Managed accounts hold promise for advisors but they require adherence to an audited prudent investment process, a process that could take years to achieve scale. Moreover, managed accounts have operational challenges in providing customized service to each investor. Thus, target date funds and balanced funds are the immediate play. Advisors will be called upon to find the best among both. As a part of that process, relevant benchmarks will be needed.
The target date industry is still in its infancy and is likely to evolve very rapidly, if for no other reason than the probable stampede into these funds. The potential growth in assets committed to target date funds over the next five-10 years is astounding. At year-end 2006, there were 168 distinct target date mutual funds with $109 billion in total assets. As of December 31, 2007 (see Figure 1), there were 229 target date funds with $178 billion in assets. This represents a 36% increase in the number of funds and a 63% increase in total assets in just 12 months.
In light of anticipated growth both in the number of target date funds and the assets committed to them, it is critically important to have appropriate indexes to evaluate and benchmark their performance. Appropriate benchmark indexes also increase the likelihood that 1) investors are better served, and 2) the fiduciary responsibilities of financial advisors and plan sponsors have been fulfilled.
Figure 1. Target Date Funds
The primary purpose of a target date fund is to replicate prudent (i.e., “best practice”) transitions in a portfolio’s asset allocation strategy over the lifetime of an investor. This is accomplished primarily in two ways. First is the asset allocation model employed by the fund. Second is the “glidepath,” or asset allocation adjustments over time.
The primary purpose of a glidepath is to adjust the return and risk characteristics of a portfolio over time (see Figure 2). When the portfolio is 30-40 years away from the target date, it is weighted toward higher return and, as a result, higher risk. As the fund approaches the target date, the glidepath calls for allocations that emphasize lower risk exposure, and hence lower potential return.
Displayed in Figure 2 are the average equity and fixed-income allocations, by target date cohort, for the average target date fund as of year-end 2007. The total equity allocation is comprised of U.S. equity and non-U.S. equity. The total fixed-income allocation is the combination of the allocation to bonds and the allocation to cash. For example, as of 12/31/07, the average equity allocation among all 25 2040 target date funds was just under 90%, while their average allocation to bonds and cash was just over 10%.
Figure 2. Average Equity And Fixed-Income Allocations For Target Date Funds
Data As Of 12/31/07
As shown, the glidepath for equities descends from a high of roughly 90% among 2040 target date funds to an average of 40% in funds that have already reached their target date (i.e., “Current” or Today funds). Conversely, the glidepath of bonds/cash ascends from an average of 10% in 2040 funds to about 60% in Current funds.
The average allocations to the four core assets in target date funds (U.S. equity, non-U.S. equity, bonds, and cash) for all 229 funds are shown below in Figure 3. The average 2040 target date fund has a 90% equity/10% fixed-income portfolio, the average 2030 target fund has an 80/20 portfolio, the average 2020 fund has a 60/40 portfolio, the average 2010 fund has a 50/50 portfolio, and the average current fund has a 40/60 portfolio.
Figure 3. Average Portfolio Allocations To Four Core Asset Classes
Data As Of 12/31/07
Evaluating and comparing target date funds is no simple task due to the fact that there are many interpretations of what constitutes a prudent and appropriate glidepath. Bear in mind, the graphs above depict the “average” target fund, which masks the variation that exists among them. Consequently, there is a need for independent target date indexes that can serve as benchmarks for target date funds. Until now, the only suite of target date indexes has been the Dow Jones Portfolio Target series.
This article proposes a new methodology for the construction of target date indexes that incorporates several “best practice” elements that take into account the need for adequate capital growth and the need for safety of principal. It is curious that the remarkable growth in the number of target date funds during the past several years has not spawned the development and introduction of more target date indexes (or benchmarks). This represents an ironic void in an era marked by the promulgation of literally hundreds of indexes, index funds and index-based exchange-traded funds.
Pure Target Indexes
A new suite of target date indexes is presented in Figures 4-7: the Defensive Pure Target Index, the Conservative Pure Target Index, the Moderate Pure Target Index, and the Aggressive Pure Target Index. Each index has six target dates: Current, 2010, 2020, 2030, 2040 and 2050.
Having four distinct target date index categories (Defensive, Conservative, Moderate, Aggressive) that share the same pedigree in terms of theoretical design and core portfolio holdings—but with different glidepaths in the 20 years prior to the target date—permits more meaningful benchmarking and categorizing of individual target date funds.
Figure 4. The Defensive Pure Target Index
Figure 5. The Conservative Pure Target Index
During the first 20 years (40 years prior to target until 20 years prior to target), the Pure Target indexes have subtle performance variations within each target date cohort, which are based on differences in the allocation to the core assets. This can be seen clearly when comparing the differential in annual returns among the four Current Pure Target Indexes in Figure 8, compared to the differential in the annual returns among the four 2040 Pure Target Indexes in Figure 12.
However, once the glidepath is initiated 20 years prior to the target date, the four different Pure Target indexes begin to differentiate themselves from each other. As a result, the Pure Target Indexes have greater discriminatory power when used to benchmark target date funds in the Current, 2010, and 2020 target date cohorts.
