GMO: How to Build a Better Target Date Fund

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.

(Related on ThinkAdvisor: SEC ‘Continues to Wrestle’ With Target-Date Fund Risk Rule: IM’s Grim)

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.

(Related on ThinkAdvisor: TDFs’ Underlying Funds May Not Meet Plan Sponsors’ IPS Standards)

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.