Target-Date Fund-mageddon

September 26, 2012

Markets are rarely tractable, which is one reason why significant flexibility is required over an investment lifespan.  Flexibility is something that target-date funds don’t have much of.  In fact, target-date funds have a glidepath toward a fixed allocation at a specified time.  I’ve written about the problems with target-date funds extensively—and why I think balanced funds are a much better QDIA (Qualified Default Investment Alternative).  It appears that my concerns were justified, now that Rob Arnott at Research Affiliates has put some numbers to it.  According to an article in Smart Money on target-date funds:

A target-date fund is a one-decision mutual fund that you can invest in over the course of your entire career.

Each fund is designed for those aiming to retire at a certain date. The fund starts with a lot of “risky” stocks, and over time it moves to “safer” bonds. The fundamental idea is that at any given moment between age 21 and age 65 you should be invested in a particular balance of assets — more stocks when you are younger, and more bonds when you are older.

The track to retirement, according to the industry jargon, is a “glidepath.”

Billions of dollars are invested in these target-date funds. They are today the default investment option in many 401(k) plans. Now comes Rob Arnott, the chairman of Research Affiliates and one of the handful of serious money managers in the country. In a new research paper he published yesterday, “The Glidepath Illusion,” he has blown this idea full of holes. “Shockingly,” he says, “the basic premise upon which these billions [of dollars] are invested is flawed.”

When Mr. Arnott investigated the results of such target-date funds, he found them to be incredibly variable—and possibly upside-down.  (I put the fun part in bold.)

Arnott has mined data from the stock and bond markets going back to 1871 and then run simulations to see how these target-date portfolios would have worked in practice. He considered a fund that started out with 80% stocks and 20% bonds, and then adjusted gradually over an investing life of 41 years so that it ended up 80% bonds and 20% stocks. He considered an investor who invested $1,000 a year, adjusted for inflation, from the day she started work at age 22 to when she retired at 63.

Bottom line? This investor could have done very well — or very badly. Far from enjoying a smooth “glidepath” to a secure retirement, she could have retired with as little as $50,000 in savings or as much as $211,000. She could have ended up with a retirement annuity of $2,400 a year — or $13,100 a year. There was no way of knowing in advance.

That wasn’t all. Arnott found that in most eras, investors would have actually been better off if they had stood this target-date strategy on its head — in other words, if they had started out with 80% bonds, and then took on more risk as they got older, so that they ended up with 80% stocks.

No kidding. Really.

The median person following the target date strategy ended up with $120,000 in savings. The median person who did the opposite, Arnott’s team found, ended up with $148,000. The minimum outcome from doing the opposite was better. The maximum outcome of doing the opposite was also better.

Amazing.  Even the minimum outcome from going opposite the glidepath was better!  Using even a static 50/50 balanced fund was also better.  Perhaps this will dissuade a client or two from piling into bonds only because they are older.  No doubt path dependence had something to do with the way returns laid out, but it’s clear that age-based asset allocation is a cropper.

Asset allocation, diversification, and strategy selection are important.  Decision of this magnitude need to be made consciously, not put on autopilot.

[You can read Mr. Arnott’s full article here.  Given that most 401k investors are unfortunately using target-date funds instead of balanced funds, this is a must read.  I would modestly suggest the Arrow DWA Balanced Fund as a possible alternative!]

Click here to visit ArrowFunds.com for a prospectus & disclosures.  Click here for disclosures from Dorsey Wright Money Management.

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ETF Trading Trends

September 26, 2012

Exchange traded funds comprise of groups of assets that are traded on the stock exchange. Similarly to mutual funds, ETFs track a basket of securities. This makes them more diversified than a single stock. Yet like stocks, they are easily traded, can be sold short, and often have lower transaction costs than mutual funds. ETFs tend to perform best under a buy-and-hold approach, but has the ease at which they trade caused investors to trade them more? Vanguard set out to answer this question.

They looked at “3.2 million transactions in more than 500,000 positions held in the mutual fund and ETF share classes of four different Vanguard funds from 2007-2011.” While ETFs were traded more often, mutual funds and exchange traded funds still had similar trading patterns.

Some in the investment community have suggested that ETFs tempt investors to increase their trading activity. Given the lack of investor-level analysis supporting or refuting this presumption, we examined the trading behavior of Vanguard investors. We found that, contrary to speculations in the popular media, most investments are held in a prudent, buy-and-hold manner, regardless of share class. Although behavior in ETFs is more active than behavior in traditional mutual funds, some of that difference is simply due to the fact that investors who are inclined to trade choose ETFs, not that investors who choose ETFs are induced to trade. We conclude that the ETF “temptation effect” is not a significant reason for long-term individual investors to avoid using appropriate ETF investments as part of a diversified investment portfolio.

In short, it is investors themselves that are responsible for increased trading of ETFs, not an inherent quality of the funds. Owning exchange traded funds won’t lure a long-term owner toward short-term trading.

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Are 401k Investors Making a Mistake with Hybrid Funds?

September 26, 2012

I think this is an open question after reading some commentary by Bob Carey, the investment strategist for First Trust.  He wrote, in his 9/11/2012 observations:

  • Hybrid funds, which tend to be comprised primarily of domestic and foreign stocks and bonds, but can extend into such areas as commodities and REITs, saw their share of the pie rise from 15% in Q1’07 to 22% in Q1’12.
  • One of the more popular hybrid funds for investors in recent years has been target-date funds. These funds adjust their asset mix to achieve a specific objective by a set date, such as the start of one’s retirement.
  • In 2010, target-date fund assets accounted for 12.5% of all holdings in employer-sponsored defined-contribution retirement accounts. They are expected to account for 48% by 2020, according to Kiplinger.
  • Plans are shifting away from the more traditional balanced funds to target-date funds for their qualified default investment alternative (QDIA).

There’s a nice graphic to go along with it to illustrate his point about the growing market share of hybrid funds.

Are 401k Investors Making a Mistake?

Source: First Trust, Investment Company Institute  (click to enlarge)

He points out that 401k assets in hybrid funds are rising, but the growth area within the hybrid fund category has been target-date funds.  It troubles me that many 401k plans are moving their QDIA option from balanced funds to target-date funds.  QDIAs are designed to be capable of being an investor’s entire investment program, so the differences between them are significant.

There is a huge advantage that I think balanced funds have–much greater adaptability to a broader range of economic environments.  Balanced funds, particularly those with some exposure to alternative assets, are pretty adaptable.  The manager can move more toward fixed income in a deflationary environment and more toward equities (or alternative assets) in a strong economy or during a period of inflation.

Most target-date funds have a glide path that involves a heavier and heavier allocation to bonds as the investor ages.  While this might be worthwhile in terms of reducing volatility, it could be ruinous in terms of inflation protection.  Inflation is one of the worst possible environments for someone on a fixed income (i.e. someone living off the income from their retirement account).  Owning bonds just because you are older and not because it is the right thing to do given the market environment seems like quite a leap of faith to me.

Asset allocation decisions, whether strategic or tactical, should be investment decisions.

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High RS Diffusion Index

September 26, 2012

The chart below measures the percentage of high relative strength stocks that are trading above their 50-day moving average (universe of mid and large cap stocks.)  As of 9/25/12.

The 10-day moving average of this indicator is 86% and the one-day reading is 77%.

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