Retirees' target date funds making hedge fund style bets

By Reuters

Dec 08, 2014 07:15 AM EST

A fast-growing segment of U.S. retirement plans is using hedge-fund type strategies to bet a small but increasing slice of their assets.

BlackRock Inc (BLK.N), the world's largest asset manager, and Manning & Napier are among the managers that use strategies such as shorting stocks and trading derivatives in some 401(k) retirement plans, including target date funds. J.P. Morgan Asset Management and Voya Investment Management are considering adding similar strategies, executives told Reuters.

A hedge-fund style can be more expensive and riskier than just buying stocks and bonds, and workers may not fully realize their exposure, retirement consultants said. On the other hand, they can act as a shock absorber to events like the 2008 financial crisis.

Target-date funds, where some of these strategies are being used, have more than doubled their assets to $701 billion since 2010, according to Morningstar. U.S. legislation in 2006 allowed employers to automatically enroll employees into these funds, a default feature that has spurred asset growth.

In a target-date fund, retirement savers choose or are placed in a fund based on their expected retirement year and the portfolio adjusts its mix of assets, which traditionally were stocks and bonds, to become less risky over time.

About 41 percent of 401(k) plan participants invest in target-date funds, compared with 20 percent five years ago, according to the SPARK Institute, a Washington DC-based retirement plan lobbyist.

As of December 2013, 14 percent of target date fund managers had allocations to hedge fund strategies, up from 10.5 percent three years ago, according to retirement plan consultant Callan Associates.

The median target date fund allocation to hedge fund strategies rose to 5 percent in 2013, from 1.86 percent in 2011.

Many target date funds saw their performance plummet during the financial crisis because they were too heavily exposed to stocks and are turning to hedge strategies to prevent that from happening again, said Lori Lucas, defined contribution practice leader for retirement plan for Callan.

Meanwhile, these funds' expenses have risen. A 2050 target date fund with a 5 percent allocation to hedge funds carries a 60 basis point expense ratio, nine basis higher than an average target date fund, according to Callan. That would add about $450 a year in fees to a retirement account containing $500,000.

Asset managers say the true value of adding alternative strategies, which are designed to protect investors from downside risk, will not prove itself fully until equity markets stumble.

"These strategies have not helped in the bull market but tough times will be the litmus test," said Jeff Coons, president and co-director of research at Manning & Napier, which manages about $50 billion, including about $768 million in target date funds.

Last summer, Rochester, New York-based Manning & Napier's target date funds began trading fixed income futures contracts to hedge against interest rate risk, as well as stock option calls and puts on stocks it holds in its portfolios to hedge against equity market volatility.

Employers with 401(k) plans and the advisers who serve them worry that these additions mean more complexity.

"How are we supposed to evaluate and monitor these investments?" said Don Stone, director of defined contribution strategy and product development for Pavilion Advisory Group, which advises 401(k) plans. "The fact is it is hard and there has to be a certain level of trust in the managers."


Mutual funds using hedge fund strategies have grown in popularity since the financial crisis and had $158 billion in assets as of October, up from $37.6 billion at year-end 2008, according to Morningstar.

When average investors assess how risky their target date funds are, however, most just look at the allocation to equity versus fixed income, said Jim Lauder, portfolio manager of Wells Fargo's Advantage Dow Jones Target Date Funds, which are index-based.

By adding hedge-like strategies to its target date funds, firms like BlackRock expect they are reducing the risks of their portfolios.

Over the past 12 months, BlackRock has added alternative strategies to its $200 million Lifepath Active target date funds. The funds' allocation to hedge fund strategies rises as the investor gets closer to retirement, with the current maximum percentage allocated to them "in the high teens," said Dagmar Nikles, head of investment strategy for BlackRock's U.S. and Canada defined contribution group.

BlackRock has offset any added expense through other enhancements to the funds. As such, the overall expense of the funds hasn't risen and is below average.

Manning & Napier bought a team of portfolio managers earlier in the year that specializes in managed futures and wanted to add the capability to its target funds. The goal is to protect investors at or near retirement from interest-rate risk, Coons said.

Still, the average 401(k) plan participant does not have access to these kinds of strategies because employers will not offer them.

Jim Phillips, president of Retirement Resources, a Peabody, Massachusetts-based firm that advises 401(k) plans with $50 million to $100 million in assets, said employers don't want to offer hedge fund strategies to their workers as stand-alone investments. The fear is that employees would put all of their retirement savings into those strategies.

He said he welcomes the addition of hedge fund strategies as a piece of target-date fund portfolios.

"It is really the only sensible way to give these investors exposure to alternative investing," Phillips said.

More target date funds may add these investments once the current bull market comes to a close.

New York-based Voya is holding off because there is no rush given the strong equities market, said Paul Zemsky, CIO of multi-asset strategies. The average alternative mutual fund has returned 2.3 percent over the past year, compared to the average equity fund, which has returned 10.55 percent, according to Morningstar

"You are really putting a lot of faith in the skill of the portfolio manager when you choose these funds," Zemsky said.

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