Your 401(k) may be skimping on this key investment

Target-date funds have become the retirement investment of choice for Americans in 401(k) plans. Target-date funds’ autopilot approach — which automatically shifts to more conservative holdings as individuals approach retirement — are touted because they eliminate the risk that an investor, on their own, won’t properly diversify.

That’s led to a growth rate for target-date funds of 280 percent over the past five years, according to fund research firm BrightScope. But there’s one notable asset class that’s missed out on that growth and is missing from many retirement fund series.

DNY59 | Getty Images

DNY59 | Getty Images

Fund firms preach the importance of alternatives as part of a long-term investing plan, but not enough target-date funds are practicing what the fund companies preach.

Of the roughly $800 billion in target-date funds — primarily within 401(k) plans — only 11 target-date funds series include allocations to portfolios identified as alternative investments, according to research conducted by fund-industry consultant Strategic Insight. Target-date series actually have more than $1 trillion in assets when including funds registered as commingled investment trusts. That’s one-fifth of all assets going into defined contribution retirement plans.

“The fund industry generally advocates a 10 percent to 20 percent allocation to liquid alternatives for risk mitigation, but many off-the-shelf asset-allocation portfolios seem to fall short of that,” said Bridget Bearden, Strategic Insight’s director of retirement research.

The 11 target-date fund series that did include alternative investments had $58 billion in total assets, or about 8 percent of market. The average target-date fund’s allocation to alternatives was only 6.2 percent, Strategic Insight found. Outside of the target-date structure, alternative mutual funds and exchange-traded products held $271 billion in assets, as of the end of the first quarter of 2015.

The fund industry’s difficulty of sticking to one definition that encompasses all alternatives as an asset class helps explain the slow rate of adoption within target-date funds.

David Blanchett, head of retirement research at Morningstar, said that 10 years ago commodities were considered an alternative, but most firms now don’t define commodities within the “alternatives” bucket. About 45 percent of fund series have exposure to commodities, which is up from 10 percent in 2008, according to Morningstar.

“That has definitely been on the rise,” Blanchett said.

“It’s a moving-target definition,” said Rich Weiss, senior portfolio manager with American Century Investments’ target date One Choice Portfolios. “As people get comfortable with an asset class, it’s not considered alternative anymore.”

Weiss said American Century Investments’ target-date series holds high-yield bonds, emerging market equity and real estate investment trusts, all considered alternative in the past but no longer viewed that way.

Strategic Insight includes 15 categories of alternative funds in its research, but notably does not include real estate or commodities/natural resource funds as alternatives unless these are leveraged investments.

Weiss said that about 3 percent to 5 percent of target-date fund-of-funds are in alternatives — primarily its hedge fund–like, long/short equity fund, the American Century NT Core Equity Plus Fund (ACNKX). “Given our other asset classes, we feel that’s the optimal level,” he said.

Other fund companies go much further in defining alternatives and providing retirement investors with exposure to them.

Strategic Insight found that the “noticeable outliers” in alternatives exposure are Nationwide and Vantagepoint. The Nationwide Target Destination has the highest allocation to alternatives among the sample, peaking at 20 percent for its 2025, 2030 and 2035 funds. Vantagepoint’s target-date funds increase alternatives allocation to 15 percent in 2030.

Manulife Asset Management, which runs the John Hancock suite of target-date funds, has exposure to alternatives that range from 13 percent (for its 2055 target retirement date series) to 22 percent (for the 2010 series). The 22 percent exposure to alternatives for the 2010 target-date fund — for those already in retirement — goes straight to the difficulty in defining alternatives, as a significant portion of that exposure is in bond funds, where you would expect retired investors to be focused. In this case, it’s just the newer, unconstrained approach to bond fund investing, meaning bond fund managers have latitude to invest across a wide range of fixed income.

“We believe it is important to diversify alternatives in the same manner investors have been diversifying across traditional asset classes for decades,” said Nathan Thooft, senior managing director of asset allocation at Manulife Asset Management.

“The fund industry generally advocates a 10 percent to 20 percent allocation to liquid alternatives for risk mitigation. But many off-the-shelf asset allocation portfolios seem to fall short of that.”-Bridget Bearden, director of retirement research at fund industry consultant Strategic Insight

In any event, Manulife doesn’t believe that one alternatives fund can get the job done, no matter how you define it.