Achieving greater precision in benchmarking target date funds is an important step forward. Rather than simply comparing the performance of the XYZ 2020 Fund against the average performance of all 2020 funds (a “peer group” comparison), it is now possible to determine if the XYZ 2020 Fund is a defensive, conservative, moderate or aggressive 2020 fund based on its correlation to each of the four different 2020 Pure Target Indexes. Just as nontarget-date funds have their “best-fit” index (as determined by Morningstar, for example), target date funds will now have their “best-fit” Pure Target Index within each target date cohort.
Figure 6. The Moderate Pure Target Index
As shown in the Figures 4-7, the asset allocation model and glidepath in these three target date indexes span a 40-year period, simulating only the accumulation period for an investor. The accumulation period ends at the target date, which typically coincides with the retirement year of the investor. A 40-year accumulation period may seem optimistic given that far too many people do not start investing in their mid-twenties. However, auto-enrollment of employees into retirement plans should begin to remedy this problem. Add to that the likelihood that today’s young workers will not likely retire until their late sixties or early seventies, and a 40-year accumulation period is quite likely.
How are the Pure Target Indexes different from the typical target date fund? First, they include only two broad investment groups: a Risky Asset group and a Reserve Asset group. The Risky Asset group is comprised of six separate sub-assets: two broad equity assets, two broad bond assets, and two diversifying assets. Collectively, these six risky assets represent a capitalization-weighted, global basket of investable assets. It’s instructive to note that we include two bond assets and two equity diversifier assets as components of the Risky Asset group. Including bonds as a “risky” asset is a departure from the norm, but is in keeping with the central tenets of Markowitz’s efficient frontier (which includes all risky assets).
Missing from the Markowitz efficient frontier, however, is cash (and other “Reserve” assets). Enter the Capital Market Line: By including Reserve assets in each Pure Target Index, it is possible to create a portfolio mix that has risk/return characteristics that are superior to a portfolio that includes only those risky assets that reside on or near the efficient frontier.
Figure 7. The Aggressive Pure Target Index
Secondly, we implement a transfer-of-assets protocol (through rebalancing) that creates a “Lockbox.” The lockbox performs the role of insulating money from loss caused by equity market gyrations by migrating portions of the portfolio into the Reserve Asset at an increasing rate as the investor approaches the target date. In fact, at the target date, the allocation of the Defensive Current Index is 100 percent Reserve Asset; the Conservative Current Index has an allocation of 75 percent in the Reserve Asset; the Moderate Current Index has a 50 percent Reserve Asset allocation; and the Aggressive Current Index has a 25 percent allocation in the Reserve Asset.
While not an annuity, this lockbox concept incorporates elements of Liability Driven Investing (LDI) into the construction of our target date glidepath. At retirement, the investor is then able to determine how best to position his/her portfolio. We anticipate that many individuals will choose to purchase an annuity product. LDI represents a “best practice” that should be followed when building a target date fund and/or target date index.
Target date funds comprise two very separate functions: an accumulation phase and a decumulation (or distribution) phase. Each phase presents unique goals and challenges. We have chosen to solely focus on the accumulation phase in our Pure Target Indexes. We suspect that target date funds will be segmented into two separate products: an accumulation vehicle and a distribution vehicle. In fact, this evolution is beginning already with a new breed of target date funds being introduced under the banner of “income replacement.” The Pure Target Indexes outlined in this study represent accumulation indexes, rather than indexes that attempt to cover both the accumulation and distribution periods.
The performance of the Pure Target Indexes (Defensive, Conservative, Moderate, Aggressive) will now be compared against the average performance of all target date funds (“Peer Group Average”), the S&P 500 Index, and the Dow Jones Portfolio Target Indexes. The target date of 2050 is omitted in this study as there was only one peer target date fund in that cohort as of December 31, 2007. Each performance comparison will take place within target date cohorts (Current, 2010, 2020, 2030, 2040).
In Figure 8, the annual returns from January 1, 1998 to December 31, 2007 are listed, as well as the average annualized return and the standard deviation of monthly returns. Raw data for this study were obtained from Morningstar Principia.
Figure 8. Annual Returns For Current Indexes And Funds
Data As Of 12/31/07
*The S&P 500 Index is not a relevant benchmark index for target date funds, but is included as a reference point only.
The Defensive and Conservative Pure Target Current Indexes had considerably better performance than the peer group average and the S&P 500 during the difficult years of 2000, 2001 and 2002. The performance of the Dow Jones Target Today Index also weathered the three-year storm well. The performance of the Defensive and Conservative Pure Target Indexes during those three turbulent years is a direct result of the previously mentioned lockbox concept. Interestingly, the Pure Target Defensive Current Index was also the high performer in 2007.
The 10-year annualized return of 6.00 percent for the Pure Target Defensive Current Index was lower than the 6.49 percent return of the Dow Jones Portfolio Target Today Index and the 6.08 percent annualized return of the peer group. Recall that the performance for the Pure Target Defensive Current Index was achieved with a portfolio allocation of 100% Reserve Assets over the entire 10-year period, whereas the average allocation among peer group current target date funds is 40% equity, 60% fixed income. The Pure Target Conservative Current Index (6.85 percent 10-year return) outperformed the peer group average return as well as the DJ Target Today Index, and did so with less volatility (as measured by standard deviation of monthly returns).
