Hedge Fund Strategies Edge Into Retirement Market

Mutual funds that use the same strategies as hedge funds are moving into individual retirement accounts and could be making their way to 401(k)s, according to AIN sister publication Defined Contribution & Savings Plan Alert. But questions remain as to the best way to get them there--via fund of funds structures or by simply importing hedging strategies into mutual funds--whether the funds would actually benefit participants and whether firms can cover the relatively high costs while the funds gain traction.

UBS Global Asset Management Strategist Greg Fedorinchik said the firm has considered marketing hedge-fund like vehicles to the IRA and 401(k) market, but thus far has not acted on it. UBS offers two funds with hedging strategies, the Absolute Return Bond Fund and the Dynamic Alpha Fund, to retail investors. Both funds are mutual funds but haven't been pushed into the retirement market. "We're just beginning to design these things for 401(k)s," Fedorinchik said. UBS hasn't rolled one out yet because it is unclear how to market them and how to educate participants on their proper use.

Fedorinchik said a big advantage for participants and plans is the use of strategies such as shorting and leverage. He said for most participants the big problem is that there are few good ways to increase the Sharpe ratio. "Right now you can use more equity but there is not much diversification like that," he said. "Going into a high-growth fund might get a Sharpe ratio of about 0.25 and in a global fund you might get 0.35. A hedge fund typically hits closer to 0.5." The down side of hedge funds in plans is that they would be relatively illiquid and run risks when using shorting or leverage. That same risk-return might be achieved with swaps or options in a garden-variety fund, said Fedorinchik.

Morgan Stanley launched a registered fund of hedge funds earlier this month that is designed for the IRA market. Michael Kiley, head of Americas retail and intermediary distribution, said the Absolute Return Fund is being marketed to IRAs and eventually to 401(k) plans, and that the firm chose a fund of funds structure to offer diversity to their clients. Kiley sees hedge funds becoming part of retail and retirement investing in the same way that many vehicles that were formerly for the large investor, such as pension plans, have worked their way down-market.

Wirehouses are a natural place for such funds to appear, said Richard Steiny, co-founder and president of AssetMark. They have distribution channels already, and a fund of funds structure can offer access to managers that might ordinarily be difficult to hire on an ordinary mutual fund. He added that many firms, including AssetMark, have looked at creating mutual funds with absolute return strategies. Brian O'Toole, ceo of AssetMark, said the issue is figuring out what techniques benefit retail investors. It is one more way to provide downside protection, he said. But both questioned whether having a hedge fund (or similar vehicle) is any better than a lifecycle or balanced fund over the time periods most plan participants care about.

Lee Schultheis, ceo at Alternative Investment Partners, said his firm has a 40 Act fund that has used hedging strategies since 2002. But that took some time to get traction and similar funds entering the retirement market would have the same issue, he said. Part of the problem for AIP was a lack of a track record. Schultheis said anybody entering the market needs a three-year performance record, at least, before many retirement plans will look at a fund.

Hedge funds are also widely perceived as risky vehicles, but Schultheis said they need not be. He said they would work better for people close to retirement rather than those who have a lot of years to invest. This is because someone with many years in which to save needs only wait out the volatility, whereas someone with only a few years left to save needs the capital preservation hedge funds provide. But Schultheis sees it as something that could definitely grow as boomers retire and start to need those capital preservation strategies.