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Hedge Funds in a 401(k)?

In a recent Wall Street Journal article, “Hedge Funds in Your 401(k): Do they Fit,” (subscription required) Jason Zweig discusses the possible “place” of alternatives in 401(k) plans. In the article, “alternatives” refers to “anything other than plain old stock or bond portfolios.” 

This conclusion seems to be a bit at odds with the title in that alternatives (using this definition) can, of course, represent many different types of investments, which can be found in mutual funds, separate accounts, collective trust and ETFs. The “hedge fund” term best describes the type of fee structure as well as the greater latitude of the manager to alter their strategy, which is the primary reason that hedge funds are only sold to “qualified investors” as defined by SEC rules.

From the perspective of the plan advisor, the issue is not about hedge funds being offered to participants as direct investments (something that is not happening and probably would not be allowed due to SEC/DOL restrictions) but whether it is appropriate to include alternatives in a core fund lineup or imbedded in a target-date fund or other asset allocation program.

The article notes that although most target-date funds “don't yet hold any alternatives,” the “25 target-date funds with the biggest stake … have an average of 36% of [alternative] assets” — an increase of 21% from a year ago.

Here’s an educated guess as to why many TDF providers are increasing their exposure to alternative assets: Many managers believe that we may be nearing the end of a long period of gains in the equity and bond markets and these gains need to be protected. Developed countries’ stocks and bonds seem to have run their course and could experience a severe downturn as the result of insufficient growth to support what many are perceiving as “stretched valuations.” How will the great Keynesian experiment (first initiated to deal with the fallout from the Great Recession) end? Will the Fed be able to facilitate a smooth landing or will they be forever stuck in the “new neutral” (to use Bill Gross’ term for the Fed’s policy to maintain zero interest rates for many years to come)? 

Conclusion

Utilizing alternatives to help keep an asset allocation strategy on track is a sophisticated undertaking. This is why it is best to keep alternatives (most of which, as a single investment, are not diversified) out of core lineups and left up to the professional asset allocators to include in asset allocation constructs. Most DC investors do not understand the difference between a large-cap value fund and a small growth fund, much less an absolute return fund (unless they erroneously believe that such funds “absolutely” provide a return, no matter what).

The grouping of alternatives (an asset class) with hedge funds (a portfolio structure) is not necessary as hedge funds in a core lineup are not coming to a 401(k) plan anytime soon. Or perhaps they will not come at all, given that hedge funds will not be offered to “non-qualified” investors even if they are part of a 401(k) trust.

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