Target-Date Funds with Hedge Fund Exposure
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Target-Date Funds with Hedge Fund Exposure

As more investors look to simplify their retirement savings, target-date funds continue to grow in popularity. And what’s not to like? The portfolios of stocks, bonds and cash offer instant diversification within one ticker. Additionally, that asset allocation becomes more conservative as an investor gets closer to the target date of the fund. Basically, target-date funds offer an easy, “set it and forget it” method for beginner investors or for those without much financial experience or time to manage a full portfolio.

And yet, some feel that target-date funds may be lacking.

The problem is that these traditional asset classes and the backbones of most target-date funds are becoming ever more correlated with each other. During the credit crisis, both bonds and stocks fell. That normally doesn’t happen but it could happen again.

To that end, liquid alternatives have begun to garner investor interest. But target-date fund investors are often left out in the cold when it comes to these strategies. That is, until recently. More and more TDFs are now including them in their portfolios. But what exactly are liquid alternatives and how do they benefit investors?

Read on to find out.

Exotics for the Masses

Managed futures, merger­-arbitrage, long/short, and global macro may not sound familiar to most investors, but they could become your portfolio’s best friend over the long haul. These are strategies that make up a “new” investment category of liquid alternatives. I say “new” since various institutional investors (e.g. pension funds, endowments, and sovereign wealth funds) have always dabbled in alternative investments.

Defined as any asset class that isn’t stocks, bonds or cash, liquid alternatives can be as simple to understand as commodities futures to more complex fare like 130/30 strategies­ which uses short positions to boost its long positions in stocks.

At first blush, using these hedge fund-­like strategies may not seem worth it, especially when considering their higher fees. But the basic principal is to find a way to generate consistent returns without the volatility associated with the stock market as well as provide more “oomph” to a fixed-income portfolio.

Perhaps their most important attribute is the lack of correlation to regular stocks and bonds. Over time, correlations between asset classes are growing closer together. According to alternatives and leveraged fund manager Direxion, between 1994 and the end of 2013, developed international and emerging stocks moved in lock­step with the S&P 500. Even the benchmark bond index, the Barclays Capital U.S. Aggregate Index, showed a positive correlation with stocks during that time. Direxion’s data showed that things like managed funds, commodities and currencies all behaved much differently and even moved in the opposite direction. That means that when the crash happens, these things should protect a portfolio unlike even bonds.

Additionally, several alternatives such as Merger­Arbitrage or Credit Neutral are designed to provide bond-like steady returns. Investors looking for a ballast will be better suited in these alternatives than regular bonds.

At the end of the day, investors can think of alts as a way to regain the diversification benefits they have been losing.

Target Date Funds & Liquid Alts

Some advisors have postulated that investors have as much as 30% of their portfolios in these sorts of alternatives. However, even a small 5% weighting can do a portfolio some good and provide needed diversification benefits. Which could explain why many target-date funds are now beginning to add exposure to several of these strategies.

For example, Alliance Bernstein’s target-date funds now include exposure to an equity long/short fund as well as a global macro fund­ that can bet on a diverse set of assets including stocks, bonds, and commodities as opportunities arise. Another example is Principal Financial’s series of target-date funds that hold a multi­sector alternatives fund that bets on various liquid alt strategies. Further, more and more fund managers,­ from BlackRock to Voya Investment Management­, have begun to explore adding liquid alts to their target-date funds.

Again, the idea is to add a dose of uncorrelated returns that can help reduce downside risk, while still offering some upside. With that in mind, there is no such thing as a free lunch. For one thing, liquid alts cost a whole heck of a lot more in expenses. The average alts mutual fund can run 1.73% in annual expenses. That does drive up the overall expense ratio of a target-date fund using them. Secondly, in the credit-fueled bull market of the last few years, many alts strategies and asset classes have underperformed or have actually provided losses to portfolios. That may be a bitter pill to swallow for some investors. However, it just goes to highlight their uncorrelated nature. If and when, the market gets wonky, these funds should do better.

The Bottom Line

While they may sound exotic, liquid alternatives are about one thing­: providing uncorrelated and steady returns. Once the fare of high-net-worth and institutional investors, many regular Joes now have access to the asset class via target-date funds. Ultimately, that could be a good thing as the benefits could outweigh the additional costs associated with these strategies.

Disclosure: None

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Sep 18, 2015