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Rekenthaler Report

Can a Fund Be Too Institutional?

Intel is about to find out.

For God, For Country, and For Yale
In 2009, Intel’s Investment Committee had a hard think. Responsible for Intel’s 401(k) plan, the Committee had created several custom funds for participant use, in addition to the usual off-the-rack mutual funds that were available. The Global Diversified Fund was the Committee's version of a balanced fund, and there was a custom target-date series. Those custom funds, in common with their retail competitors, had taken a lick during the 2008 bear market. 

The Committee decided to adopt the Yale Model. Named after the Yale endowment fund, the Yale Model diverged sharply from the traditional balanced-fund approach of blending U.S. blue-chip stocks with investment-grade bonds. The Yale fund’s chief investment officer, David Swensen, had taken to heart the chief lesson of Modern Portfolio Theory--that seemingly risky assets could reduce the risk of the portfolio through the math of diversification. Yale looked--and looks--nothing like a traditional balanced fund.

As of its most recent report, for example, Yale held a puny 4% of its assets in U.S. stocks and 8.5% in cash/bonds. Its biggest position was in hedge funds, at 21.5%, followed by private-equity funds, international stocks (more than triple the U.S. stock weighting), venture-capital funds, real estate, and natural resources.

Intel's Investment Committee took quick action. At the end of 2008, the Global Diversified Fund had a modest 6% position, combined, in hedge funds, private equity, and commodities. One year later, it was at 15%. The next year it reached 22%. By the end of 2011, the alternatives position was up to 33%. The average alternatives stake for the custom target-date funds also ballooned, to 23%.

In moving from U.S. equities to alternatives--that is, in moving toward the Yale Model--Intel’s Investment Committee echoed the broad trend among institutional investment managers, albeit more dramatically. From 2009 to 2012, per a Towers Watson report, private pensions boosted their weighting in alternative assets from an average of 9.8% to 11.5%. Meanwhile, their equity positions declined, even as stock prices were sharply rising. Stocks were sold; alternatives bought.

This move toward more institutional behavior has earned the Intel Investment Committee ... a lawsuit.

On Oct. 29 of this year, in the U.S. District Court of Northern California, a class action suit was filed against the Intel 401(k) Savings Plan and Intel Retirement Contribution Plan. The complaint--

Defendants breached their fiduciary duties by a) investing a significant portion of the Plans’ assets in risky and high-cost hedge fund and private-equity investments, and b) adopting asset allocation models for participant accounts that departed dramatically from prevailing standards employed by professional investment managers and plan fiduciaries. As a result of these misguided and imprudent investment decisions, the fiduciaries of the Plans caused the Plans and many of their respective participants to suffer massive losses and enormous excess fees.

The plaintiff’s tale is that Intel failed by trying to be like Yale.

Analysis
I have no comment about the case’s legal merits, as that is for lawyers to discuss. (This is a polite of way of writing that I do not wish to hear from either side's legal counsel.) I do have some thoughts, however, from the investment perspective.

1)    Risky assets
The fundamental precept of Modern Portfolio Theory is that assets should not be selected--or criticized--on their own, as a single entity, but rather for how they function within a portfolio. Plaintiffs, along with most of the investment press, consider hedge funds to be risky. But institutional investors do not. They typically add hedge funds to a portfolio not to increase returns but as a method of risk reduction through diversification. (That was Intel’s rationale, too.)

In a related item, the “massive losses” alleged by the plaintiffs are those of opportunity cost, rather than of actual price declines. The Global Diversified and target-date funds were profitable during most of the time period covered by the suit. Thus, those are relative losses, calculated by the plaintiffs by comparing the custom funds’ returns against those available from retail mutual funds.

They are, after all, called hedge funds. And for all their bad publicity in 2008 for not properly protecting themselves and for disappointing their shareholders, hedge funds on average only lost about half as much as the typical stock fund. They are indeed lower-risk securities, as a whole, during stock bear markets. 

On slightly firmer ground is the notion that hedge funds are for accredited investors and 401(k) plans are not. Not in a legal sense (oh dear, and I did promise, too), as registered mutual funds are permitted to hold a certain percentage of their assets in accredited investments, and I suspect that custom funds are permitted even more. One can argue, however, whether it is appropriate for funds that are valued daily to hold so much of their assets in securities that are valued less frequently.

That would seem to be an investment question rather than a legal issue, however.

2)    Asset-allocation models
As we have seen, the asset allocations used in Intel’s custom funds do not “depart dramatically from prevailing standards employed by professional investment managers.” They are, in fact, constructed in the spirit of the nation’s most highly regarded professional investment manager, albeit in a somewhat watered-down form.

They do, however, depart dramatically from the prevailing standards that are used for participant accounts in defined-contribution plans. In that, the lawsuit’s allegation is correct. Whether it is appropriate for 401(k) accounts, which are generally intended to be held for several decades but that might rolled over at any time, to emulate endowment portfolios that have indefinitely long time horizons is a worthy discussion. It seems to me once again more of an investment concern than a legal concern.

3)    High cost
This item surprised me.

Giant companies usually create custom funds for their 401(k) plans with the idea of saving money. They can use their volume to negotiate better fees from money managers. Such was very much not the case with Intel’s custom funds, though. According to the filing, Intel’s target-date funds had annual expense ratios of about 1.3%. That’s a very high figure for a large-company 401(k) plan! As the filing notes, those numbers are 8 times higher than the fees charged by Fidelity’s index-based target-date funds.

Once again, I have no idea about the legal ramifications. Are fiduciaries legally liable for spending much more money on active management than they would have needed to spend for passive managers? Should they be? Beats me. But I am puzzled that Intel let the funds’ expenses creep that high.

It would be instructive to compare those funds’ costs against the expenses paid by Yale on its endowment portfolio. Swensen talks about the importance of selecting the right hedge funds, at the right price, and uses his fund’s size to cut better deals from the investment manager. The Intel funds, while large, lack that level of heft.

Execution, Execution
As Morningstar’s former chief operating officer liked to say, “Ideas are easy, execution is hard.” (He didn’t have much use for ruminating columnists.) While this lawsuit, and Swensen’s reputation, stem from the ideas of asset allocation, the execution of the investment implementation also matters. According to Yale’s investment department, its endowment fund gained 17.4% per year on its foreign equities from the decade through June 30, 2015, as opposed to 9.0% for the benchmark! Its domestic stocks beat the index by just over 400 basis points per year.

If Intel had enjoyed similarly strong execution, its custom funds would likely have beaten their retail fund competitors, and the lawsuit likely would not have been filed. Our ex-COO, it would seem, had a point.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.