Is All-Passive Really the Best Thing for Target-Date Funds?

A recent AB article highlights the limitation of some Target-Date Funds (Life Cycle Funds).

AB propose:

“With market returns expected to be lower going forward, target-date funds that invest in passively managed underlying components are at risk of underdelivering. We think diversifying beyond traditional asset classes and tapping alpha opportunities with a multi-manager structure can increase the chances of success. “

 

I would argue more broadly, despite the market outlook, any passive portfolio that only invests into the traditional markets of equities, bonds, and cash are not well diversified for a range of possible economic and market outcomes. They are further at risk if they take a set and forget approach to the overarching strategic asset class positioning of the fund i.e. these short-comings are not limited to passively managed Target-Date Funds.

 

In short, AB argue that the outlook for traditional markets (beta) is challenging. As a result, this environment pose:

“major headwinds to target-date funds as they work to provide the growth participants need. Target-date funds that invest only in traditional asset classes, such as large-cap equities and core bonds through indices, face limitations in their glide path designs. This can make it a struggle for target-date funds to meet participants’ needs in anything but a high-return, low-risk market environment. And in terms of environments, that ship has likely sailed for now.”

Further: “A lower-beta landscape challenges a popular line of thinking that says investing in funds with the lowest fees will ensure compliance with plan sponsors’ fiduciary responsibilities. Low fees aren’t the end all and be all. For one thing, focusing too much on fees could cause sponsors to overlook other factors in retirement investing that also have fiduciary implications.”

The bold is mine.

 

My Opinion and solution

Increase the diversification of the Target-Date Fund and more actively manage the glide path of the strategy.

There could well be a blend of active and passive strategies.

Quite obviously increasing true portfolio diversification is paramount to building robust portfolios and increasing the likelihood of achieving investment objectives.

The prospect of a low returning environment only reinforces this position.

As mentioned in my last post, Reports of the death of Diversification are greatly exaggerated, also see my post Invest more like an Endowment, which also touches on the fee debate, investors should seek true portfolio diversification. The portfolio should be constructed to meet an investor’s objectives “through a range of potential outcomes”. There would appear to be a diverse range of likely economic and market outcomes currently.

Robust portfolios are positioned for a range of outcomes and are “forecast-free as possible”.

We all know a robust portfolio is broadly diversified across different risks and returns.   Increasingly institutional investors are accepting that portfolio diversification does not come from investing in more and more asset classes. True portfolio diversification is achieved by investing in different risk factors that drive the asset classes e.g. duration, economic growth, low volatility, value, and growth.

 

Limitations of Target Date Funds

The AB article touches on the limitations of most Target-Date Funds, weather the underlying asset classes are actively or Index (passively) managed.

Essentially, most Target-Date Funds have two main short comings:

  • They are not customised to an individual’s consumption liability, human capital or risk preference e.g. they do not take into consideration by way of example future income requirements or likely endowments, level of income earned to retirement, or investor’s risk profile.

They are prescribed asset allocations which are the same for all investors who have the same number of years to retirement, this is the trade-off for scale over customisation.

  • The glide path does not take into account current market conditions.

Therefore, linear glide paths, most target date funds, do not exploit mean reversion in assets prices which may require:

      • Delays in pace of transitioning from risky assets to safer assets
      • May require step off the glide path given extreme risk environments

Most Target-Date funds don’t make revisions to asset allocations due to market conditions. This is inconsistent with academic prescriptions, and also common sense, which both suggest that the optimal strategy should also display an element of dependence on the current state of the economy.

 

Therefore, there is the risk that some Target-Date Funds will fall short of providing satisfactory outcomes and meeting the key requirement in retirement of sufficient income. See A more Robust Retirement Income Solution is needed.

Target-Date Funds (Life Cycle Funds) focus on the investment horizon without protecting investors’ retirement needs, they focus on one risk, market risk.   The focus is not on producing retirement income or hedging risks in relation to investment risk, inflation risk, interest rate risk, and longevity risk. A better solution is required.

 

The optimal Target-Date fund asset allocation should be goal based and multi-period:

  • It requires customisation by goals, of human capital, and risk preferences
  • Some mechanism to exploit the possibility of mean reversion within market

 

Happy investing.

 

Global Investment Ideas from New Zealand. Building more Robust Investment Portfolios.

 

Please see my Disclosure Statement

One thought on “Is All-Passive Really the Best Thing for Target-Date Funds?

  1. Pingback: Is the 4% rule dead? – Approaches to Generating Retirement Income | Kiwi Investor Blog

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