Evaluating Target Date Funds: Part 1 By: Gabriel PotterMBA, AIFA® 2013.12.19
Target Date Funds Increasing Popularity

Target Date Funds (TDFs) are one of the most popular investment options for 401(k) plans.  It’s easy to see why:  target date funds offer a single investment solution for employees which is diversified and automatically rebalanced over the years as an employee reaches retirement.  Furthermore, the 2006 Pension Protection Act sanctified Qualified Default Investment Alternatives (QDIAs) as a tool to steer employees into participating in company retirement plans and provided legal protections for companies automatically enrolling employees in qualified investments, like TDFs.

Given the massive popularity of Target Date Fund investments, we thought it was worth a thorough examination of these funds and how the prudent selection of a target date fund differs from a traditional investment in a 401(k) lineup.

First: Traditional Due Diligence

First, let us describe the due diligence process for a traditional investment.  Broadly speaking, the process of vetting an investment takes two forms:  quantitative and qualitative assessment. 

Quantitative assessment focuses on the numeric, quantifiable attributes of an investment product.  First, there is the most obvious of investment metrics:  what is the product’s return?  Moreover, there are a variety of useful quantitative criteria including: measuring performance relative to peer group and indices, risk relative to peers and indices, history of style adherence, correlation to benchmark, and cost.  Investment manager due diligence reports may also highlight Modern Portfolio Theory (MPT) metrics including as up-capture, down-capture, alpha, beta, Sharpe ratio, and batting average.   Furthermore, ongoing research into a product can generate additional attribution data detailing the source of the relative performance (sector attribution, stock selection).

Simply counting which stocks from which sector contributed and which positions detracted from relative performance is only the first step of understanding the causes of relative performance.  It is often more revealing to focus on qualitative factors, like style bias and the investment process, to generate a truer understanding of a product’s composition.  Knowing the people, philosophy and processes used helps fiduciaries isolate the unique aspects of an investment product.  We encourage fiduciaries to examine the people making the decisions, not only the portfolio managers, their education and experience, but also the culture of the firm, and whatever parent or subsidiary relationships which affect the product.   The overarching philosophy of the product, once verbalized, can give fiduciaries an expectation of how a product is positioned given various market environments.  Finally, recognizing the underlying investment selection process (buy & sell discipline, targeted attributes, position limits) can distinguish a product from peers.

For example, two managers (Manager A & Manager B) may have similarly good quantifiable performance metrics during a recent down market, but Manager A tactically reallocated to cash at the Portfolio Manager’s discretion whereas Manager B was always fully invested, but he tended to invest in businesses with predictable income statements.  Understanding the nuances of different investment processes can help investment committees select an appropriate manager for their plan. The challenges of fund combinations are shared with both Target Date Fund series and other QDIA options, like Target Risk funds.  (Target Risk funds are balanced products which create efficient portfolios that cater to constant levels of risk, such as “Conservative, “Moderate” or “Aggressive”.)  On the other hand, Target Date Funds are not usually included in a retirement plan as a stand-alone product, but rather as part of a series.  For example, a Target Date Fund from manager ACME might be incorporated into a retirement plan investment lineup with many separate funds, such as “ACME Target Date 2010”, “ACME Target Date 2020”, “ACME Target Date 2030” and so on. 

Analyzing a series of funds, rather than an individual fund, raises several questions.  For example, how many funds are available in the series?  How far out does the target date series extend – 2040 or 2060?  A business with younger employees may need a target date series which extends farther into the future.  Most target date funds are separated in 10 year increments, but others have 5 year increments (i.e. 2035, 2045); does a finer level of detail improve retirement outcomes?  Finally, how does the relative strength of the fund series change over the series?  Imagine that ACME investment management excels in active equity management, but their fixed income options often struggle.  As a result, their target date products with high amounts of equity (e.g. – 2050, 2060) will look attractive relative to peers whereas recent vintages (e.g. 2010) with high proportions of fixed income will look unappealing.

Additional Due Diligence For Target Date Fund Series

For more insights into the traditional due diligence, please see our April 2012 article on Investment Manager Due Diligence here.  As you can see, a lot of effort can go into thorough due diligence of a perfectly ordinary investment product.  To build upon the existing complexity, there are two fundamentally unique elements which make Target Date Fund series due diligence even more challenging:  fund combinations & timing. 

Fund Combinations

Target Date Funds usually are a balanced blend of other investment products, so they are necessarily more complex than a single-mandate investment (e.g. – a US Large Cap Value fund).  A novice investor might be tempted to approach due diligence of a Target Date Fund with this simplistic attitude: “All I need to do is conduct due diligence on each of the underlying funds which make up the Target Date Fund.”  Sadly, a Target Date Fund is more than the sum of its underlying parts.  In actuality, the due diligence process requires an additional layer of examination.