Volatility is an important consideration for funds that hold the assets of retirees. The price of the Defensive Index’s slight “underperformance” over this 10-year period was safety of principle during the market storm of 2000-2002. We believe that many retirees will gladly pay that price.
As anticipated (because of greater equity exposure), the 10-year annualized return of the Pure Target Moderate Current Index (7.60 percent) and Pure Target Aggressive Current Index (8.29 percent) were considerably higher than the comparison groups in Figure 8 (Dow Jones Today Index, peer group of target funds, and the S&P 500). It is worth noting that the while the Moderate and Aggressive Pure Target Current Indexes outperformed the S&P 500 Index, they did so with substantially lower volatility of return. This serves as a reminder of the value of portfolio diversification across a wide variety of assets—a common characteristic of target date funds.
Performance data for the 2010 target date cohort are presented in Figure 9; 2020 cohort in Figure 10; 2030 cohort in Figure 11; and 2040 cohort in Figure 12.
Figure 9. Annual Returns For 2010 Indexes And Funds
Data As Of 12/31/07
Figure 10. Annual Returns For 2020 Indexes And Funds
Data As Of 12/31/07
Figure 11. Annual Returns For 2030 Indexes And Funds
Data As Of 12/31/07
Figure 12. Annual Returns For 2040 Indexes And Funds
Data As Of 12/31/07
The assessment of performance would be incomplete without a further consideration of risk (i.e., volatility of returns). This is accomplished by the use of X-Y scatter graphs. In Figure 13, for example, the 3-year risk & return coordinates for the four Pure Target 2010 Indexes are noted by large triangles (Defensive is plum, Conservative is teal, Moderate is blue, Aggressive is orange), whereas the three-year risk and return coordinates of actual 2010 target date funds (only those with at least 36 months of performance as of 12/31/07) are shown by small dots of varying colors.
As would be expected by theory, the constellation of the plotted risk/return coordinates demonstrates an upward slope suggesting that greater return is achieved by accepting higher volatility of return. In X-Y graphs such as these, the coveted location is the northwest corner. The four Pure Target 2010 Indexes define the efficient frontier, while the Pure Target Defensive and Conservative 2010 Indexes (plum- and teal-colored triangles) occupy the ideal location nearest the northwest corner.
Figure 13. 36-Month Risk/Return Map For 2010 Indexes And Funds
Data As Of 12/31/07
By incorporating a wide variety of asset classes into their design, the Pure Target Indexes (www.TDBench.com) improve resistance to loss and performance potential. Carefully constructed target date funds ought to have comparable risk and return characteristics.
It’s important to remember that target-date indexes (and target funds in general) have two vitally important elements: a core asset allocation model and a glidepath design. In the Pure Target Indexes, performance during the first 20 years (beginning 40 years prior to the target date) is governed entirely by the asset allocation model, whereas the performance of the indexes during the final 20 years (the 20 years prior to the target date) is a function of the asset allocation model and the glidepath.
This study illustrates the virtues of a target-date fund design that incorporates two essential mandates: prudently grow money and progressively protect it as the target date approaches. The Defensive Pure Target Index asset allocation model—with its lockbox-oriented glidepath—represents a blueprint for target-date design that supports both mandates.
In addition to being a blueprint for the design of target date indexes and target date funds, the Pure Target Indexes will facilitate more accurate benchmarking of target date funds. Currently the tools available to categorize target date funds are nebulous at best. With only one target date index series currently in the market (Dow Jones), it is difficult to clearly determine if a specific target date fund (within a particular target cohort, say 2020) is defensive, conservative, moderate or aggressive. The Pure Target Indexes solve that dilemma.
The appeal of a good target date fund is simple sophistication. Investors in target date funds are like Lexus car buyers – they don’t want to look under the hood. The Defensive Pure Target Index is simple in the following two ways. First, an investor who enters at any time is highly likely to earn a positive real return if he stays in the fund to the target date. Secondly, at the target date (i.e., “Current”) the Defensive Index is positioned in a 100% Reserve Asset allocation so as to protect the investor from material loss.
Such a strategy might be viewed by some as too protective. As noted in Figure 8, the 10-year annualized return of the “Current” funds peer group of target date funds was 6.08% and the 10-year return of the Current Pure Target Defensive Index was 6.00%. However, the average “Current” target date fund has an asset allocation of 40% equities and 60% bonds/cash. More importantly, the average “Current” target date fund lost nearly 2% in 2002, whereas the Defensive Pure Target Index set the standard of asset protection with a return of 10.54%.
Target date funds should be designed to match or exceed the risk-adjusted performance of the Pure Target Defensive Index. Its motto is simply this: grow money prudently and then protect it aggressively. The other index series (Conservative, Moderate, Aggressive) sacrifice to varying degrees these two objectives so as to be more in line with industry practices, and are in fact exposed to the problems that critics have identified, such as path dependency and potential for loss. Time will tell which of these lifecycle alternatives garners the greater acceptance.