Red Flags Rise at Some Target Date Mutual Funds
Target date mutual funds are reportedly introducing complex new and untested strategies ostensibly to add ballast to their portfolios. But that make them more like hedge funds, according to a September 4 Wall Street Journal article by Jane J. Kim and Anne Tergesen called “A Hedge Fund Lurking in Your 401(k).” They are being marketed as risk-reducing mechanisms but, in fact, they may introduce new risks as well as costs.
Some target date funds are moving to “absolute return” portfolios, commodities and derivatives, as well as granting managers wider latitude to change asset allocations. These strategies introduce greater complexity and higher costs, and can “look a lot like market timing – the very antithesis of the target-date approach,” according to the article. Market timing can lead to whipsawing. “When managers move in and out of asset classes quickly, they have to be able to make the right calls at the right times,” Katie Rushkewicz, a senior fund analyst at Morningstar Inc., was quoted as saying. “Frequent trades also inflate transaction costs, thereby reducing returns.”
The use of derivatives by target-date funds, which are often opaque and illiquid, raises red flags raises red flags at Morningstar. It also adds another layer of risk called counterparty risk—the risk that the party on the other side of a derivative transaction will not be in a position to fulfill its contractual obligations in a major financial crisis, as happened with AIG.
"These are really complex investments, and they just get more complex when management has this go-anywhere mandate and they end up purchasing a lot of exotic securities," Laura Lutton, editorial director at Morningstar, was quoted as saying. The innovations, she adds, “are relatively new and untested strategies."
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