As a reminder, let us review a basic principle:  Modern Portfolio Theory is based on idea in which imperfectly correlated asset classes (e.g. cash, US large-capitalization stocks, international-bonds, etc.) are combined to create blended portfolios with different levels of risk and return.  Using models, investors can select diversified combinations of these different assets to create “efficient” or “optimal” portfolios which maximize the amount of expected return for any given level of risk.

Target Date Funds are typically combinations of other products which are meant to act as an efficient portfolio for a specific demographic.  For instance, a particular Target Date Fund mutual fund might exist to provide 70% of income replacement for employees planning to retire in the year 2030.  The underlying products which make up a Target Date Fund should, of course, be itemized and understood, but – more importantly – the combination of those funds also represents a unique attempt to create an efficient portfolio.  The sum of the underlying products has created a novel entity which deserves scrutiny, particularly in regards to its efficiency (i.e. – risk adjusted returns, historically or presumptively).

A novice investor, believing in a purely mathematical and scientific approach to investing, might mistakenly believe that Target Date Funds of competing providers should be similar to each other.  In other words, the 2045 Target Date fund from company ABC should be relatively similar to the 2045 Target Date fund from company XYZ.  After all, the portfolios were put together following data-driven computer models, so shouldn’t the efficient portfolios be similar for each Target Date Fund product?  As you’ll soon discover, this assumption couldn’t be further from the truth.  The structures of various Target Date Funds are astoundingly dissimilar to each other because the underlying presumptions are different.  Therefore, to determine the suitability of a Target Date Fund, an analyst must understand the underlying philosophy and presumptions used to determine the TDF series.  We will detail some of these differences of philosophy and approach in future newsletters.

TIMING



First, let us describe the due diligence process for a traditional investment.  Broadly speaking, the process of vetting an investment takes two forms:  quantitative and qualitative assessment. 

Quantitative assessment focuses on the numeric, quantifiable attributes of an investment product.  First, there is the most obvious of investment metrics:  what is the product’s return?  Moreover, there are a variety of useful quantitative criteria including: measuring performance relative to peer group and indices, risk relative to peers and indices, history of style adherence, correlation to benchmark, and cost.  Investment manager due diligence reports may also highlight Modern Portfolio Theory (MPT) metrics including as up-capture, down-capture, alpha, beta, Sharpe ratio, and batting average.   Furthermore, ongoing research into a product can generate additional attribution data detailing the source of the relative performance (sector attribution, stock selection).

Simply counting which stocks from which sector contributed and which positions detracted from relative performance is only the first step of understanding the causes of relative performance.  It is often more revealing to focus on qualitative factors, like style bias and the investment process, to generate a truer understanding of a product’s composition.  Knowing the people, philosophy and processes used helps fiduciaries isolate the unique aspects of an investment product.  We encourage fiduciaries to examine the people making the decisions, not only the portfolio managers, their education and experience, but also the culture of the firm, and whatever parent or subsidiary relationships which affect the product.   The overarching philosophy of the product, once verbalized, can give fiduciaries an expectation of how a product is positioned given various market environments.  Finally, recognizing the underlying investment selection process (buy & sell discipline, targeted attributes, position limits) can distinguish a product from peers.

For example, two managers (Manager A & Manager B) may have similarly good quantifiable performance metrics during a recent down market, but Manager A tactically reallocated to cash at the Portfolio Manager’s discretion whereas Manager B was always fully invested, but he tended to invest in businesses with predictable income statements.  Understanding the nuances of different investment processes can help investment committees select an appropriate manager for their plan. The challenges of fund combinations are shared with both Target Date Fund series and other QDIA options, like Target Risk funds.  (Target Risk funds are balanced products which create efficient portfolios that cater to constant levels of risk, such as “Conservative, “Moderate” or “Aggressive”.)  On the other hand, Target Date Funds are not usually included in a retirement plan as a stand-alone product, but rather as part of a series.  For example, a Target Date Fund from manager ACME might be incorporated into a retirement plan investment lineup with many separate funds, such as “ACME Target Date 2010”, “ACME Target Date 2020”, “ACME Target Date 2030” and so on. 

Analyzing a series of funds, rather than an individual fund, raises several questions.  For example, how many funds are available in the series?  How far out does the target date series extend – 2040 or 2060?  A business with younger employees may need a target date series which extends farther into the future.  Most target date funds are separated in 10 year increments, but others have 5 year increments (i.e. 2035, 2045); does a finer level of detail improve retirement outcomes?  Finally, how does the relative strength of the fund series change over the series?  Imagine that ACME investment management excels in active equity management, but their fixed income options often struggle.  As a result, their target date products with high amounts of equity (e.g. – 2050, 2060) will look attractive relative to peers whereas recent vintages (e.g. 2010) with high proportions of fixed income will look unappealing.

GOING FORWARD

Target Date Funds, arguably, are the most critical element of a retirement plan’s investment lineup.  In the upcoming newsletter, we will expand our analysis to include more information about the vetting and selection of a Target Date Fund series.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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