projects assets growing from $368 billion in 2013 to $1.8 trillion in 2018. Those are numbers to die — or kill — for.

Consider that the typical hedge fund manager charges a 2 percent management fee plus a share of profits (as much as 20 percent), you can see why there’s a lot of fee money to be made in Liquid Alts as compared to stodgy index funds from Vanguard or Fidelity, which charge only a few basis points, about one-twentieth to one-fortieth of the hedge fund fee without taking into account the performance fees. And investment advisors and broker dealers can’t make any commission dollars selling index funds.

According to CitiGroup, investment advisors and brokers are asking for more Liquid Alts to sell to their clients — no doubt because these products come with very high sales commissions. Thus Liquid Alt managers are focusing on independent broker dealers and registered investment advisors in particular. This is a rich and largely untapped market because approximately $9 trillion in professionally managed individual investor assets, or 73 percent of individual investor assets, do not meet the minimum net worth requirement for privately marketed funds. Indeed, this is exactly why individuals should be supporting the Department of Labor’s efforts to hold independent broker dealers and registered investment advisors to ERISA’s fiduciary standards.

Consider also, as author and hedge fund expert Simon Lack wrote in his book the “The Hedge Fund Mirage”, 98 percent of the profits generated by hedge funds have been collected by hedge fund managers. And, Lack adds, hedge fund performance metrics vastly overstate actual investor experience. So, when your investment consultant or broker shows you a performance chart for a hedge fund index or a specific hedge fund, you should ask “But what returns did the investors actually get?” And “What is your commission on this versus a Vanguard index fund?”

If high fees and poor performance aren’t enough to worry you, hedge funds and private equity have lots of other problems making them unsuitable for 401(k) plans, IRAs, and individual investors.

For one, they lack transparency. In fact, in many cases these investment partnership agreements say that the plan fiduciaries can’t even share the agreements with their own plan participants. And plan fiduciaries have little or no ability to supervise or monitor the managers. Moreover, as the SEC recently reported, a majority of private equity managers inflate fees or charge undisclosed or improper fees to investors.

Hedge and private equity investments often impose strict redemption requirements and penalties, meaning that a 401(k) plan can’t simply exit a fund if the plan fiduciaries want out. In contrast, a plan can liquidate its mutual fund holdings in a matter of seconds if the fiduciaries decide that the fund is not prudent. Although the theoretical appeal of Liquid Alts is that they are traded like mutual funds, the reality is the underlying assets are anything but liquid.

Many hedge and private equity funds are in highly illiquid investments. That means two things. First, that large scale redemptions, if allowed, are likely to cause an asset fire sale as the manager sells illiquid assets to meet redemption demands. It also means that the assets aren’t valued by an efficient market. We all know what Apple is worth because the stock exchange tells us. But what about the small company in Omaha that makes plastic widgets? Or emerging market bonds? There’s no efficient market for these assets. So valuation is left to the fund manager.

The fund manager gets paid 2 percent of assets under management. Thus for hard-to-value assets, known as Level 3 assets in the business, the fund manager essentially sets its own compensation. Does anyone really trust a fund manager to set its own compensation?

This brings us back to Bailey & Glasser’s class action lawsuit against Intel. In the ERISA class action complaint, we allege that the Intel investment committee put two defined contribution plans into about $3.6 billion of hedge funds, private equity and commodities, with the overwhelming majority, about $2.5 billion, in hedge funds.

The employees did not have any say in these decisions. In fact, the participants in the Retirement Contribution Plan had no option but to have their accounts invested in hedge funds, private equity and commodities. And most participants in the 401(k) plan were defaulted into target date funds stuffed with hedge funds.

We estimate that Intel employees have lost at least $600 million through the end of 2014, with the losses mounting. Indeed, according to most reports 2015 is going to be one of the worst years for hedge fund performance ever, as reported by Preqin, a leading source of hedge fund data.

In 2013, Bloomberg Businessweek published an article titled “Hedge Fund Are for Suckers.” It was true then and it’s true today. If your 401(k) plan has hedge funds or Liquid Alts or your investment broker is pushing you to buy Liquid Alts for your IRA: Stop and Think. Ask why CalPERS, the largest retirement fund in the country, has abandoned hedge funds. Ask about commissions. Ask about true investor experience.

Please contact us if you have any questions. Below are some links to articles about the Intel 401(k) class action lawsuit.

NY Times: Intel Lawsuit Questions Place of Hedge Funds in Retirement Plans

MorningStar: Can a Fund Be Too Institutional?

Pensions & Investments: Intel Sued Over Hedge, Private Equity Fund Investments in DC Plans

Bloomberg BNA: Intel 401(k) Participants Sue Over Hedge Fund Losses

RIA Biz: Will the alternative assets Intel added to its 401(k) plan backfire legally as well as financially?

Business Finance News: Keep Your Friends Close But Your Enemies Closer: Intel Corporation Lawsuit By Ex-Employee

Plan Sponsor: Intel Lawsuit Questions Custom Target-Date Fund Construction

Plan Adviser: Intel Lawsuit Questions Custom Target-Date Fund Construction

FIN Alternatives: Former Employee Sues Intel Corp. Over Hedge Fund, PE Allocations in Retirement Plans

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