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Will Your TDFs Stand Up in an Economic Storm?

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Target-date strategies took a beating when the equity market lost more than half its value in the early part of the recession, but a white paper published in January by Old Mutual Asset Management offers low-volatility strategies to help mitigate some of the risk.

Target-date funds are a useful tool for unsophisticated investors, Mike Raso, head of Retirement at OMAM, wrote in the paper. However, “prepackaged target-date solutions” failed to protect retirees’ and pre-retirees’ assets when the market crashed.

Raso describes the “equity dilemma”: the need to ensure investors don’t outlive their assets and are protected against inflation while minimizing the risk of dramatic losses in a severe downturn. Low-volatility strategies are the answer to that dilemma, he wrote.

“Low-volatility, as an investment strategy, is uniquely positioned to provide increased downside protection to weather the financial storms of the future while also permitting participation in market rallies.”

Raso referred to studies that have found low-volatility stocks frequently perform better than their higher-volatility counterparts. One explanation is that investors tend to favor risky investments with the potential for a huge payoff, even if the probability of that payoff is low.

Raso listed three ways for plan sponsors to lower the volatility in their equity offerings within a target-date portfolio:

  1. Utilize defensively oriented value managers.
  2. Hire managers who use a quantitative approach that looks for the lowest expected volatility for a given set of constraints.
  3. Use alternative investments like commodities, managed futures, real estate and hedging strategies along with traditional equity strategies to smooth returns and create a low-volatility effect.

Raso noted that alternatives are frequently used to lower volatility, but can be more expensive and have higher liquidity constraints.

Ultimately, low-volatility strategies in target-date portfolios provide downside protection and upside participation, Raso wrote. Unlike bonds, which can also provide downside protection, low-volatility equities can “keep pace and participate in longer-term equity rallies.”

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As an example of low-volatility strategies’ success in protection against down markets, Raso pointed to the MSCI World Index, which fell approximately 54% between October 2007 and March 2009. By comparison, the MSCI World Minimum Volatility Index fell only 43% during the same period.

Furthermore, the Minimum Volatility index rose 76% to $1,054 in June 2012, compared with the World Index’s 77.5% increase to $861.

The goal of plan sponsors and participants should be both to reduce the overall risk in a portfolio and to budget appropriate risk through diversification. Raso described three model portfolios. Each had the same allocation of 6% cash, 7% commodities and 7% global bonds. However, while the portfolio with an 80% allocation to global equity returned 5.3% over 10 years, the portfolio with an 80% allocation to low-volatility global equity returned 7.2%. The more diversified portfolio, which divided the equity allocation between 31% low-volatility global equities and 39% emerging market equities, and added a 7% managed futures and 5% real estate allocation, returned 10.3% over 10 years.

“Even a small allocation to a low-volatility strategy could enable a plan sponsor to allocate a portion of its risk budget to asset classes with higher risk and return profiles such as emerging markets, real estate and managed futures,” Raso wrote. He acknowledged that a nearly 40% allocation to emerging markets may be too high for many investors, but “this extreme hypothetical illustrates the significant risk savings that can be achieved through the use of low-volatility strategies within the equity portion of a portfolio.”

It’s important to balance the need for growth with protecting assets as investors continue to opt for target-date funds, Raso wrote. Indeed, by the end of 2012, target-date mutual funds had $485 billion in assets and “have become the most common way for Americans to save for retirement,” according to Morningstar.

For plan sponsors looking to take advantage of target-date funds’ popularity, “selectively implementing de-risking and/or risk-budgeting through low-volatility strategies will empower them to create better solutions for their plan participants and better fulfill their fiduciary duties,” Raso concluded.