Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

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:

Daily Volatility of Target-Date Funds over 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.

TDF Returns and Volatilities - November 2007 – February 2009
Source:  Morningstar, Nuveen Asset Management as of 12/31/2011.