Target Date Fund Performance During the Volatile Quarter
Target date funds (TDFs) are an important component in many defined contribution retirement plans. Since their inclusion as a qualified default investment alternative (QDIA) under the Pension Protection Act of 2006, target date funds have seen an explosion of growth, with assets eclipsing $2 trillion as of the end of 2019(1) in the top flow category.
When used appropriately, target date funds can mitigate the impact of poor investment choices made by individual investors during times of market volatility by reducing an investor’s tendency to make emotional, financially-irrational investment decisions and keeping investors on a steady, pre-determined glidepath as they approach/enter retirement.
However, target date funds are not immune to market downturns. This is not surprising, as they were never meant to be capital preservation products, but rather to serve as a diversified portfolio with asset allocation based on participants’ age. The first quarter of 2020 has been the most defining moment for target date funds since the Great Financial Crisis. In general, the performance of target date funds met expectations and provided better downside protection relative to the last bear market. Yet, there was a wide array of results between the best- and worst-performing target date funds, due to glidepath differences, investment styles and objectives, and the performance of the underlying portfolio manager. The differences in these results highlight the importance of selecting the most appropriate target date solution for plan participants.
The following chart compares the Q1 2020 returns for the vintages of each Morningstar target date universe to the S&P Target Date Index Series.
A major contributor to the differing performance results among target date fund managers were the series’ glidepaths. Varying manager objectives lead some to emphasize capital preservation and market risk, while others focus on capital extension and longevity risk. This results in significant differences in glidepaths and performance by managers in varying market environments. Considering that the U.S. equity market lost nearly -20.9% (represented by Russell 3000), compared to fixed income, which rose by 3.2% (as represented by Barclays U.S. Agg), the breadth in returns during the first quarter is not surprising.
These significant differences in glidepaths can be difficult to track. In order to facilitate a more true comparison, Cammack Retirement has developed a six-category classification system. In our model, we specifically emphasize the vintages approaching retirement, since the point at which plan participants’ financial capital outpaces their human capital is the most vulnerable to market downturns. The following chart uses our six proprietary glidepath categories to highlight the minimum, maximum, and average Q1 returns for the 2020 vintage.
The average performance for target date funds with glidepaths in the Preservation of Capital: Most Conservative category is -7.1%, compared to an average of -11.93% for those falling within the Extension of Capital: Most Aggressive category. Thus, aggressive TDFs have lost more during this market volatility than more conservative funds. This highlights the importance of understanding a target date fund’s risk profile.
Passive Versus Active and the Quality of Fixed Income
Another interesting observation from the market downturn is that passive target date strategies outperformed active series, even for the same target date managers with the same glidepath. The performance advantage of passive compared to active was greater for vintages closer to retirement, as those funds hold a higher fixed income allocation. The differences in returns may be related to the short-term dislocations in the market, particularly within the higher-yielding fixed income allocation of their actively managed funds. Fixed income performance varied greatly. Long-term Treasuries were the biggest winners, amid a flight to safety and record low long-term yields. The 10-year Treasury yield fell to 0.68%, after starting the year at 1.92%. Credit-sensitive bonds and emerging markets debt lost ground due to concerns about the financial health of borrowers. This contributed to active underlying managers with higher allocation to more credit-sensitive areas underperforming passive counterparts with significant exposure to Treasuries.
The following chart displays the first quarter return difference between active and passive series across three major target date funds that have multiple versions of the same glidepath. The chart shows that the active series underperformed the passive series. It also highlights the margin of outperformance for passive was higher for vintages closer to retirement, than for those vintages further from retirement.
Differences in performance are also attributable to target date managers having varying investment styles and equity factors. For example, the target date funds with higher large capitalization equity exposure tilted towards more growth-oriented equities, and domestic-oriented portfolios experienced more tailwinds in their performance during the quarter. Another major contributing factor is the strength of the underlying funds within the target date series.
Comparison to Previous Downturns
Target date funds held up better during the coronavirus drawdown than they did during the Great Financial Crisis of 2008, a sign of progress within the industry. On average, investors saw 91% downside capture compared to 98% in the 2007-2008 crisis. As equity markets cumulatively lost -33% between 02/20/20 to 03/20/20, compared to -55% between 10/11/2007 to 03/09/2009, participants close to retirement in the 2020 Fund lost an average of 17.8% from peak to trough, compared to a loss of 27% in the typical 2010 fund during the Great Financial Crisis. Looking to the future, the passage of the SECURE Act in December of 2019 may lead to the potential inclusion of guaranteed income products in target date strategies. Inclusion of the guaranteed income products within target date funds should help to further mitigate market risk and provide future downside protection for target date investors.
Source: Morningstar Office
Over the past 20 years, investors who manage their own asset allocation significantly underperformed because they tended to buy when prices were high and sell when they were low. According to Dalbar, the average mutual fund investor return over the past 20 years was 2.54%, compared to an average annual return of 6.06% for the S&P 500 Index and 5.03% for the Bloomberg Barclays Bond Index(2). Industry research has shown that investors who are invested in target date funds are less likely to change their allocations. According to Morningstar research on participant behavior during the COVID-19 pandemic, only 5.6% of plan participants changed their portfolio allocations throughout the first quarter(3). However, there was significant variation based on how the participants were invested. Of participants who were self-directing their portfolios, nearly 11% changed their allocations during the first quarter of 2020, compared to just 2.4% of participants using a target date fund. With less market timing and a suitable glidepath, target date fund investors are better poised for future market volatility.
While assets in target date funds fell to $1.9 trillion for the first quarter of 2020 — a decline of about 17% — growth is expected to continue to rise. Retirement plan sponsors should ensure they understand the nuances of target date funds and continuously review the underlying components to ensure they are offering the most appropriate selection to their participants.
(2) Dalbar 2020 Quantitative Analysis of Investor Behavior
(3) Morningstar: Keep Your Distance: 401(k) Participant Investment Behaviors (So Far) During the COVID-19 Crisis
Note: This feature is to provide general information only, does not constitute legal advice, and cannot be used or substituted for legal or tax advice. Opinions expressed are those of the author, and do not necessarily represent the opinions of Cammack Retirement Group.
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