The Use of Hedge Funds in 401(k)

by Geri Terzo

It is unusual for plan sponsors of a 401k retirement plan to include hedge funds as an investment option, but it is possible. Increasingly, however, mutual funds, which are a common investment used in a 401k retirement plan, are starting to resemble hedge funds. Although hedge funds are not used pervasively in 401k retirement plans, there are ways for plan members to gain exposure to funds with similar features.

Risk

Hedge funds are widely considered risky investments that can amplify returns in a retirement portfolio or cause severe losses. Many defined benefit pension funds use hedge funds, although in this plan structure, investment officers make decisions on behalf of plan members. The 401k retirement funds are structured as defined contribution plans. In this type, plan sponsors place much of the investment risk on plan members, who must make investment choices based on options offered by the sponsor. Without the proper investment acumen, a plan member could exposure their retirement plan to too much risk.

SEC

According to a 2001 investment management memo issued by law firm Gardner, Carton & Douglas, a U.S. 401k retirement plan can legally invest in hedge funds as long as the plan sponsor abides by rules set forth by the Securities and Exchange Commission. Among the requirements, the 401k plan must oversee at least $25 million in assets under management. The SEC requires that plan members avoid investing in only one hedge fund with a risky strategy and instead spread capital to several transparent fund strategies.

Customized Funds

There are ways for 401k plans to incorporate strategies that are prevalent in hedge fund investing. In 2002, J.P. Morgan added its first client with a defined contribution retirement plan structure for an investment fund that used hedge fund strategies. A key difference in this Life Cycle Series of funds is that while the fund managers used hedge fund techniques, investments could be tailored to comply with an investor's tolerance for risk.

Consideration

Target date funds, which are a type of mutual fund, are increasingly using some of the complex financial securities, such as derivatives, normally associated with hedge funds. Traditional target date funds change periodically to reflect changing risk tolerance. After the financial crisis of 2008, some target date funds began including hedging techniques in an attempt to recover assets.

About the Author

Geri Terzo is a business writer with more than 15 years of experience on Wall Street. Throughout her career, she has contributed to the two major cable business networks in segment production and chief-booking capacities and has reported for several major trade publications including "IDD Magazine," "Infrastructure Investor" and MandateWire of the "Financial Times." She works as a journalist who has contributed to The Motley Fool and InvestorPlace. Terzo is a graduate of Campbell University, where she earned a Bachelor of Arts in mass communication.

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