Some critics contend the 401(k) concept is broken and has failed its basic mission to fund the great American retirement. Avatar Associates begs to differ.
The New York City-based institutional money manager serving financial advisors and others gets roughly half of its revenue from the 401(k) market, and expects that to rise to 75% to 80% over the next five years. Its foundation is a quantitative investment process that puts less stock in standard financial models and more emphasis on a "weight of evidence" approach that takes a range of economic and market indicators and puts them in a blender to divine which way the investing winds are blowing. Avatar employs a tactical allocation approach it says enables it to react to changing market conditions and mitigate volatility, while building its portfolios solely with low-cost exchange-traded funds across various asset classes.
But while 401(k) plans help Avatar pay the bills and then some, the company isn't an apologist for the industry's perceived shortcomings. If anything, it has been pushing for reforms to make retirement plans more effective and plan providers more accountable to plan sponsors and investors.
Larry Medin, the company's president, has worked with Congress, the Securities and Exchange Commission and the U.S. Department of Labor on 401(k) issues, and before he joined Avatar played a role in making the Pension Protection Act of 2006 possible. Among other things, this regulation amended the Employee Retirement Income Security Act (ERISA) to provide a safe harbor for plan sponsors to invest participant assets in qualified default investment alternatives (QDIAs) when participants fail to provide investment direction for their accounts. This act has been credited with boosting 401(k) plan participation and savings rates.
And with the U.S. Department of Labor currently considering a proposal to redefine who should be a fiduciary in the retirement planning space under ERISA, Medin is on his soapbox stating that mutual fund companies, which currently are exempt from fiduciary status under ERISA, should be held to that standard. It's that exemption, Medin says, that helped cause the disappointing performance of target-date funds-an increasingly popular QDIA in 401(k) plans-during the market downturn because fund companies made conflicted choices by stocking their target-date funds with their own proprietary funds rather than picking the funds best-suited for market conditions at that time.
"To say the vast majority of assets moving into the QDIA space-target-date funds among them-will be excluded from fiduciary responsibility is absurd," Medin says.
The 401(k) industry has been plagued by low participation and savings rates, allocation problems such as heavy weightings in company stock, and failed efforts to educate the public on how to get it right. "I think 401(k)s were broken, and they've been partially repaired," Medin says. "The Pension Protection Act was a tremendous step in the right direction, but a lot of things still need to be done."
One of those things was Rule 408(b)(2), a Labor Department regulation issued last summer that was scheduled to take effect this July. Recently, that start date was pushed back to January 2012. The regulation will impact both defined contribution and defined pension plans subject to ERISA, and will require providers and plan sponsors to clearly disclose the services being provided, explain who gets paid for what, highlight built-in conflicts of interest and say whether the investment provider is acting as fiduciary of the plan. The name of the game is to boost transparency, help sponsors better manage their plans, control risks and reduce fees for both plan sponsors and participants.
And now there's the Labor Department's re-examination of who exactly should be a fiduciary under ERISA. Avatar believes these mandated--and potential--changes "will be like a tsunami washing over the 401(k) market that will require each plan sponsor to re-evaluate the current arrangements and carefully consider products and services like Avatar's," says Dan Carlson, the firm's chief marketing officer.
Avatar was formed in 1970 and entered the 401(k) space in 2006. It's making a bigger name for itself there, but it might be known by some people more for one of its co-founders, noted investor Marty Zweig, and a couple of aphorisms he coined back in the day--"Don't fight the Fed" and "Don't fight the tape." These concepts speak to the role of monetary policy and market performance on investment management, and they guide the firm's philosophy to this day along with the non-mainstream market views of Zweig, the firm's first research director, and Avatar's other co-founder, Ned Babbitt.
"Our model assumes the world is messy and non-linear," says Ted Theodore, Avatar's chairman and chief investment officer. "We needed a mathematical framework that can deal with how the world really works, which contrasts with a lot of the standard financial models that developed over the years that assumed the market was normal and had bell-shaped distributions."
Prior to joining Avatar in 1989 to share research director duties with Zweig (who no longer works at the firm), Theodore was a strategist/portfolio manager at Morgan Stanley Asset Management and the director of equity strategy at Citibank. He had done financial modeling similar to what Avatar was doing. "When the opportunity to join Avatar came, it was a natural fit," he says.
Avatar calls itself a value investor, but it doesn't rely on standard valuation measures such as price-to-growth, enterprise value, EBITDA and the like. "They all have their place," Theodore says, "but they are most effective on a three- to five-year horizon; 401(k) investors seem to have a three- to 12-month time frame when making investment decisions and reviewing their selections, so reliance on those standard valuation tools aren't as effective for short time periods."
