Thursday, October 1, 2015

Target date 401K - Perfect place for hedge funds?



An important investment area over the last two decades has been the development of the target date funds as a simple method of asset allocation risk adjustment as investors age. An investor buys a target fund that will adjust the allocation between stocks and bonds as you move to the target date. As the you approach the target date more of the allocation is held in bonds. If you have 20 years until retirement, an investor could buy a target date that mature in 2035.

Some professionals have always argued that this approach is an asset allocation gimmick. There are better ways of conducting asset allocation as you reach retirement but as a simple rule that helps many less sophisticated investors, it can be effective. Yet, the low yields on Treasury securities mean that target funds are going to generate almost no income as you move to the target date. With lower yields, the cash flow is diminished and there will be more duration risk for any bond maturity. Additionally, a secular increase in bonds will significantly harm those that are positioned with higher fixed income exposure. There is no risk reduction if the tilt is toward higher rates. Of course, we cannot predict bonds yields, but the stated policy of the Fed is to raise rates and get inflation higher.

A better alternative for these target date funds would be to increase the exposure to hedge funds as an alternative to bonds. As the portfolio  gets closer to the target date, the allocation to hedge funds with lower equity beta would increase. This strategic allocation change may generate higher returns versus bonds at similar risk to the bonds. For 401K investors, there are no negative tax implications from the more active trading by hedge funds. There are also more liquid alternatives available that can make this within the reach of investors.

A better strategy may be to create a target fund surrogate through an equity hedge fund combination that is rebalanced each year toward hedge funds as an investor approaches retirement. Risky hedge funds for a retirement strategy? This may not be that crazy if you look closely at the relative risks. 

No comments: