The benefits of portfolio diversification become more apparent during periods of market volatility. These are also times when defined contribution (DC) plan participants might make costly, emotional decisions and sell at the wrong time.
Therefore, it’s urgent for plan sponsors to review their investment lineup to ensure they provide a meaningful mix of choices that can improve portfolio diversification and give investors the confidence to stay the course.
In our view, it’s just as important to motivate participants to select and maintain diversified portfolios, which is why investment education is paramount.
Add low-correlation and diversified strategies
Begin with reviewing the primary assets in your plan–equities and fixed income–for sub-sets with lower-correlation characteristics, and then consider diversified strategies and alternatives.
In equities, stocks of different capitalizations and domiciles tend to be less correlated to large-cap stocks. Consider small-cap, mid-cap, and international equities.
Investors may also benefit from growth and value equity options. In 2022, value has outperformed growth. Longer-term growth has outperformed value. Since markets change, having exposure to both may help participants reduce the impact of market volatility.
Regarding fixed income, certain periods of severe volatility have caused the asset class to fall with equities. But over the long run, fixed income has proven to provide portfolio diversification that could smooth the ride for investors.
Fixed income comes in a variety of types that perform differently depending on exposure to credit risk, interest-rate risk, and even currency risk. For diversification, consider global, high-yield, and emerging markets strategies with a lower correlation to core U.S. investment grade bond or government bond funds.
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In terms of fund structures, consider offering a mix of actively managed and passive strategies. These work well together, as passive funds deliver benchmark performance while active funds seek to add alpha and/or mitigate downside risk. You empower participants to make their own choices by including active and passive.
Diversified strategies
The U.S. Department of Labor established Qualified Default Investment Alternatives (QDIAs) to give DC plan participants appropriate, typically age-based, professionally managed diversified strategies.
QDIAs can be target-date funds (TDF) either off-the-shelf or customized; balanced funds that do not taper exposure to risk over time like TDFs; or professionally managed accounts, which are relatively new and growing in DC plans.
These accounts can be customized to fit the participant; a recent trend is a hybrid approach that begins with a TDF and migrates participant assets to a managed account as they get closer to retirement.
In terms of alternative assets like real estate, commodities, hedge funds, and private equity, they have a lower correlation to core asset classes. Still, they can be more volatile and difficult to understand. Plans offering alternatives should proceed with caution and lead with investor education, so participants understand the options and use them in small doses.
Don’t overwhelm participants
A tricky aspect of creating a diversified lineup is knowing when to stop; too many choices can overwhelm participants with inertia. There is a consensus that roughly 12 to 20 fund choices can provide enough variety to enable diversification with divergent strategies without becoming unwieldy.
Educate to motivate
Offering options in the lineup for diversification is half the battle; ensuring participants understand the power of diversification and how their options work can help them stay the course and potentially achieve greater outcomes.
The key is to help plan participants avoid losses arising from classic mistakes. They include:
Key points to stress on diversification in educational programs include setting realistic expectations of diversification strategies. While long-term results consistently show the benefits of broad diversification and asset allocation to risk-adjusted returns, anything can happen over shorter periods, and positive returns are not guaranteed. When market volatility is extreme, investor sentiment can lead almost all assets to perform similarly. While long-term results consistently show the benefits of broad diversification and asset allocation to risk-adjusted returns, anything can happen over shorter periods, and positive returns are not guaranteed
In addition, it’s critically important to discourage market timing since it’s almost impossible to do it successfully. Attempts to time the market typically lead to selling low and buying high. This is particularly true for investors who trade frequently.
The concepts of diversification and participant education are not new or novel to the defined contribution marketplace. One could argue that they’ve become so commonplace, they’re at risk of being tuned out or ignored as our attention is focused on the latest and greatest trends shaping the industry. However, if market events of recent years have taught us anything, it’s that sometimes the best advice is the oldest.
Deb Boyden is Head of U.S. Defined Contribution with Schroders.
Deb Boyden is Head of U.S. Defined Contribution with Schroders.
