July 20, 2011

To Improve Target-Date Fund Performance, Folio Uses Relational Diversification

Strategy focuses on relationship between asset classes, sectors

Folio Investing, an online brokerage, announced Monday that since launching its suite of target-date funds in 2007, the average return for the 2010, 2020, 2030 and 2040 Moderate target-date folios was 1.13% higher per year than the average return for comparable target-date funds offered by three other mutual fund companies and is up 1.87% per year compared with the universe of target-date funds.

The reason for the funds’ success, according to the company, is relational diversification, a strategy that manages a portfolio’s risk level and the evolving relationships between asset classes.

Steven Wallman, CEO, Folio“The concept is straightforward,” Steve Wallman (left), founder and CEO of Folio Inc., which operates Folio Investing, says of relational diversification. While Folio’s funds are diversified in the traditional sense, the company is “also looking at the relationship between sectors to take advantage of any changes,” he told AdvisorOne.

Among the standard stock and bond allocations, the Target Date Folios also invest in commodities, inflation-tracking bonds (TIPS), real estate assets, and include explicit allocations to infrastructure stocks such as utilities.

Other large target-date funds follow an outdated design approach that may leave them vulnerable to risk, according to Folio. Most target-date funds can enhance their approach to asset allocation, Wallman said in a statement.

“Our analysis shows that these funds are not as well diversified as they could be beyond stocks and bonds – which are correlated with those stocks – thereby leading to a high exposure to risk from a decline in stocks,” he added.

“During the 2007 to 2008 period, target-date funds experienced a lot of volatility. There was an increase in correlation between stocks and bonds, and the benefits of diversification began evaporating,”  Wallman said in a phone interview.

Some “sizeable firms” have adopted Folio’s strategy, Wallman told AdvisorOne, though he declined to name the firms at the time, citing disclosure agreements.

Geoff Considine“What’s interesting is that even over the last three years, which were not good years, target-date funds are an example of how a well-diversified portfolio can do even during difficult years,” Geoff Considine, strategic consultant to Folio Inc., told AdvisorOne.  

“It seems as though the starting assumption about target-date funds is that they’re well-diversified. That’s the question we started addressing when we launched the Folios in 2007,” Considine said.

“Three years is a pretty short time period,” Considine acknowledged, “but results have been consistent.”

Wallman noted that there are important policy matters regarding target-date funds that affect huge numbers of investors. In a comment letter sent in January to the Securities and Exchange Commission regarding target-date fund names and marketing, Folio argued that more important than a fund’s glide path is its “risk glide path.”

“We have learned that it is that expected portfolio risk that is the critical design feature of target date vehicles, with the asset allocation simply being a means to achieve that expected risk level as it changes over time,” according to Folio.

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