Articles

Fixing The Flaws With Target Date Funds
By Navaid Abidi and Dirk Quayle

Page 1 of 6

Selecting the appropriate target date fund (TDF) is a challenge for even the most sophisticated professionals. As evidenced over the past two years, there can be a wide disparity in the performance of TDFs, making the risk of picking a single provider significant. This paper presents a new TDF index based on a dynamic market average, thereby avoiding risks associated with a single provider’s methodology. This paper also presents a methodology framework that can be used to build custom target date solutions based on different market assumptions. The TDF index mitigates asset allocation and retirement methodology risks while allowing an institution/adviser to add value based on investment selection. The index’s methodology framework allows an institution to create a customized version of a target date index based on its specific needs.

TDFs are designed to automatically manage investor assets with an age-appropriate investment strategy that becomes more conservative as the target date is approached. Target date funds can provide a good option for plan sponsors and advisers looking for an automated way to maintain appropriate diversification over time, but selecting the appropriate target date funds has been a challenge for even the most sophisticated professionals. This is because TDFs bundle investment management with retirement advice to combine four methodologies that result in a single package that is easy to use, but difficult to decipher.

Four methodologies bundled by TDF managers:

an asset allocation methodology that specifies a set of efficient portfolios
a retirement methodology that determines a glide path with a changing portfolio allocation
a fund selection methodology that tracks asset class benchmarks
a rebalancing methodology of funds that tracks the target asset allocation

As was apparent in 2008 and 2009, making active decisions about four contributing methodologies that apply to TDFs provides many opportunities for performance divergence.

Target Date Funds: Risks Exposed

TDFs experienced their first real test during the market turmoil of the past two years, and to some degree, they failed. Consider three 2010 funds from Oppenheimer, Wells Fargo and Fidelity. Figure 1 shows what an investor would have seen had they looked at the 2007 performance of each fund before making a TDF investment decision at the beginning of 2008.

Fixing The Flaws With Target Date Funds Fig1

Fixing The Flaws With Target Date Funds Fig1

The returns look similar enough. Yet Figure 2 shows how the investor would have done in 2008 and 2009.

Fixing The Flaws With Target Date Funds Fig2

That was an incredible performance range for funds targeting an imminent retirement date in two years. With that short time horizon, it was logical to assume a consistent, conservative risk/return profile across the industry, but that clearly wasn’t the case. This performance variance highlights the difficulty for investing professionals expected to effectively analyze and select a fund/methodology initially, and then monitor with rigor in the future.

Risk Of Bundled Services

The TDF manager’s bundling of four methodologies into a single product can mask the embedded risks associated with poor choices at any of the four steps. Major differences in asset allocation exist but are not always obvious. For example, some TDFs have high-yield bonds, TIPS and emerging market investments in their asset class models; others don’t. A poorly designed retirement methodology may not provide young investors with enough market risk to grow their capital, or may expose late-stage workers to excessive market risk. A poor investment manager selection in any one of the tracker funds for asset classes could result in overly concentrated portfolios, excess turnover with high tracking error and high management fees. Some TDFs in 2008 were caught with illiquid fixed-income securities that had been characterized as low-risk cash equivalents. Lastly, a poorly designed rebalancing algorithm can result in high tracking error to the target asset allocation, or might not reinvest the dividends on a timely basis.