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Aiming at Alternatives

Target-date funds are finally incorporating alternative investments into their mix.

Josh Charlson, 12/01/2010

Target-date funds have been one of the brightest success stories in the mutual fund industry over the past five years, propelled by the Department of Labor's ruling that target-date funds could serve as qualified default investment alternatives under the 2006 Pension Protection Act. Since then, assets in target-date funds have exploded, with inflows ballooning to $45 billion in 2009 from $22 billion in 2005. Increasingly, investors in employer-sponsored retirement plans are putting their assets, and retirement futures, in the hands of target-date fund managers.

Despite the prominent role these funds play in investors' retirement well-being, target- date managers have been slow to adopt new asset classes and investment types, preferring to stick with the status quo. But we're seeing signals of change. Some of the largest providers have expanded their allocations into less-traditional areas, while some newer entrants to the target-date scene have taken fairly bold steps into alternatives.

Meeting Resistance
"Alternative investments" is a cloudy term to begin with, and there's even greater ambiguity when it comes to target-date funds. Because the typical target-date fund shareholder is a novice investor, and because these investments are constrained by both the structure of the Investment Company Act of 1940 and the QDIA requirements established under the Employee Retirement Income Security Act of 1974, target-date funds are working within a more limited framework than are institutional managers or advisors for high-net-worth individuals.

Some target-date fund asset-allocators view ventures into more-specialized areas of traditional asset classes, such as high-yield bonds and Treasury Inflation-Protected Securities, as "alternative." Other firms, trying to develop their target-date allocations as "mini defined-benefit or pension" models, would label as "alternative" only the asset classes or strategies that offer low correlations to traditional asset classes, such as commodities, real estate, derivatives, or hedging-type strategies. Definitions will differ from firm to firm, but this recapitulates a fairly typical industry perspective. Target-date funds have very low average allocations to alternative investments by any definition.

Yet research continually shows that adding diverse investments to a portfolio can improve its risk/reward profile, and institutional investors have eagerly adopted alternatives over the past decade, hoping to replicate the success of the "Yale model." Why, then, have target-date funds been so reluctant to adopt this investment trend? There are at least three factors that have accounted for the timidity of the industry.

* Operational Obstacles
Even when an optimization model makes a strong case for adding a new asset class or investment strategy, a firm's hands are tied if it lacks a fund with which to implement the strategy. A proprietary, or closed- architecture, firm (which uses only managers available from its firm's fund universe) may lack a capability in-house. Even an open- architecture series, which can hire third- party subadvisors, requires significant lead time to do a manager search, get board approval, and launch a brand-new fund.

* Investor Behavior
Many of the largest target-date providers are also large record-keepers, and they're extraordinarily sensitive to the behavior of plan participants. Because investors defaulted into target-date funds are generally not sophisticated and knowledgeable about financial markets, asset-allocators lean toward simplicity, de-emphasizing asset classes and financial products that may be unfamiliar or appear risky to investors.

* Fiduciary Considerations
Plan sponsors are a key link in the chain between those who construct target-date funds and those who invest in them. Although the Department of Labor has provided safe harbor to employers who use target-date funds as a QDIA option in their plan lineups, they remain obligated to provide prudent selection and monitoring of funds in their plans (adhering to the "prudent person" principle). Thus, plan sponsors are cautious in introducing unusual or trendy funds that investors might misuse or misunderstand. In turn, target-date funds limit introduction of alternative asset classes to better attract plan-sponsor clients.

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