Mutual fund managers' use of exotic strategies, including leverage and derivatives, so far is yielding varying performance and mixed reviews from financial advisers.
Firms using leverage and derivative-based strategies to boost the performance of their target date funds in down markets include
AllianceBernstein LP,
Invesco Ltd. and Pacific Investment Management Co. LLC. Legg Mason Global Asset Allocation elected last month to use options in its target date fund series to manage tail risk, that is, the risk posed by events that are unlikely to happen but would have a big impact on portfolios if they did.
The strategies are fairly new, with
AllianceBernstein adding its strategy to target date funds last year, and Pimco and
Invesco beginning to implement their strategies in 2008 and 2009, respectively. As a result, there isn't much performance data to indicate whether the measures are paying off.
But this year's market volatility has revealed the extent to which these strategies zigged when markets zagged.
PERFORMANCE VARIES
Advisers are intrigued by the funds' methodologies, but because they have a short historical timeline and perceived complexity, they are wary.
“When you look under the hood at what the companies are doing to produce results, sometimes the strategies seem to work, and other times, when you think it should work, it backfires,” said Gerald Wernette, principal and director of retirement plan services at Rehmann LLC.
Invesco's Balanced Risk Retirement 2020 fund (AFTAX) combines commodities, leverage and derivatives with equities and fixed income. It was up 7.48% year-to-date through Dec. 15, and the trailing one-year return was 10.44%. By comparison, the S&P 500 was largely flat — down by 3.33% year-to-date, and down by 1.58% over the past 12 months.
Pimco's RealRetirement series, which uses derivatives to hedge against tail risk, largely buffered investors against major declines during the market tumult in August and September. During those months, RealRetirement 2020 (PTYAX) lost only 5.7%, while the S&P 500 tumbled 12.45%.
Year-to-date through Dec. 15, the fund was up 0.2%.
AllianceBernstein LP, which also uses derivatives as part of its dynamic-asset-allocation strategy, has seen a year-to-date decline of 6% in its AllianceBernstein 2020 Retirement Strategy (LTHAX). The firm implemented the strategy — which mitigates losses by seeking to remove portfolio risk during periods of market volatility — in the second quarter of 2010. Portfolio manager Christopher Nikolich noted that shedding risk during a difficult August helped to stem losses that otherwise would have been worse.
To put things in perspective, the target date funds in Morningstar Inc.'s universe dated 2016 through 2020 are down 2.22% year-to-date and down 0.4% over the past 12 months.
Fund analysts and managers alike are quick to point out that skyrocketing performance isn't necessarily the objective of these funds.
“Pimco's tail risk hedging is going to cut losses during dips in the market, but the trade-off is that you might give up some returns,” said Josh Charlson, senior mutual fund analyst at Morningstar.
LESS ROBUST RESULTS
Mr. Nikolich noted that while third-quarter performance in AllianceBernstein's target date series exceeded expectations, results were less robust in October. “We de-risked in an environment where the performance was good, but providing smoother returns is what we're realizing.”
The inconsistency in performance across the board for these funds has been a factor in advisers' decisions to keep the products at an arm's length.
Another concern is that leverage can exaggerate the effect of both market gains and declines, requiring fund managers to be vigilant.
“Strategies deploying tail risk hedging have been additive to the portfolios, but there are cases where we've seen managers with specific hedges that don't help as much as they'd like because of that volatility,” said Eric Freedman, chief investment officer at Captrust Financial Advisors. He performs due diligence on these funds for Captrust's advisers.
Mr. Charlson added that leveraging the bond component of a target date fund's portfolio could raise risk if interest rates were to spike.
Further hampering advisers' acceptance of funds that use these strategies is the difficulty in explaining them to clients. Given that each deploys derivatives, leverage and strategies in unique ways, it's not easy to get investors — especially retirement plan participants — to understand the differences among funds.
“You only meet with 401(k) participants for a short time, and with plan sponsors, an hour is too long for a meeting,” said Joe Connell, senior benefits consultant at Financial Concepts. “Explaining the concept of a target date fund inside of that time frame is hard enough. We'd like to see the investments be a little more generic.”
To some extent, sheer lack of availability through the largest record keepers has kept advisers and retirement plan sponsors from getting familiar with these strategies.
“The defined-contribution-plan space is still dominated by large record keepers,” said Scott Wolle, portfolio manager and chief operating officer at Invesco Global Asset Allocation. “Regardless of the appeal and the performance of a particular strategy, it's a battle to get through into the lineup.”
Still, some advisers see the addition of these more esoteric strategies as the next evolution in target date funds. It simply may take more time and more fund families using derivatives, leverage and other exotic methods to determine whether they're worth the buzz.
“We're getting recognition that even more-sophisticated risk management strategies should be applied in target date funds,” said Edward M. Lynch Jr., managing director and chief retirement officer at Dietz & Lynch Capital. “Time will tell whether these strategies are delivering more value.”
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