Academic egghead alert! It appears target date funds aren’t all that, at least according to a recent research posted to the Social Science Research Network (SSRN). One premise examined is particularly compelling; the notion that “the increasing popularity of TDFs is related to the promise of simplicity rather than improved outcomes.”
Indeed, many TDF proponents point to their ease-of-of-use for 401k participants, and the good behavior they engender in times of market peril, specifically trumpeting their positive track record during the shock of 2008.
Their actual participant outcomes, however? Not so much.
“Target date funds have become very popular with investors saving for retirement,” the authors assert innocently enough. “The main feature of these funds is that investors are automatically switched from high risk to low risk assets as retirement approaches.”
However, their analysis questions the rationale behind them.
“Based on a model with parameters fitted to historical returns, and also on model independent bootstrap resampling, we find that constant proportion strategies give virtually the same results for terminal wealth at the retirement date as target date strategies.”
It’s a fancy way of saying proper portfolio diversification and rebalancing work just as well as glide paths when all is said and done.
“This suggests that the vast majority of target date funds are serving investors poorly,” the authors note. “However, if we allow the asset allocation strategy to adapt to the current level of the total portfolio value, significantly lower risk of terminal wealth can be achieved, at no cost to its expected value.”
When an optimal glide path strategy was calculated and compared with the outcomes of a constant proportion equity allocation, they found that “the best possible glide path strategy” offers virtually no improvement compared to constant proportion rebalancing, based on both simulated and historical markets.
They conclude by considering a new strategy, target wealth (TW), which they find quite promising.
“This strategy is adaptive, in that the fraction of the portfolio invested in equities depends on the achieved wealth compared to the target, as well as the time left until retirement. Significant improvements are observed with this enhanced strategy.”
With more than 20 years serving financial markets, John Sullivan is the former editor-in-chief of Investment Advisor magazine and retirement editor of ThinkAdvisor.com. Sullivan is also the former editor of Boomer Market Advisor and Bank Advisor magazines, and has a background in the insurance and investment industries in addition to his journalism roots.
