The success of 401K plans is crucial to the US Economy because social security alone won’t be enough for today’s living costs. Therefore, 401K plans are protected by federal regulations regarding how funds might be invested. So, are hedge funds available to 401K plans?
401K plans cannot invest in hedge funds because of their inherent risks. But a hybrid form of hedge funds, called hedge-like mutual funds, is now available to 401k investors. Employers still must perform their due diligence before making this option a part of their 401 plan.
The rest of this article will explain the difference between hedge funds and hedge-like mutual funds. It also discusses why some employers are adding hedge-like funds to their existing 401k plans and talks about their potential benefits and pitfalls.
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Is Investing in Hedge Funds Risky for 401Ks?
Until recently, the only way 401Ks could invest in hedge funds was through mutual funds that invested in other hedge-like mutual funds. But many plan participants ask why. This strategy offers more diversification to the 401K, but often higher fees too.
So, at first glance, simply adding “hedge-like” to the term mutual funds might appear as if plan managers are trying to maneuver around government regulations or trick employers into allowing risky investments into their 401K retirement plans.
While untrue, this thought holds merit because hedge funds offer higher rewards, and for years 401k participants, particularly those farther from retirement, want 401k plans to earn money faster. Therefore, they’re ok with riskier investments, especially when they see media accounts of high rewards earned from hedge funds.
However, the purpose of the 401k is to fund retirement, so regulations are in place to make sure managers cannot take huge risks. These regulations are reasonable because people who depend on the plan during retirement most likely don’t have the ability to re-enter the workforce if the plan runs out of money due to risky investments.
The Difference Between Hedge Funds, Mutual Funds, and Hedge-Like Mutual Funds
To understand why 401Ks cannot invest in hedge funds, it’s essential to know that these two investment vehicles are similar in some ways. They both work by using “pools” of investors and money that a fund manager manages.
This fund manager receives a predetermined fee for managing the funds, though hedge fund managers receive a higher payment.
However, the several differences between mutual funds and hedge funds are the main reason 401Ks cannot invest in hedge funds.
Mutual Funds vs. Hedge Funds
Mutual funds are regulated and publicly traded. The fund cannot share in the profit made from the investment. In addition, fund managers cannot invest in high-risk products, limiting them to investing in publicly traded securities and stocks or bonds. As a result, mutual funds typically produce lower rewards than hedge funds.
On the other hand, hedge funds are available only to “accredited” investors who are wealthy enough to be insulated against a loss. Specifically, only two types of people have access to this investment vehicle: Individual investors who earn $200,000 per year, or couples who make a combined $300,000 per year for at least two years prior to investing in hedge funds.
This stipulation, which is part of Regulation D of the Securities Act of 1933, may sound absurd to new investors. After all, it’s your money to do with as you see fit, but the fact that the stipulation is in place helps explain why hedge funds have been off-limits to 401K plans, but mutual funds aren’t.
Also, hedge funds are private investments, and they operate by taking both long and short positions in the market, which effectively makes bets against the stock market. Most 401K participants cannot tolerate these risky bets even if the payoff is higher.
Additionally, hedge funds managers can be more aggressive with their investment strategies, such as taking both long and short positions in the market. They can also invest in derivatives, bitcoin, and lottery tickets, to name a few. If any of those investments were to fail in a 401k, people’s lives could be irrevocably changed.
What is a Hedge-Like Mutual Fund?
Hedge-like mutual funds appear to be the best of both worlds, or at least a happy compromise for 401K plan participants. In short, hedge-like mutual funds reduce the risk for investors, including 401k plans, by limiting the amount of portfolio leverage allowed.
According to the writers at NerdWallet, “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.”
In addition, although these hedge-like mutual funds have standard minimum investment requirements, those requirements are waived for retirement plan investors.
So, the main difference between hedge funds and hedge-like mutual funds is government regulation. Hedge-like funds seem to offer 401K managers the freedom to take a slightly higher risk while maintaining a higher level of protection.
Why Are Employers Considering Hedge-Like Mutual Funds?
The first answer is simple. In many cases, these hedge-like mutual funds help the 401K grow at a faster rate. Since most 401K plans enjoy compound interest, the more invested, and the earlier the investment is made, the better the plan.
A not-so-obvious reason, though, is that in this post-pandemic, labor-shortage market, many employees and potential employees see not only the 401K but also the ability to invest in hedge-like mutual funds within the 401K as a highly sought after perk.
The key to successful management of the hedge-like mutual funds is for the employer/plan manager to do their due diligence from the start. Each hedge-like mutual fund varies in investment strategies, so those strategies must match the employee tolerance level.
The bottom line is that the option is available to 401K managers to invest in hedge-like mutual funds. However, if employees don’t want that benefit or see little value in it, adding a hedge-like fund won’t make sense due to fees and regulations. For example, many hedge-like mutual funds charge the average expense fee but often add up to a 1 percent management fee.
Even though the costs are higher, for some employees, particularly those who are many years from retirement, the ability to choose a hedge-like mutual fund as part of the 401K is worth the added expense due to the expected higher return.
Benefits of Hedge-Like Mutual Funds
Aside from the possibility of higher returns, increased diversification is a benefit. Another benefit is even though these funds have been around since 2010, currently, few employers are offering this investment vehicle as part of their 401K; therefore, it’s a valued benefit to an employee who desires this investment vehicle in a 401K.
Potential Pitfalls With Hedge-Like Mutual Funds
Due to government oversight, losing an entire portfolio is unlikely, particularly in the 401k environment. However, hedge-like mutual funds are riskier than mutual funds. Remember, where there’s great reward, there’s also significant risk.
In addition, social media platforms, such as Reddit, can impact hedge funds and hedge-like mutual funds more than they can mutual funds that typically make up 401k portfolios.
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Conclusion
Because of our aging workforce, retirement plans, like 401ks, are crucial to America’s economy. With so much at stake, it’s a good thing that 401ks cannot invest in hedge funds. However, the middle ground — the hedge-like mutual fund — offers the strategy that many investors have hoped for.
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