From Seattle to Palm Beach, investors in one TDF own slivers of prime commercial real estate

In 2016, the largest defined benefit plans within U.S. Fortune 1,000 companies held upwards of 15 percent of assets in real estate, private equity, hedge funds, and “other” alternatives, according to analysis by Willis Towers Watson. Smaller pensions with less than $500 million in assets were less reliant on alts, averaging about a 6 percent allocation. Around the world, pension funds large and small, public and private, leverage alternatives to balance risk and meet funding goals. But what about 401(k) plans?

For investors in defined contribution plans, opportunities to diversify beyond a stock, bond, and cash mix are scant, despite some research—though not a consensus—that shows long-term investors in 401(k) plans could benefit from institutionalizing their approach to retirement savings.

In the $1.1 trillion target-date fund market, only a handful of fund managers incorporate underlying alternative assets.

“The use of alternatives in TDFs hasn’t been picked up nearly to the extent that some have predicted,” said Leo Acheson, associate director, multiasset and alternative strategies, at Morningstar.

Alternatives come with a couple of strikes against them within the context of a 401(k) investment. They are often illiquid assets relative to public securities. And alternatives tend not to be priced daily—securities regulations place liquidity and daily pricing requirements on the mutual funds that host alternative assets.

But from Acheson’s and others’ vantage, the real hurdle to building alternative strategies into TDFs may be more a question of plan sponsor psychology than alternatives’ structural challenges.

“The biggest thing we hear is the fees on alternatives make them prohibitive from a fiduciary perspective,” said Acheson.

Location, location, location

Last year, a record $70 billion flowed into TDFs–an astonishing 95 percent of which went into passively managed funds. “Cost is clearly driving a lot of sponsors’ decisions,” noted Acheson.

Demand for low-cost qualified default investment alternatives in 401(k) plans has forced some fund managers to rethink even small allocations to alternative strategies in TDFs. Acheson said last year’s survey of the market showed some managers pulled alternative funds from actively managed TDFs.

So far, TIAA-CREF Lifecycle Funds is opting to stay the course with a direct real estate investment fund that was added to the 100 percent actively managed series in the middle of 2016.

“Commercial real estate is a hybrid-like asset,” said John Cunniff, manager of TIAA-CREF’s lifecycle funds. “It’s like bonds because of the income it generates from rent, and like stocks because of the rising value of properties over time.”

After getting the green light from regulators, Cunniff and TIAA Investments turned to TH Real Estate, a specialist real estate investment management firm, to create a new investment option only available to DC investors in TIAA’s lifecycle funds. TH Real Estate and TIAA Investments are both is owned by Nuveen, which TIAA acquired in 2014.

“Having our own affiliate under our umbrella allows for a close partnership, which is to our advantage,” explained Cunniff, who called TH Real Estate a top-three property investment manager.

Having a relationship under the same roof allowed Cunniff and his team access to stress test potential investment strategies against “extreme, worst-case scenario hypotheticals.”

Morningstar’s Acheson gives TIAA credit for looking “deeply” into allocation models and running scenario analysis before blending direct real estate exposure into its TDFs.

Ultimately, Cunniff says all vintages will incorporate a 5 percent allocation to the Real Property Fund: Younger investors will have fixed-income allocations diverted to the fund; older investors will have equity allocations diverted to the fund. As of the end of February, the fund held a 2.9 percent allocation across all vintages, according the Life Cycle Funds prospectus.

Can TDFs with alts compete in a passive market?

Morningstar analysis notes TIAA’s conviction that its direct investment in real estate will provide better diversification than investing in real estate investment trust securities. Whether that will be the case is yet to be proven, according to one rating of the fund.

“We didn’t downgrade or upgrade it after the initial announcement,” said Acheson. “We want to see how they manage the fund.”

Just how much time the jury will need is hard to say. “If they move up to the targeted 5 percent allocation, manage it for three years and are able to keep the allocation at the target weight in the face of market volatility, then you would get a sense of how well it’s being managed,” said Acheson.

Cunniff, a long-tenured manager with over a decade overseeing TIAA Investments’ target-date funds, has over $1 million of his own money invested in the Lifestyle 2030 vintage, according to regulatory filings.

All told, the Real Property Fund holds 19 assets valued at more than $1 billion. Its top-10 holdings include office, multi-family, and retail spaces in Seattle, Silicon Valley, Manhattan, Boston, and Palm Beach. Cunniff calls them “institutionally liquid markets”—properties that will be in high demand, claim high rents, and that could sell if the fund needed to raise cash.

Of the $43.6 billion TIAA Investments manages in its TDF lines, about $31 billion is in its active series and includes the Real Property Fund. As of the end of March, the fund’s one-year real return was 9.31 percent. It returned 1.78 percent in the first quarter, when equities were down, interest rates went up, and bonds sold off. “Now, that’s not going to happen every quarter,” said Cunniff.

The cheapest share classes of TIAA Investments’ actively managed TDFs can be had for about 42 basis points—very competitive for an active series, but still a big chunk to bite off for sponsors who are just trying to not get sued.

That begs an important question—can TDFs evolve to incorporate wider institutional investing strategies under the current threat of litigation?

“As everyone knows, a majority of active funds underperform passive when accounting for fees,” said Acheson, not speaking directly of any fund family.

“But we think sponsors’ decisions are being driven more by cost—at least in many cases—as opposed to belief in passive investing over active investing,” he added.

There are “some really good” actively managed options, said Acheson. “I don’t think they should be overlooked simply due to their cost.”