Target date funds have “solved the behavioral problem” of getting investors to save for retirement “but not the investment one,” says Peter Chiappinelli, portfolio strategist at Grantham, Mayo, Van Otterloo & Co. and co-author of a new white paper on TDFs.
With that challenge in mind — to get better performance from TDFs — Chippinelli and colleague Ram Thirukkonda studied TDFs from 1975 to 2015, adjusting portfolios, glidepaths — the formulas that define asset allocations based on the number of years to the target date — and deferral rates.
Here’s what they found:
Active Management Does Not Add Value
The researchers compared the performance of three different groups of active managers over three-year lookback periods from 1975 until 2015 in six asset classes: U.S. large cap, U.S. small cap, Internaitonal equity, emerging equity, U.S. investment grade bonds and cash.
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The managers were divided into three groups: managers that ranked at the exact median of their respective asset class, that ranked in the top quartile of returns, that placed in the top quartile for risk-adjusted returns, using Sharpe ratios.
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Then using data from active mutual fund returns from the Center for Research in Security Prices (CRSP), the researchers compared the returns of all three managers groups to the returns of a common industry benchmark minus a modest fee.
None of the active manager groups yielded additional incremental returns over passive funds. In fact, all three active managed fund categories underperformed their comparable passive funds, with the median manager group performing the worst and the top quartile funds performing the best.
“It is clear from the scoreboard that active management across the time frame, using admittedly simple backward-looking metrics did not add value,” the report states. “Plan sponsors should not obsess about open-architecture or ‘best in breed’ active frameworks.”
Dynamic Glidepaths (Asset Allocations) Can Add Value
Most target-date funds use “predetermined” glidepaths. They change asset allocations based on an investor’s years to retirement, making no adjustments for changing market conditions.
“This strikes us at GMO as a bit silly given that destructive asset class ‘bubbles’ have formed through time, and are, we believe, detectable and largely avoidable,” the researchers wrote. So they devised a test that used market valuation as the guide for asset allocation, not time (until retirement).
They compared the usual static glidepath funds to two different types of funds that adjust stock allocations: one that allocates 20% of assets based on changing market conditions (called “Dynamic Swing”) and one that could adjust 100% of its assets based on market conditions (called “Dynamic Core”).
The adjustments were based back on Shiller cyclically adjusted price-to-earnings ratio (CAPE) for stock funds and on real yields for bond funds.
The results: The Dynamic Swing glidepath added about 9% to to retirement wealth, and the Dynamic Core approached added 14%.
Plan sponsors should “worry about what matters the most: the asset allocation levels,” said Chiappinelli.
“U.S. stocks today are more expensive than before the 1929 crash,” but target date funds are doing nothing about that, said Chiappinelli, calling it “a crying shame.”
“Last summer the 10-year Treasury yield was the lowest yield in history. They should have stopped buying bonds at that price.”
He added that “it’s so much more important” for TDFs “to look at emerging markets vs. U.S. stocks than whether to own coke or Pepsi.”
Such adjustments are also much more important than tweaking the riskiness of glidepaths, according to the GMO researchers. They found that funds with aggressive equity allocation of equities — starting at 95% and ending at 60% — performed only slightly better than conservative funds — starting with 85% equities and ending at 40%. The more aggressive funds returned 4% compared with -2% for the more conservative funds.
Increased Deferral Rates Make a Big Difference
The GMO researchers found that increasing an employee’s contribution by 1% — from a median 6% to 7% of salary — could provide an additional 11% increase in their retirement wealth over the course of the 40 years time frame they studied, from 1975 to 2015.
And they noted that this can be done at no cost to the plan sponsor. Automatic deferral rates can be increased from, say, 2% or 3% to 4%, for example.
In addition, matching formulas can be changed so that employees are “nudged” to contribute more funds. Employers could, for example, agree to match the first 25% of an employee’s contribution, up to 12%, rather than the first 50% of contributions, up to 6%.
This “behavioral nudge” helps employees “make better decisions subconsciously.”
The researchers conclude that for target date fund performance, “adding a dynamic component to the glidepath combined with an earnest effort to boost deferral rates appears to have the potential to deliver the biggest bang for the buck.”
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