Sexy Hedge Funds Make Their Way Into Retirement Plans

Hedge funds have traditionally been the domain of the ultra-wealthy. These investment vehicles, which are typically open to a limited number of high-net-worth investors, became all the rage during the market downturn earlier this decade. While the stock market was taking a nose dive, hedge fund performance was flourishing.

    That’s because unlike mutual funds, hedge funds leverage their investments by taking both long and short positions in the market—effectively allowing them to make bets against the stock market and perform well when the stock market falters.

    “Hedge funds got a lot of press earlier this decade because many of them had incredible performance during the bear market,” says Todd Troubey, a mutual fund analyst at Morningstar. “Everyone wanted a hedge fund.”

    But until recently, mainstream investors have not been able to access these investments. That’s changing as an increasing number of employers look to add hedge-like investments to their retirement plans.

    What has sparked employers’ interest is that in the past few years a number of mutual fund companies have launched hedge-like mutual funds.

    Unlike traditional hedge funds, hedge-like mutual funds are regulated by the Securities and Exchange Commission, have lower fees and minimums than their traditional counterparts, and don’t have multiyear lockups.

    Like many mutual funds, hedge-like mutual funds often have minimum investments of a couple thousand dollars, but those minimums are waived for retirement plan investors.

    Another offering that has come to market are mutual funds that invest in hedge-like mutual funds—yet another option for retirement plans. These vehicles have higher fees than hedge-like mutual funds but offer more diversification, experts say.

    “Seven years ago there were very few hedge-like mutual funds on the market, but today there are hundreds, and employers are paying attention,” says Mendel Melzer, chief investment officer at the Newport Group, a Heathrow, Florida-based provider of retirement plans and investment advisory services.

    In 2006, $17 million flowed into R-shares of hedge-like mutual funds, up from $1 million in 2005, according to Financial Research Corp. R-shares typically are the class of fund shares restricted to retirement plans.

    But employers need to do their homework before adding these vehicles to their 401(k) plans, experts say.

    “If it’s done right, it can be viewed by employees as a great perk,” says Carl Hess, practice director of Watson Wyatt Investment Consulting. “But there are a lot of factors to weigh when deciding if this is right for a company’s plan.”

Due diligence
    The first question that employers need to ask before adding hedge-like funds to their 401(k) plan is, does this make sense? Typically, employers enhance their 401(k) plans as a way of attracting and retaining employees. So before adding a hedge-like fund to a 401(k) plan, companies need to make sure it is something employees would value, Melzer says.

    “Generally these options make sense for employers that have a highly educated workforce,” he says. Many financial services companies and IT providers have added hedge-like strategies to their 401(k) plans during the past few years, he says.
Companies need to really dig in and make sure they understand the investment strategies of these investment vehicles, Troubey says.

    While equity funds might differ in how they invest, by and large they are doing the same basic thing, he says. But hedge-like mutual funds can vary significantly in which investment strategies they use, he says.

    This means that benefit managers need to understand specifically how these funds are generating returns and what they use as a benchmark, says Andrew Clark, head of research, Americas, at mutual fund research company Lipper.

    This requires more work for mutual funds that invest in hedge-like mutual funds because they consist of several strategies and managers, experts say.

    Also, it can be difficult to gauge the performance of hedge-like mutual funds because very few of these offerings have a significant history, Troubey says.

    “There are about 50 of these funds, and half of them have only been around a couple of years,” he says.

    Cost is another major factor that employers need to consider when assessing these investment options. The average hedge-like mutual fund charges 2.07 percent in expenses, compared with 1.43 percent for the average U.S. stock fund, according to Morningstar.

    “And we think 1.43 percent is too high,” Troubey says. “Almost all of these hedge-like mutual funds are low-risk, low-return, so why would you pay up for something that is supposed to achieve lower returns?”

    Fees for mutual funds or managed accounts that invest in hedge-like mutual funds are even higher. For example, the Long and Short Opportunities program, a multi-manager investment offering that invests in hedge-like mutual funds managed by Lake Partners, a Greenwich, Connecticut-based investment advisor, charges average expenses of 1.7 percent plus a 1 percent management fee.

    But the portfolio’s performance is worth the expenses, says Ron Lake, president of Lake Partners. The company’s cumulative return during the past eight years has been 72 percent, compared with 37 percent for the Standard & Poor’s 500 during the same period.

    These kinds of multi-strategy offerings that are managed by a third party can be worth their expenses since employees can rely on a manager to oversee their investments, Hess says.

    “The single-strategy hedged mutual funds can be unwieldy, and you have to worry whether employees understand what they are buying,” he says.

    The educational efforts that employers have to undertake to make sure employees understand these investments shouldn’t be underestimated, experts say.

    “Diversification is key here,” Melzer says, adding that employers want to make sure employees don’t invest 100 percent in a hedge-like mutual fund.

    If employers are interested in adding a hedge-like fund to their plans but are wary of the implications, there may be a new option for them in months to come, Hess says.

    “You will start to see these strategies pop up in life-cycle funds,” he says. Hedge-like investments can make sense for these funds, which become more conservative as the investor approaches retirement, he says.

    “Employers can really play up having life-cycle funds that invest in hedge funds,” he says. ‘They can say, ‘Here is something you can’t get anywhere else.’ “