Target date funds lack alternatives

Apr 8, 2012 @ 12:01 am

By Darla Mercado and Jason Kephart

Financial advisers intent on including alternative investments in the target date retirement funds they advise are finding few choices available to them.

“If an investment committee is looking for a suite of target date funds that use alternatives to manage risk or enhance return, few fund families would [have one],” said Jim Phillips, president of Retirement Resources Investment Corp., a broker-dealer that specializes in retirement plans.

“Alternatives don't seem to be in the target date funds we're finding,” said Stan Milovancev, executive vice president of Sequoia Financial Group LLC, which also serves the retirement plan market.

One possible explanation involves costs. With the coming of mandated fee disclosure, plan sponsors are very conscious of costs in their target date funds. That's made some asset managers even more reluctant to consider alternatives, which generally have higher fees than other investments.

In December 2010, in fact, J.P. Morgan Asset Management removed a 130/30 strategy fund that was part of its target date series because it had become too costly.

Fund companies believe that plan sponsors, who express a desire for new investments and lower costs, are speaking out of both sides of their mouths.

“There's a real interesting divergence between plan sponsors' very laserlike focus on the sticker price of what they're buying, and what they're also saying about being really interested in embracing this new way of investing,” said Anne Lester, a senior portfolio manager in the global multiasset group at J.P. Morgan. “Those two [reactions] are in direct conflict with one another.”

Despite the higher costs of alternatives, demand is growing among investors.

In a survey released last week by Pensco Trust Co., 80% of the 365 advisers polled said their IRA clients have expressed interest in using alternatives.


Retail alternative mutual funds have attracted $123 billion in assets since 2009, said Josh Charlson, an analyst at Morningstar Inc.

But as interest grows, exposure to alternative strategies and asset classes in target date funds remains “very minimal,” he said.

At MFS Investment Management, for instance, the allocation to an absolute-return strategy in the firm's target date funds tops out at 2%, according to Joe Flaherty, a portfolio manager and head of MFS' Quantitative Solutions unit.

“Investors still believe target date fund performance is primarily driven by traditional assets,” he said. “We don't want something like commodities to drive the portfolios.”

To have any impact on performance, however, portfolio allocations should be 5% or more, according to investment theorists.

“If you're going to put in 2% or 3% of your assets into alternatives, don't bother doing it — it's not going to affect outcomes,” said David O'Meara, senior investment consultant at Towers Watson Investment Services Inc.

“It's hard to imagine you could allocate enough to alternatives to make a difference and still have a plan sponsor feel comfortable,” said Tom Fontaine, head of defined-contribution investments at AllianceBernstein LP. “A 5% allocation to whatever asset class can help, but it won't make a huge difference.”

Giants such as Fidelity Investments and The Vanguard Group Inc. have fared well with standard asset allocations in their target date funds, so delving into alternatives beyond the scant current level may not be worth the effort or risk, Mr. Charlson said.

For example, Vanguard's target retirement funds have minute REIT exposure via the underlying Vanguard Total Stock Market Index Fund.

“While we continue to evaluate "alternative' investment options such as commodities futures, hedge funds, real estate and other strategies, it is clear that most "alternatives' — particularly highly concentrated, illiquid, opaque and/or difficult-to-value strategies — do not pass this screen,” said Linda Wolohan, a spokeswoman for Vanguard.


In a perfect world, advisers said, target date funds would be ideal vehicles to provide participants with exposure to alternatives, giving them diversification without their assets' being concentrated in a single type of alternatives fund.

“I'd like to see this done in a way that the manager is controlling risk and giving you the benefits of broader diversification,” said Keith Olshove, vice president of investment, trusts and retirement services at Northwestern Bank.

But other advisers believe the effort may not be worth it.

“Some of the major players touting alternatives have the worst performance,” said Charles Warren, owner of Oswego Crest Financial Group LLC. “The industry has a tendency to fixate on what's hot and what sells.”


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