As shown in Figure 6, fund providers appear to exhibit little consistency in their fixed income allocations. In 2008, this disparity contributed to the differences in returns across TDFs as certain funds maintained larger allocations to corporate bonds while others maintained larger allocations to U.S. government bonds. The return differentials were particularly noticeable in near-dated funds whose portfolios maintained a sizable fixed income allocation. It is not surprising that in 2008, funds with both a higher overall bond exposure and relatively higher allocations to U.S. government bonds performed better.

Different Implementation Strategies Can Lead To Different Returns

In comparing TDF returns, it is critical to consider not only differences in the portfolio’s asset allocations but also differences in how the allocations are imple­mented. Some TDFs use passively managed funds (that is, index strategies) to construct their glide path, while others use actively managed products. Index funds are designed to provide returns that are very close to those of their asset-class performance benchmarks. Active funds, on the other hand, offer potential value by attempting to outperform a bench­mark—at the risk, of course, of subtracting value by underperforming the benchmark.

Active management can also take the form of a tactical allocation strategy, in which a manager adjusts a portfolio’s asset and sub-asset allocations to capitalize on short-term market fluctuations across sectors. Tactical strategies pose a risk similar to that of actively managed funds: the potential to detract value by incorrectly timing buy and sell decisions.[7] Actively managed strategies inevitably contribute to the differences in returns across the TDF landscape by charging higher expenses than passive strategies and incorporating manager risk into the risk profile of these portfolios.

Future Considerations For Evaluating TDFs
Among industry professionals, healthy debate continues on how best to construct target-date portfolios. These discussions typically revolve around the optimal level of equity exposure and the rate of change in that exposure as the investor ages, since these are the most recognizable components of risk in TDFs and their most significant long-term performance drivers. However, as we learned in 2008, over shorter periods, the equity glide path cannot be viewed in isolation, as the return differentials for funds with the same target date are not always proportional to the differences in equity exposure. Several components of a TDF portfolio—aspects that, notably, garnered more attention in 2008 than in previous years—can contribute to the portfolio’s overall performance. Although it is difficult to quantify the relative impact of these differences across providers, it is possible to draw high-level conclusions. Over long periods, research has shown that the asset allocation of a broadly diversified portfolio engaged in limited market-timing has had the most pronounced impact on performance. However, over shorter periods, as in 2008, performance differentials can stem not only from differences in the portfolio’s broad asset allocations but also from the portfolio’s relative allocation to sub-asset classes within stocks and bonds. Ideally, plan sponsors can use this information to reinforce TDFs’ role as long-term investment vehicles and to better understand and communicate the funds’ relative risks and performance compared with similarly dated funds from other providers.

References
Davis, Joseph H., Francis M. Kinniry Jr., and Glenn Sheay, 2007. The Asset Allocation Debate: Provocative Questions, Enduring Realities. Valley Forge, Pa.: Vanguard Investment Counseling & Research, The Vanguard Group.

Hess, Michael, John Ameriks, and Scott J. Donaldson, 2008. Evaluating and Implementing Target-Date Portfolios: Four Key Considerations. Valley Forge, Pa.: Vanguard Investment Counseling & Research, The Vanguard Group.

Kinniry, Francis M., Jr., Donald G. Bennyhoff, and Christopher B. Philips, 2009. 2008: The Historical Impact and Future Implications of Extraordinary Markets. Valley Forge, Pa.: Vanguard Investment Counseling & Research, The Vanguard Group.

Endnotes

1. All returns and asset-allocation data for TDFs in this paper’s figures are from Morningstar, Inc., as of December 31, 2008.

2. All returns are nominal. Stocks represented by the Standard & Poor’s 500 Index, 1926 through 1970; the Dow Jones Wilshire 5000 Composite Index, 1971 through April 22, 2005; and the MSCI® US Broad Market Index thereafter. Bonds represented by the S&P High Grade Corporate Index, 1926 through 1968; the Citigroup High Grade Index, 1969 through 1972; the Lehman Brothers U.S. Long Credit AA Index, 1973 through 1975; and the Barclays Capital U.S. Aggregate Bond Index thereafter. Equity return premium equals the annualized return of a 100% stock portfolio minus the annualized return of a 100% bond portfolio.

3. Calculation uses annualized, year-end returns; the first 20-year return available was for the period ended December 31, 1945. Analysis was conducted through the end of calendar 2008, creating sixty-four 20-year returns.

4. This is not to suggest that historical returns are indicative of future returns, but to highlight that, absent philosophical or structural shifts in the financial markets, the rationale for risk premiums and the historical relationships between asset classes can reasonably be expected to continue in the future.

5. Plan sponsors seeking to extend the glide path of their TDFs beyond the traditional asset classes need to understand both the rationale for including alternative asset classes as well as the potential risk and costs that alternatives can add to a portfolio. For further discussion on evaluating target-date strategies, see Hess, Ameriks, and Donaldson (2008).

6. For purposes of this paper’s analysis, “U.S. government” bonds refers to U.S. Treasury and government-agency bonds, per Morningstar’s criteria.

7. In considering actively managed target-date strategies, plan sponsors need to examine the suitability of exposing investors to an additional layer of management risk beyond the market risk inherent in all TDF strategies.

© 2009 The Vanguard Group, Inc. All rights reserved.

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