Target date and lifecycle funds have taken off since 2006, when they were deemed qualified default investment alternatives in the Pension Protection Act. I’m sure it seemed like a good idea at the time. Unfortunately, it planted the idea that a glidepath that moved toward bonds as the investor moved toward retirement was a good idea. Assets in target date funds were nearly $400 billion at the end of 2011—and they have continued to grow rapidly.
In fact, bonds will prove to be a good idea if they perform well and a lousy idea if they perform poorly. Since 10-year future returns correlate closely with the current coupon yield, prospects for bonds going forward aren’t particularly promising at the moment. I’ve argued before that tactical asset allocation may provide an alternative method of accumulating capital, as opposed to a restrictive target-date glidepath.
A new research paper by Javier Estrada, The Glidepath Illusion: An International Perspective, makes a much broader claim. He looks at typical glidepaths that move toward bonds over time, and then at a wide variety of alternatives, ranging from inverse glidepaths that move toward stocks over time to balanced funds. His findings are stunning.
This lifecycle strategy implies that investors are aggressive with little capital and conservative with much more capital, which may not be optimal in terms of wealth accumulation. This article evaluates three alternative types of strategies, including contrarian strategies that follow a glidepath opposite to that of target-date funds; that is, they become more aggressive as retirement approaches. The results from a comprehensive sample that spans over 19 countries, two regions, and 110 years suggest that, relative to lifecycle strategies, the alternative strategies considered here provide investors with higher expected terminal wealth, higher upside potential, more limited downside potential, and higher uncertainty but limited to how much better, not how much worse, investors are expected to do with these strategies.
In other words, the only real question was how much better the alternative strategies performed. (I added the bold.)
Every strategy option they considered performed better than the traditional glidepath! True, if they were more focused on equities, they were more volatile. But, for the cost of the volatility, you ended up with more money—sometimes appreciably more money. This data sample was worldwide and extended over 110 years, so it wasn’t a fluke. Staying equity-focused didn’t work occasionally in some markets—it worked consistently in every time frame in every region. Certainly the future won’t be exactly like the past, so there is no way to know if these results will hold going forward. However, bonds have had terrific performance over the last 30 years and the glidepath favoring them still didn’t beat alternative strategies over an investing lifetime.
Bonds, to me, make sense to reduce volatility. Some clients simply must have a reduced-volatility portfolio to sleep at night, and I get that. But Mr. Estrada’s study shows that the typical glidepath is outperformed even by a 60/40-type balanced fund. (Balanced funds, by the way, are also designated QDIAs in the Pension Protection Act.) Tactical asset allocation, where bonds are held temporarily for defensive purposes, might also allow clients to sleep at night while retaining a growth orientation. The bottom line is that it makes sense to reduce volatility just enough to keep the client comfortable, but no more.
I’d urge you to read this paper carefully. Maybe your conclusions will be different than mine. But my take-away is this: Over the course of an investing lifetime, it is very important to stay focused on growth.