Instead, Avatar employs "practical" value measures that combine a mosaic of investor actions and attitudes by keeping track of surveys and following gauges such as mutual fund flows and insider trading. "Insiders get it right when it comes to buying and selling," Theodore says, adding that insiders were in sell mode from summer through the autumn, but became buyers in recent months.
Some of the metrics Avatar parses are leading indicators of business--and thus, market--activity. As Theodore explains, the shape of the yield curve can impact profits because a wide curve is good for business and vice versa. In the credit markets, a spread between high- and low-quality might be a leading indicator for a currency.
"We don't forecast anything, but we measure lots of indicators in a multi-factor model," Theodore says. "We combine all those indicators into a composite scoring model most economists would call a diffusion index. It's a quantitative model requiring constant refining and the need to find new market drivers."
All of this modeling forms the backbone of Avatar's various portfolios, or strategies. These include risk-based strategies ranging from capital preservation (primarily fixed income) to aggressive growth (all equity), along with age-based, target-date strategies up to year 2050.
Avatar says financial advisors use the firm to be their investment strategist and to manage portfolios within the risk parameters they identify for the client, whether they be private investors or retirement plan participants. Carlson says Avatar obtains its 401(k) business through consultants, advisors to plan sponsors and record-keeping platforms.
Avatar runs eight portfolios in the non-qualified space, and offers five risk-based funds and nine target-date funds for 401(k) investors that are based on Avatar's overall investment strategies. Avatar's 401(k) offerings are in the form of collective trust funds, which pool assets of individuals and organizations into larger, diversified portfolios. These funds are exempt from the 1940 Investment Company Act and SEC registration, but are under the jurisdiction of bank regulators and the Labor Department. Thus, they fall under ERISA's fiduciary umbrella.
After a portfolio's asset mix is determined, Avatar stocks it with ETFs it thinks can grow earnings in the future but are relatively undervalued today. Theodore says the firm has 200 funds on its approved list, and uses between 20 and 40 at any time in each portfolio. They'll use ETFs for exposure to a range of asset classes, from stocks and bonds to commodities and real estate. With alternative investments, Theodore says Avatar recently bought an inverse ten-year Treasury ETF, which he says did well when Treasurys slumped toward the end of last year.
As active asset allocators, the Avatar team constantly checks to make sure their funds are still on track and that their valuation metrics still make sense. "We don't swing around portfolios radically," Theodore says. "There are bands of asset allocation changes that we stay within. They're not very wide, but they can make a difference."
One of the things that can impact valuations is liquidity caused by monetary policy ("Don't fight the Fed") and the economic system, which generates liquidity as a normal part of the business cycle." Liquidity, of course, can juice the markets.
Avatar also seeks confirmation through market momentum. ("Don't fight the tape.") "We want to make sure we're not fighting the markets, and insisting we're right when the markets are punishing us," Theodore says. "We're fairly quick to recognize our mistakes and cut our losses, and we let our profits run."
In the 401(k) space, Avatar's most conservative offering, the capital preservation fund, held up well in 2008, with a loss of 1.58% versus an average loss of nearly 19% that year in the Morningstar universe of conservative allocation U.S. open-end funds. When the markets rebounded in 2009, Avatar's capital preservation fund gained 11.24% versus the average 20.29% gain in the comparable Morningstar category. But Avatar notes the fund's combined two-year performance still beat the Morningstar category by 5.82% because of the downside protection in 2008.
At the other extreme is Avatar's all-equity aggressive growth fund and its nearly 38% drop in 2008, which mirrored the 38% drop in the S&P 500. In 2009, Avatar's fund gained almost 30% versus the S&P's 23% rise that year.
"We don't believe in market timing, but we do try to lean the portfolio in the direction we think it's going and be comfortable with modest outperformance of the benchmark over intermediate periods," Theodore says. "And if you string that together over long time periods, you get very good performance and extremely good risk-reward performance."
Avatar has a reputation as a conservative shop, but that might be misconstrued. "Avatar has taken the indexing concept and overlaid a tactical allocation approach to it, so it can be viewed as less volatile, which can be translated to conservative," says Randy Kamps, an RIA in Traverse City, Mich. "My take is they have the most rational approach I've come across for my clients."
Kamps uses other investment managers for his 401(k) clients, but he says Avatar is his predominant choice. "My experience with Avatar has been very good," he says. "Their managers utilize the most transparent and efficient investments possible."
Carlson says Avatar is involved with more than 400 401(k) plans, and on average is adding five to ten plans a month of various sizes. He adds the company supports the plan consultant or advisor serving the plan with plan sponsor meetings or conference calls.
Sue Thompson, managing director at iShares, gives the firm credit for providing institutional quality management at prices normally only available to big companies. "Typically, the smaller the company trying to launch a 401(k) program, the more expensive it is," she says. "Now, even small companies can get a 401(k) plan at reasonable cost, which goes to the bottom line of a participant's account."
