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The attack on target-date funds (TDFs) continues to gain steam, and for good reason. Virtually all TDFs offer a mechanical approach to glide-path management, unnecessarily exposing investors to risk – most noticeably when they are on the verge of retirement. A superior approach would keep the long- and short-term volatility of an investor’s portfolio within appropriate ranges by actively managing the glide path.
Most recently, Robert Huebscher wrote that there should be a clear distinction between glide-path implementation and active management, and that glide-path implementation should cost no more than a few basis points. Given the poor track record of TDFs, it is clear why even a few basis points is generous.
Because they are so passively mechanical, TDFs have been utterly inept at risk management. The glide path is often developed at the TDF’s inception, and the investment manager follows a simple reallocation schedule over its life. This type of passive management does indeed warrant only a few basis points in fees, since it does little to protect investors in volatile environments.
Therein lies the problem. Instead of trying to create a clear distinction between glide-path management and active management, we should adopt a different solution: actively managing the glide path itself.
The sad story of TDF investors
Consider the second half of 2008, when market volatility rose dramatically. At the end of August, the VIX Index (a measure of implied volatility) stood at 21. As a point of reference, since 1926 the average volatility of stocks has been approximately 20%. Over the next month, the VIX nearly doubled, finishing September at 39. On October 24, the VIX reached an intraday high of 89.5.
What did TDFs do during this time? In the face of severely rising volatility, the majority of TDFs mechanically followed their glide-path and made few or no changes. The following graph illustrates the daily volatility of target-date funds during this time:
Source: Morningstar, Nuveen Asset Management (“NAM”) as of 12/31/2011.
The volatilities of most TDFs spiked dramatically from 2007 through 2008 and into 2009. But what we find most shocking in the above graph is the volatility exhibited by the 2000-2010 TDFs in particular, which rose to 36% in 2008 – well beyond the historical volatility of an all-stock portfolio (20%). Is that the type of risk profile most investors want just before they retire?
The 2021-2025 (and longer) TDFs also reached extreme levels of volatility in 2008, exceeding 60% at some points; that is triple the historic volatility of US stocks. Fee-paying investors were deprived of risk management.
Granted, not all TDFs are alike. The following chart plots the annualized returns against the annualized volatilities of two groups of TDFs at the height of the subprime crisis.
Source: Morningstar, Nuveen Asset Management as of 12/31/2011.
An investor hoping to retire in 2010 (i.e., about one year from when those data were obtained) would have had a dramatically different experience depending upon which 2010 TDF was in his or her 401(k). “Lucky” investors in a 2010 TDF would have experienced average volatility levels of 8% and would have lost approximately 15% per annum.
But what if the TDF in your 401(k) was among the more volatile of the 2010 TDFs? You would have experienced a loss in excess of 40% (annualized) – one year before retirement. Now, many may look at that loss and argue that a 2010 retirement date is not the investor’s ultimate time horizon (since the investor still has the de-accumulation phase ahead) and that short-term losses will likely be recovered over the long term.
But what do investors do when presented with losses in excess of their risk tolerance – especially when faced with a loss of their future income stream for retirement? They panic. The following graph displays the net flows into and out of 2000-2010 TDFs.
Source: Strategic Insight as of 12/31/2011.
Prior to 2008, net flows into 2000-2010 TDFs had never been negative. In September of 2008, however, flows did turn negative – sharply. In October alone, $722 million flowed out of 2000-2010 TDFs, and by the end of February 2009, over $1 billion had flowed out of this group of TDFs over the trailing six-month period. These investors essentially locked in their losses.
To illustrate the gravity of this problem, consider an investor who intended to retire in 2010 and, as of September 2007, had invested his or her $500,000 401(k) portfolio in a 2010 TDF. Had the investor allocated to one of the TDFs in Figure 2 that experienced volatility in excess of 20% during the period, the investor would have had $300,000 remaining at the end of February 2009 – one year before retirement. Out of panic, many investors liquidated their holdings and went to cash, and the investor in our example would have locked in a $200,000 loss. A $200,000 realized loss just before retirement will have serious implications on the quality of life in retirement for most investors.
