Target date funds aim to reduce volatility in bond holdings

Some point out that many target-date funds are overly invested in one part of the fixed income market (investment grade bonds), which could leave their portfolios overly exposed to U.S. interest rates. They argue that by holding a broader mix of fixed income assets, investors can earn higher returns over the long term and reduce volatility during periods of rising interest rates.

When investing in a 401(k) or other retirement savings account, target date funds are an easy option. If you choose a fund that coincides with your planned retirement date, the fund will gradually rebalance and reallocate your assets, changing the risk profile of your investments as your retirement date approaches.

Target-date funds typically allocate more to higher-risk investments, such as stocks, early on and shift toward more conservative investments, such as bonds and cash, as investors approach their retirement date.

The percentage of Vanguard's defined contribution plans offering target-date funds increased from 86% in 2013 to 96% in 2022. As of the end of 2023, target-date funds will have total net assets of $1.75 trillion, according to Morningstar Direct. .

active and passive

One of the main differences between target-date funds is whether they are actively or passively managed. Passive target date funds are a popular choice for many defined contribution plans because they generally have lower fees. Target-date funds invested in passive underlying assets will hold 60% of target-date retirement assets in 2022, up from 51% five years ago, according to JPMorgan Asset Management.

Passive target-date funds typically limit their underlying investments to low-cost index funds for both stocks and bonds. This is where the industry debate on bond diversification comes to the fore.

The S&P 500 index represents over 80% of the U.S. stock market. By contrast, the Bloomberg U.S. Aggregate Bond Index, a benchmark commonly used by bond funds, accounts for just 52% of the U.S. bond market. The majority are U.S. Treasuries, investment-grade corporate bonds, and agency mortgage-backed securities.

Market trend

“There's a huge opportunity cost just in terms of how much coverage you have in the market,” said Emily Kao, retirement solutions strategist at JPMorgan Asset Management.

She points out two problems. U.S. Treasuries account for about 40% of Bloomberg's total assets, and investors can earn higher yields by investing some of their money in other fixed income assets, she said. Another problem she has is that the average lifespan of Bloomberg Agg is 6.2 years. This is long enough to fall significantly if interest rates rise dramatically. In 2022, Agg fell 13%.

This can be a problem for investors who are nearing retirement or have already retired. Target-date funds have higher allocations to bonds, which should result in lower volatility. A sharp decline in long-term or intermediate-term government bonds would hurt your portfolio. Cao says the ability to proactively adjust the duration of a portfolio based on the interest rate environment reduces volatility.

From 2009 to 2019, stock returns exceeded 10% annually, inflation was low, and bond yields were low but stable. In other words, it was easy to invest money in a blend of US stock and bond indices and forget about it. If this environment continues, there will be little need for a more diversified bond portfolio, said Christopher Nikolic, head of glide path strategy at AllianceBernstein.
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Multi-asset solution business. “But that's not what we're seeing.”

Unlike passive managers, active managers invest in core fixed income assets, including various sectors of the credit market such as high-yield non-investment grade bonds, emerging market bonds, securitized credit, and real assets such as natural resources and real estate. You can select assets that exceed your quota. real estate.

“[The Agg] This is a small world compared to the entire world of credit types available in the institutional market,” said David O’Meara, WTW’s senior director of investments.
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Some investors may balk at the idea of ​​allocating money to riskier parts of the market, such as high-yield bonds or real estate. High-yield bonds have similar risk and return characteristics to stocks, and “during periods of stock market turmoil, the downside risk of a balanced portfolio increases,” said Brian, head of target date product management at Vanguard.・Mr. Miller says.

Added value through active management

T. Rowe Price has devised a target-date fund that shifts in a way that makes it safer for older investors, said Kim DeDominisis, portfolio manager for target-date strategies.

DeDominisis said 70% of its fixed income holdings are core (including U.S. bonds and global dollar bond funds) and 30% dynamic. “As you shift along the glidepath and increase your fixed income exposure, you reduce your exposure to long-term government bonds and increase your exposure to high-yield, floating-rate, and emerging market bonds,” she says.

A T. Rowe Price study compared the performance of target-date bond allocations to a benchmark index and found that investors aged 65 returned 1.43% over the five-year period ending December 31, 2023. did. That compares with the Bloomberg U.S. Aggregate Bond Index's annual return of 1.10%.

And in 2023, the same bond component returned 6.08% annually, while the index returned 5.53%. Other research by T. Rowe compared the performance of 11 active target-date funds to their passive competitors. All 10 funds with 10-year track records included in this study outperformed their passive peer index in 100% of the 10-year rolling period from inception to December 31, 2022.

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