Avatar's management fee is 25 basis points, and Wilmington Trust charges ten basis points for its trustee services. In addition, each ETF has its own expense ratio that varies from seven basis points at the low end to as much as 70 at the high end. Carlson says they weight the various ETF expense ratios according to the relative weighting of the ETF in a fund, and that the total weighted expense can vary from 20 to 30 basis points.
One thing that helps keep Avatar's fees low is that collective trust funds have cheaper operating costs because they have less reporting and communication requirements than SEC-registered open-end mutual funds.
But there's a flip side to less reporting. "From a sponsor and participant standpoint, there's some difficulty in getting ready market information by doing a Google search for collective funds," says Mark Gutrich, CEO of ePlan Services, a Denver-based record keeper of 401(k) plans for small businesses that offers Avatar's funds to its customers. "There are some obstacles from a user's perspective when using collectives versus using open-end mutual funds. But I think the philosophies employed by both [structures] have pros and cons."
Another thing Thompson from iShares likes about Avatar is how it constructs different portfolios representing different risk levels, and then folds those different risk profiles into a target-date fund approach to create retirement glide paths that give investors more options.
The glide path is how target-date funds rebalance their allocations between stocks, bonds and other assets as the fund matures--the closer to the retirement date, the more conservative it becomes. Glide path construction played a big role in target-date performance during the downturn. On average, these "set it and forget it" funds lost 23% in 2008, according to Morningstar.
Critics howled that too many target-date funds had improper glide paths with too much equity exposure, particularly those with 2010 target dates purchased by folks closest to retirement. The worst of the 2010 target-date fund class lost 41%.
Avatar believes its flexible, tactical approach to portfolio management lets it make adjustments to better mitigate volatility than the static glide paths at other funds. It aims to smooth the ride toward retirement and prevent negative jolts that scare 401(k) investors and cause some people to bail on their plans. "The goal is to keep people invested and contributing to their plan because a person achieves their retirement goals more by contributing and compounding than by selecting an appropriate investment," Carlson says.
The aftermath of the market crash of '08-'09, as well as lingering fears about the country's looming retirement crisis, are keeping regulators busy.
The Labor Department in March will begin hearings on the feasibility of expanding the fiduciary standard under ERISA.And sometime this spring, the agency is expected to formulate the final rules for regulation 408(b)(2), which among other things aims to boost transparency and control risks in retirement plans.
And the U.S. Senate Special Committee on Aging, which held hearings on target-date funds in late 2009 and whose chairman, Sen. Herb Kohl (D-Wis.), stated that anyone operating under the Pension Protection Act should be held to a fiduciary standard, might examine the fiduciary issue later this year, according a committee staffer.
Meanwhile, the SEC weighed in last year with a proposed rule to provide more information to investors in target-date funds to help them better assess the fund's anticipated investment glide path and risk profile.
Larry Medin at Avatar has been lobbying the Labor Department to include the mutual fund industry under ERISA's fiduciary standard. "When a fund family creates a target-date fund by allocating to it from some of its existing mutual funds, and are doing business with themselves with the opportunity to make additional money [from the fund fees], that's self-dealing and would be a clear conflict of interest and a prohibitive transaction for any party under ERISA except a mutual fund," he says.
The Investment Company Institute (ICI), the mutual fund industry's trade group, sees things differently. In a February comment letter to the Labor Department regarding the re-evaluation of the fiduciary standard, the ICI wrote that simply selling an investment product shouldn't be a fiduciary act, and that while the process of selling an investment may involve an implicit recommendation by the seller, it doesn't mean a seller's activities constitute ERISA investment advice.
And in an October 2009 letter to the U.S. Senate Special Committee on Aging, ICI wrote that concerns about target-date funds using proprietary funds as underlying funds is misplaced. "There are many reasons why a fund provider would determine that using proprietary funds is the best way to achieve a fund's objective," it wrote. "In addition, there are regulatory hurdles that make it more difficult for mutual funds to use non-proprietary funds."
Jason Roberts, CEO of the Pension Resource Institute, a Manhattan Beach, Calif.-based consultant to RIAs and broker-dealers on ERISA-covered retirement plans, believes it's highly unlikely that mutual funds will be required to sign on as fiduciaries. But he does think the fiduciary issue will resonate with plan sponsors, and that in the wake of the upcoming 408(b)(2) regulation to improve 401(k) plan transparency, provider-agnostic companies such as Avatar are very well-positioned.
"They'll market them as fiduciary and they'll probably get some market share," Roberts says. "I think that applies to the collective funds that Avatar uses."
Naturally, Avatar would agree with that assessment. "We want to bring about change to the industry by lowering fees, eliminating conflicts of interest, and increasing the level of trust participants can place in the financial services industry," Carlson says.