Thooft said investors should look for an approach to alternative investments from their retirement funds that cover broad categories: inflation hedges/real assets (real estate, timber, infrastructure, agriculture, natural resources); tactical asset allocation, such as bond funds that aren’t tied to any single fixed-income benchmark (known as “unconstrained” in industry terminology); global macro equity strategies; long-short equity; and long-short currency funds.

The American Century Investments manager said it’s important that the alternatives being used to adjust to the retirement target — known as the glidepath in the fund industry — of the investor.

Far-dated portfolios should have a greater emphasis on capital appreciation, while near-dated portfolios should display a heightened need for capital protection. For example, near-dated portfolios have greater exposure to lower-risk alternatives, such as unconstrained bond funds and absolute return strategies. Far-dated portfolios make larger bets on higher-risk alternatives, such as commodities.

Cost is key

The fund experts said cost might be a factor in low alternatives exposure across target-date funds. In fact, Blanchett said that in many cases investors might be better off if their target-date funds don’t have a great deal of alternatives exposure.

“These strategies can be relatively expensive and not do much to move the needle in terms of returns,” Blanchett said. He said a portfolio that is 55 percent stocks and 45 percent bonds can generate the same expected return portfolio as a portfolio that is 50 percent stocks, 10 percent alternatives and 40 percent bonds.

Blanchett said that because of the relatively small size of allocations to many alternative funds, the impact on returns is muted. “While it’s nice to allocate small sleeves of a portfolio to alternatives, in most instances it’s really not going to affect returns that much,” he said.

Weiss noted that, for a target-date series to appeal to retail investors and their consultants, both actual and “apparent” fees need to be kept in check. “For instance, in a ’40 Act fund, market-neutral funds appear to have enormous costs because the dividends on any stock you short count as fees — it’d look like you have fees over 400 basis points,” he said. “So, for practical issues, we don’t include these types of investments in our target-date offerings.”

The 130/30 fund — 130 percent long/30 percent short maximum — that the fund company does include in its target-date fund series has much lower fees (110 basis points) than a true long-short fund, which can hold 100 percent of assets in short positions.

With alternatives, there has to be a trade-off.

Principal Financial Group portfolio manager Jeff Tyler said alternative strategies help solve particular risk issues, such as inflation or longevity. Principal’s target-date offerings tend to hold about 3 percent to 4 percent in hedge fund–like portfolios, including global macro funds, event-driven funds and a variety of long-short funds. The Principal target-date funds hold a much higher percentage — 15 percent to 25 percent — in traditional niche diversifiers, including real assets and commodities.

Reducing uncertainty costs money, though. The firm’s Global Multi-Strategy Fund (PMSAX) has fees of 165 basis points for the institutional class, more than twice what Principal’s other target-date funds cost. Used improperly, alternatives can also be a bad fit for investors — and even attract the attention of regulators.

Asking the right questions

This past July, Massachusetts’ top securities regulator, Secretary of the Commonwealth William Galvin, began an investigation into how 25 alternative mutual funds, including the Principal fund, have been recommended by registered investment advisors to investors. Strategic Insight noted in its research that legal fears may be among the reasons retirement fund series have been slow to add alternative investments.

But Tyler said Principal’s Global Multi-Strategy fund is intended to reduce overall volatility, and that “is precisely why its use in a target-date context makes sense.” He gave as an example the now-common use of emerging markets as part of diversification, but which if used excessively can make for a very risky portfolio.

“The trick is to know how much,” Tyler said. “In a target-date fund, we have the benefit of mixing various components in the appropriate weights to produce a desired level of expected return for an expected level of risk. I cannot control what an RIA will say about the fund, but we are very clear in how we communicate about our use of alternatives,” Tyler said.

The debate over alternatives raises an important question for investors choosing to “set it and forget it” with their retirement investing through target-date funds:

  1. Do you know if your retirement fund series is using alternatives?
  2. If so, to what degree?
  3. How is it defining alternatives in the first place?

Investors should take a peek at how their retirement plan is approaching alternatives, but Blanchett said investors should not be overly concerned about the current low level of alternatives fund usage in target-date funds. “Overall, I’m not that worried about the current low allocations to alternatives,” Blanchett said. “I think we’ll see the allocations continue to increase in the future, especially as more providers enter the target-date space and try to differentiate themselves from their competitors.”

By Joe D’Allegro, special to CNBC.com

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