By LARRY SWEDROE
The rise of target-date funds (TDFs, also called “lifecycle funds”) has been one of the most significant innovations over the last two decades. TDFs have risen from managing less than $8 billion dollars in 2000 to more than $2.3 trillion dollars in 2019 — about 10 percent of all mutual fund assets. TDFs are designed to provide investors with an age-appropriate portfolio of stocks and bonds that depends on the investor’s expected retirement date (target date).
Target-date funds provide important benefits, including allowing investors to hold in one fund a diversified portfolio that can include exposure to both U.S. and international (typically international large and possibly emerging markets) equities. They can also include exposure across the asset classes of small, large, value and growth. Another benefit is that over time TDFs slowly reduce risk by lowering the allocation to stocks and increasing the allocation to bonds.
In addition, in order to maintain their age-appropriate allocations, they also actively rebalance to undo changes in allocations that are caused by differential returns across the assets within the portfolio. Thus, they provide discipline that many investors fail to exhibit when self-managing a portfolio. And finally, competition has driven expense ratios down. For example, Schwab has a suite of TDFs, each with an expense ratio of just 0.08 basis points.
Jonathan Parker, Antoinette Schoar and Yang Sun contribute to the literature with their October 2020 study Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds. They began by noting that TDFs have moved a significant fraction of U.S. retail investors to a “market-contrarian” trading strategy that trades against aggregate stock market momentum and fluctuations.
“Traditionally,” the authors write, “many retail investors are either passive — letting their portfolio shares rise and fall with the returns on different asset classes — or they are active and tend to reallocate their assets into asset classes or funds with better past performance, a behavior known as ‘positive feedback trading’ or ‘momentum trading’ that can amplify price fluctuations.” In contrast, by rebalancing, TDFs trade against excess returns in each asset class.
The focus of their study is the effect of systematic rebalancing by TDFs on markets. Their sample of TDFs is from the CRSP (Center for Research in Security Prices) Mutual Fund Database. The average equity weight was 73 percent (49 percent in domestic equity and 24 percent in foreign equity), and the fixed-income weight was 27 percent. The fund flow rate to TDFs showed that the average TDF grew by 6 percent per quarter from net inflows.
Following is a summary of their findings:
— Target-date funds rebalance across equity and bond funds within a few months, behaving as predicted by their desired equity shares given realized asset returns.
— Most rebalancing occurs within the first three months of a market movement.
— Following high returns in an asset class, funds in that asset class experience outflows in proportion to their TDF ownership shares, which reduces the relationship between past fund performance and inflows to that fund. Importantly, investors do not move funds into or out of TDFs to offset these flows.
— Stocks with higher TDF exposure (through the funds held by TDFs) have lower returns after higher market performance. This correlation appears to be driven by TDFs’ price impact and is not simply the result of TDFs investing in stocks that have less exposure to market momentum. Specifically, when the excess return of the equity asset class was 10 percent in a month, stocks with a one standard deviation (0.6 percent) higher share of TDF ownership had a 0.24 percent lower return in the following month.
— Consistent with price pressure from TDF rebalancing, they found lower returns following high equity market returns for stocks included in the S&P 500 Index relative to similar stocks not in the index. Following a 10 percent excess return on the stock market in a month, the index stocks had a 1 percent lower return in the following month compared with similar non-index stocks.
— Time-series momentum (trend) in the S&P 500 Index declined from the pre-TDF to the post-TDF period. They hypothesised that this is due to the rise of TDFs dampening aggregate market fluctuation via contrarian rebalancing.
The authors’ conclusion
The authors concluded that their findings imply: “Target-date funds, by trading across asset classes, reduce the price response to asset-class-specific changes in demand from other sources.”
They added: “Our results suggest that to the extent that momentum or other anomalies are (or were) due to trend-chasing by retail investors, these anomalies may disappear (or may have already) as more retail investor money follows market-contrarian strategies.”
And finally: “Because TDFs actively re-balance between stocks and bonds, they add to co-movement in returns between these markets. An implication of this is that TDFs propagate movements in interest rates from bond markets to stock markets. Thus, TDFs automatically transmit expansionary policies such as quantitative easing from the bond market to the stock market.”
Target-date funds are an important innovation for investors saving for retirement. They relieve investors of the burden of choosing the allocation between equity funds and bond funds in their portfolios, replacing that decision with an automatic age-dependent rule, and they also provide the discipline of rebalancing that many investors fail to exhibit when self-managing a portfolio.
Parker, Schoar and Sun found that the growth of TDFs has significantly changed the patterns of fund flows and the time-series dynamics in stock returns: “If, as expected, the amount of funds invested through TDFs continues to grow, their market stabilising effects may become more pronounced.”
For example, interest rate declines may lead to stronger stock market responses, as an increasingly large number of funds invested in TDFs trade out of bonds and into stocks. In addition, the growth of TDFs might also result in a weakening of momentum in aggregate stock prices caused by trend-chasing.
While target-date funds do provide some significant benefits, investors should be aware that there are negative features that should not be ignored.
— Unless the TDF is an all-equity fund, combining equities and fixed-income assets in one fund results in the investor holding one of the two assets in a tax-inefficient manner. If the “fund of funds” is held in a taxable account, the investor is holding the fixed-income assets in a tax-inefficient location. If the fund is held in a tax-deferred account, the equities are being held in a tax-inefficient location (losing the benefits of long-term capital gains treatment, the ability to loss harvest, the ability to use the asset as a means of making a charitable contribution and avoid the capital gains tax, and losing the potential for heirs to have a step-up in basis upon death). For investors that only have tax-advantaged accounts and do not have taxable accounts, the fact that target date funds combine equities and fixed income is not a concern.
— If the fund is held in a taxable account, the investor loses the ability to loss harvest at the individual asset-class level. An offsetting benefit is that the fund should be able to rebalance internally, using cash flows and dividends, which is a more cost- and tax-efficient way to rebalance than buying and selling individual asset classes.
— If the fund is in a tax-deferred account, the investor loses the ability to use any foreign tax credits that are generated by the international equity holdings. Even in a taxable account, if the fund is a fund of funds, the investor loses the ability to utilise the foreign tax credit. For investors that only have tax-advantaged accounts and do not have taxable accounts, the fact that target date funds combine equities and fixed income is not a concern. It is better to have international diversification in a tax-advantaged account than to not have international diversification at all.
— If the fund is held in a taxable account, the equities should be in funds that are tax-managed. I am not aware of any balanced or target date fund that tax-manages the equity portion (which makes sense because the fund does not know which location it will be held in).
— If the fund is held in a taxable account, for most investors the fixed-income allocation should typically be in municipal bonds, not taxable bonds. Unfortunately, almost all of these funds hold taxable bonds.
— Investors can typically earn higher returns on riskless (from a credit perspective) FDIC-insured CDs than can be earned by investing in riskless Treasuries typically held by TDFs. And they can avoid the expense ratio associated with that allocation. Note that CDs may not be available in a retirement plan. The offset is that they lose the convenience of the fund, the benefits of automatic rebalancing, and the age-related automatic changes in their asset allocation.
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LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.
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