Subasset Allocation Can Make A Difference Over A Short Period

A portfolio’s sub-asset allocation—the makeup of its broader asset classes—refers in equities, for example, to the relative weighting to U.S. stocks versus international stocks; and, in bonds, for example, to relative weightings to corporate, mortgage-backed, and U.S. government bonds.[6] In 2008, these differences had a significant impact on the one-year TDF returns as returns at the sub-asset class level diverged markedly (see Figure 4).

A Closer Look at The Equity Allocations

In 2008, losses realized in the equity portfolios of TDFs were magnified with larger international allocations, as both developed and emerging international markets lagged the U.S. stock market by 6 and 16 percentage points, respectively (see Figure 4). In general, funds with lower overall equity allocations, and funds that maintained more of a “home bias” to U.S. markets, fared better. Figure 5 shows that the four selected TDF providers main­tained a wide range of overall equity and international equity allocations for 2008, contributing to the differences in returns across providers.

A Closer Look at The Bond Allocations

In 2008, the steep declines in equity markets, coupled with an uncertain outlook for many prominent financial institutions, led investors to seek the relative safety of government bonds. Historically, the correlation between stock and bond returns has been low; however, in extreme market conditions, as occurred in 2008, the correlation between equities and higher-risk, more aggressive bonds (i.e., corporate bonds) grew increasingly positive, as both asset classes posted negative returns.

Since TDF portfolios use bonds as the primary diversifier vis-a-vis equities, it is important to recognize that the components of the bond allocation can contribute to the portfolio’s overall level of risk and to its return variability, particularly over shorter periods. Bond allocations can vary from one provider to the next in sector allocations (e.g., U.S. govern­ment, mortgage-backed, corporate) as well as in characteristics such as duration and credit quality. In volatile equity markets, more aggressive bond allocations can exhibit higher correlations to equities, which can diminish a portfolio’s diversification benefit. When examining a target-date strategy, it is vital for plan sponsors to consider the trade-off of holding a more aggressive bond allocation during the more conservative stages of a glide path with the possibility that the bond allocation might react similarly to a portfolio’s equity allocation in an extreme downside market event such as we saw in 2008.

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