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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.

Tide Is Turning
Despite all these frictions slowing down the adoption of alternatives in target-date funds, there are several counter-vailing forces. In just the past year, several well-established target-date funds added new asset classes to their glide paths, while newer, nimbler series have taken bolder steps to expand use of alternatives. This trend is likely to continue for several reasons:

* Efficient Frontier Research
Despite a few naysayers, asset-allocation research continues to support the benefits of diversifying through low-correlation strategies, and most target-date firms believe in the story. They just need the right products to help them implement alternative strategies.

* Growth of Exchange-Traded Funds
The proliferation of new ETFs covering a vast range of market segments is one development that will allow more asset allocators to tap previously underused asset classes. While most target-date funds prefer active management, some series, such as DWS LifeCompass and Nationwide Destination, are already incorporating ETFs.

* Growth of Alternative Mutual Funds
For target-date funds seeking active management, a slew of new alternative mutual funds have launched in the past few years, including market-neutral, arbitrage, and managed-futures strategies in liquid, 1940-Act structures.

* Growth of Collective Investment Trusts
Another structural development has been the increasing willingness of large employers to use collective trusts for their retirement plans. Because they are not subject to 1940-Act restrictions, CITS have flexibility to employ alternatives in their target-date allocations. JP Morgan, for example, uses REITs in the mutual fund version of its target-date funds, but it also uses direct real estate in the collective trust wrapper.

* Marketing Muscle
The biggest players in the target-date industry have something of an arms race at work; if one firm adds commodities as an asset class, another is sure to follow. Smaller, newer target-date funds, to acquire any market share at all, must do something to stand out, and lately that has often involved alternatives.

* The 2008 Hangover
The financial crisis was in some ways a setback for diversification, in that asset classes thought to be lightly correlated actually converged. But the market crash also made many managers acutely aware of the need to search even farther afield for investments that could zig while others zagged.

The Camps
There is an inherent difficulty in coming up with an industrywide view of alternatives. Target-date funds are not required to disclose their strategic allocations at the subasset-class level, so many simply publish their glide paths in prospectuses by the broadest categories of stocks, bonds, and cash. Nevertheless, it's possible to make some broad characterizations of the industry. In their attitudes and use of alternatives, target-date funds generally fall into one of three camps: traditionalists, incrementalists, and innovators.

Traditionalists are those target-date firms that stick to the mainstream asset classes, perhaps extending allocations to one or two nontraditional areas. While traditionalists are a declining presence in the target-date landscape, several of the large providers still fall into this camp. Among actively managed series, both TIAA-CREF and American Funds land here. Two of the major index-based series, Vanguard and Wells Fargo, have also been very cautious about adding new asset classes. The Wells Fargo Dow Jones Target Date Series entirely avoids REITs, TIPS, high-yield bonds, commodities, and other alternatives in the belief that small additions to the glide path do not meaningfully affect returns. Vanguard Target Retirement does introduce its actively managed TIPS fund as investors near retirement but otherwise eschews alternatives.

Incrementalists probably represent the broadest swath of target-date funds. They are believers in the benefits of broad diversification and actively conduct research into the costs and benefits of adding new strategies. Typically, these target-date series incorporate three or more nontraditional asset classes and are willing to explore low-correlated sectors such as commodities and long-short funds. Target- date series that fall into this camp include JP Morgan, American Century, Fidelity, ING, John Hancock, Principal, and T. Rowe Price. JPMorgan SmartRetirement, for example, in addition to strategic allocations to REITs, high-yield bonds, and TIPS, has also used a 130/30 fund from the JP Morgan fund platform as part of its large-blend allocation. Recently, there's been a trend toward adding commodities exposure to target-date series. Fidelity, ING, and T. Rowe Price have either launched or announced plans to strategically allocate assets to commodities.

Innovators hew to no single model; what connects them is an emphasis on alternatives, from both a philosophical and an allocation perspective, and an ambition to express those views in modes other than the traditional target-date structure (such as a fund-of-funds wrapper, Markowitz mean-variance-optimization, or nondynamic asset allocation). Here are snapshots of how some of these firms are integrating alternatives into their target-date funds.

* DWS LifeCompass
Philosophy: Ultradiversification (across 27 asset classes).
Representative holdings: DWS Disciplined Market Neutral DDMIX and Energy SelectSector SPDR XLE.

* Putnam Retirement Ready
Philosophy: Dynamic asset allocation with absolute return emphasis.
Representative holding: Putnam Absolute Return 500 (18% in 2020 fund as of June 30).

* PIMCO RealRetirement and Invesco Balanced-Risk Retirement
Philosophy: Both firms emphasize generating real return and limiting tail risk close to retirement.
Representative holdings: PIMCO Real Return PRRIX, PIMCO Commodity Real Return Strategy PCRIX. Invesco uses a risk-parity approach that relies on derivatives, including a one-third risk allocation to commodities.

* Vantagepoint Milestone
Philosophy: A multistrategy, volatility-damping sleeve.
Representative holding: Vantagepoint Diversifying Strategies VPDAX

What's Ahead
Do these innovators represent the next wave of target-date construction? The jury is still out. From a risk-management and investment- philosophy perspective, many of these strategies certainly look compelling, and the appeal of alternatives is not going away. At the same time, these approaches are quite new and have not been battle-tested. Skeptical plan sponsors will probably need to see evidence that innovative structures can perform as advertised before they'll embrace alternatives- heavy strategies. Moreover, the diversification benefits of extended asset classes are ultimately a long-term proposition whose value may not be truly evident until a decade or more down the road. Institutions and individuals who choose to commit to these strategies must be willing to, in effect, take a seat on a long- distance, cross-country rail transport.

Josh Charlson is a senior mutual fund analyst with Morningstar.

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