One of the primary risks is investor psychology. If the TDF ignores the current market environment and mechanically implements a glide path, investor portfolios will fluctuate with the market, occasionally at levels that far exceed investors’ risk tolerance. “Bail risk” – the risk that an investor bails out of his or her long-term strategy – is an important and very real risk to investors.
The alternative to static glide paths
The alternative is a more active approach to glide-path management that consists of short-term risk forecasting and effective diversification. Instead of establishing a schedule for how much stock versus bonds should be held at a particular point in time, the focus should be on “how much risk should an investor take at a particular point in time.”
Unfortunately, databases, ratings firms, and some investment managers equate risk with the amount a portfolio allocates to stocks. For example, a 60% stock, 40% bond portfolio is commonly believed to be a “moderate risk” portfolio. But a portfolio’s weightings represent only half of what is needed to calculate the riskiness of a portfolio. The volatility (and correlation) levels of the assets in the portfolio at a specific point in time are also an integral part of this equation.
In 2005, a mostly stock portfolio would have behaved much more conservatively than a mostly bond portfolio invested in 2008. This was because, in 2005, market volatility levels were at extreme lows. All-stock portfolios exhibited volatility levels of less than half the long-run volatility of stocks. In 2008, however, unless the investor held nearly all of his investments in bonds, his portfolio’s volatility spiked to unprecedented levels. Even a seemingly conservative portfolio with 70% in bonds and 30% in stocks had a volatility of 24% at times – higher than the long-run volatility of an all-stock portfolio. This fact is too often ignored.
In addition to employing short-term risk forecasting, TDFs should diversify extensively across a range of assets that perform differently in different economic environments. Unfortunately, most TDFs are overexposed to stock risk. The following chart compares the VIX Index (which measures the implied volatility of the S&P 500) to the volatility of 2021-2025 TDFs.
Source: Bloomberg, Morningstar, Nuveen Asset Management as of 12/31/2011.
The degree to which these series move together is uncanny. A rise in stock volatility is shadowed by a nearly equivalent rise in the 2021-2025 portfolio volatility. Numerically, the correlation between the daily volatility of the 2021-2025 TDFs and the VIX Index is 0.94 – an extremely large number.
While TDF managers may contend that they are diversified, and thus offer a safer place for retirement assets, we can see that nearly all of their risk comes from stocks. If stock volatility spikes, so will the volatility of mechanical TDFs, failing to adequately address the risk profile of individual investors in times of market stress.
The glide path is the most important aspect of a TDF, yet conventional approaches allocate little time to managing it. As a consequence, investors have seen their retirement assets fall dramatically during periods of high volatility, the extent of which soared far beyond levels investors can be expected to tolerate. This willful disregard for the current market environment needs to be replaced with a more tactical, risk-managed approach that keeps the long- and short-term volatility of an investor’s portfolio within appropriate ranges. Risk-managed asset allocation funds, or risk-managed TDFs, are a superior alternative to the current TDF options.
James Colon is a portfolio manager at Nuveen Asset Management, LLC, where he specializes in asset allocation and statistical risk management. He is the lead manager for Nuveen’s Intelligent Risk Portfolios®, a suite of asset-allocation strategies that focus on tactical risk management. Mr. Colon can be reached at
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The statements contained herein are published solely for informational purposes and are based solely upon the opinions of the author (s) and do not necessarily represent the opinions of Nuveen Investments’ affiliated investment advisers. No representation or warranty, express or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein, nor is it intended to be a complete statement or summary of the developments referred to in this material. Furthermore, the information should not be construed or interpreted as investment advice or a recommendation. All opinions and views constitute the author(s) judgments as of the date of writing and are subject to change at any time without notice. The readers should not assume that the strategies identified or discussed were or will be profitable. Asset allocation strategies do not assure or guarantee better performance and do not eliminate the risk of investment losses. Past performance is no indication of future results.
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