They keep investors properly invested, and solve for many of the behavioral finance frustrations routinely trumpeted by the 401k industry, but target date funds are far from perfect.
AQR Capital’s Peter Hecht took to the pages of The Wall Street Journal last week to discuss two potentially costly flaws with the popular 401k plan saving vehicles.
Hecht, a former professor of finance at Harvard Business School, points to the ongoing scourge of home bias as one of the problems affecting target date funds.
“The typical target-date fund continues to have a ‘home bias’—focusing too much on U.S. stock and bond exposure and forgoing the diversification benefits associated with global investment opportunities,” he writes.
He also noted that in addition to underutilizing non-U.S. assets, most target-date funds contain “no-to-low allocations to inflation-protecting assets, such as commodities,” and are therefore overly exposed to inflation risk.
“Prudent investing not only requires holding the right assets, but holding them in the right proportions to balance risk,” Hecht argues. “The typical target-date fund violates this principle by continuing to over-allocate to stocks.”
The focus on “dollars invested in each asset class” instead of “risk allocated to each asset class” has given savers the illusion of diversification.
A portfolio comprised of 50 percent stocks and 50 percent bonds, for example, is “dollar diversified” but far from “risk diversified” since stocks are roughly four times as risky as bonds. In fact, stocks account for approximately 90 percent of the risk in a 50/50 portfolio.
Both issues could potentially escalate now that more people are saving all of their 401(k) assets in target date funds. At the end of the third quarter, 44 percent of Fidelity’s 401(k) savers had all their 401(k) savings in a target date fund, up from 41 percent a year ago.