16 January 2018

Hedge Funds in Your 401(k)

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Many asset managers argue that nontraditional investments belong in your 401(k) or other retirement account. But with giant pension plans like the California Public Employees’ Retirement System cutting their exposure to hedge funds, and the Securities and Exchange Commission examining how alternative funds are managed, retirement investors should open their eyes and be cautious.

Alternatives can be just about anything other than plain old stock or bond portfolios: funds that traffic in real estate, commodities, foreign currency or the debt of troubled companies; private-equity operations that buy companies outright; funds that hedge by betting on security prices to go down as well as up.

A fund that seeks to fight inflation can be useful in just about anyone’s retirement account. For most investors, however, there are simpler, cheaper ways to realize many of the goals alternative funds set out to achieve.

So far, the migration of 401(k) plans into alternative funds isn’t a stampede. Industrywide, analysts and consultants say, the percentage of retirement assets invested in alternatives is well below 10%. And most “target date” funds, the 401(k) portfolios popular among employees who expect to retire on a known date in the future, don’t yet hold any alternatives.

But according to Lipper, the fund-research company, the 25 target-date funds with the greatest exposure to derivatives—futures, options and other instruments tied to the performance of stocks, bonds and commodities—have an average of 36% of their assets there. That indirect measure of exposure to alternatives is up from 21% a year ago.

Morningstar, another fund researcher, estimates that target-date funds hold $1.7 billion in alternatives, up more than fourfold from 2010. Alternative funds, by tapping into techniques that differ from those of traditional stock and bond funds, improve diversification and provide different sources of return.

In the fourth quarter of 2012, the S&P 500 stock index lost 0.4% and the Barclays U.S. Aggregate bond index gained just 0.2%; the Neuberger fund grew by 0.4%. When stocks do very well, however, such a fund tends to lag behind; in 2013, as U.S. stocks returned 32.4%, Neuberger was up 9.6%.

In addition, many alternative strategies require investors to lock up their money for months or years at a time—and in a 401(k), participants expect to be able to move their money at will. As a result of all these factors, asset growth [in alternatives] will be minimal for most 401(k) plans. The problem is that many alternative assets seem liquid, or tradable, until there is a crisis.

If your 401(k) does start offering an alternatives fund, find out how well the managers weathered a period when liquidity dried up. Remember that you will pay annual fees of around 2%; that is 10 to 20 times what an index fund might cost you. Many existing options—real-estate and inflation-protection funds, for example—provide at least some assurance much more cheaply.

During the financial crisis in 2008 and 2009, even eminent investors like the endowments of Harvard University and the University of Chicago were surprised by how quickly and severely some of their alternative assets lost value and became hard to trade.

To believe that alternatives can work broadly in 401(k)s, you must believe that the people running the funds are better than all the other smart people who’ve thought they had a plan until they encountered roadblocks.

Click here to access the full article on The Wall Street Journal. 

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