Implications of Using Alternative Assets in Target-Date Funds

In recent years, fund providers have expanded the types of products that go into TDFs in an effort to improve risk-adjusted returns. For instance, we’ve already seen TDFs employ annuities and smart-beta strategies to their portfolios. Alternative assets, such as commodities, could be the next products to find their way in.

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When target-date funds began becoming mainstream, they tended to concentrate on simplicity. Many providers focused on simple stock/bond/cash allocations that were based mostly on an investor’s age or the number of years left until retirement. Today, fund providers are finding two issues with TDFs in this setup – they’re incomplete and inflexible.

In response, an increasing number of funds have begun making changes. To address the “incomplete” issue, TDFs have been adding new assets into their portfolios, such as real estate, gold and junk bonds. These products offer a variety of risk/return profiles with lower correlations to traditional asset classes, and can help deliver better diversified portfolios with improved risk-adjusted returns.

While investors appreciate the low-cost nature of passively-managed index funds, they also appreciate the flexibility to make adjustments to their TDFs based on current market conditions. To address this concern, some fund providers have begun incorporating active funds back into the mix. This gives fund managers the ability to tilt the portfolio based on interest rate risks, equity valuations or any other reason they feel could impact shareholder returns.

One of the criticisms of target-date funds is the one-size-fits-all approach. Focusing solely on the number of years until retirement ignores a number of risks and factors that could impact individual investors, such as risk tolerance, other asset classes, retirement objectives and tax considerations. Investors need dynamic solutions that provide more individualized attention to their particular circumstances.

This is where alternative asset classes can help. A portfolio of large-cap, small-cap and foreign equities could be considered diversified, but these classes still have relatively high correlations to each other. Real estate and gold, for example, are much less correlated to equities and respond very differently to economic conditions. These kinds of assets can provide important risk-management benefits for investors nearing retirement or worried about severe market declines. Including these products in TDF glide paths can help address the needs of a more diverse investor base.

For a listing of alternative funds, click here.

It makes sense to include some, but not necessarily all, alternative asset classes into TDFs. Here are a few of the more popular alternatives and whether or not they make sense in a target-date fund.

• Commodities – These assets, including things such as gold and silver, are often more economically sensitive and considered a safe haven in times of uncertainty. Holding these assets is beneficial from a risk-management perspective, but can be costly, especially if holding the physical asset.

• Real estate – S&P thought real estate was economically important enough to break it out from financials and give it its own sector in the GICS classification system. Owning actual real estate doesn’t make sense, but REITs make exposure to this sector easy, cheap and liquid. Real estate is already showing up in TIAA’s target-date funds.

• Liquid alternatives – These are products that invest in non-traditional assets and strategies, such as managed futures and leveraged loans, and are designed to be easily tradeable on an exchange. That’s about where the benefits end, as liquid alternatives are often costly, complex, difficult to understand and lack transparency.

• Private equity – Privately-held companies may have home-run potential, but they are costly to take a stake in, and are challenging to sell if you ever want to exit your position.

• Hedge funds – These products have traditionally been available only to high-net-worth investors, but their high costs have led many of these funds to lag their benchmarks over time.

Click here for some things you should know before investing in alternative funds.

When assessing the suitability of alternative assets in TDFs, it’s important to remember that not all options are appropriate. Real estate and commodities can make sense due to their liquidity and low correlation to other assets, but private equity and hedge funds present poor risk/return trade-offs. Effective implementation of these products and strategies in a broader portfolio usually requires the help of someone with expertise in their particular area.

Less traditional asset classes have become cheaper and more accessible than ever before. That makes including them in target-date funds easier than ever. Not all will make sense though, as costly and complex assets are best left alone. More liquid options, such as real estate, are more ideal and can lead to better overall risk-adjusted returns within a target-date fund’s structure.

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