Target-Date Fund Diversification: Don’t Settle For Simple by Richard Davies

Plain-vanilla portfolios have become a major presence in the target-date world after a difficult period for diversification. We don’t think it’s a good idea to bet that plain and simple will continue to win.

Everyone knows that capital-market returns move in cycles. For a while, value stocks will outperform growth stocks. Then the pendulum swings, and the advantage shifts back to growth. You can also see that shift between US and international investments, small- and large-cap, or corporate bonds versus sovereigns—just to name a few complementary pairs.

We’ve seen a similar cyclical shift between times when diversification holds the keys to a portfolio’s outperformance…and when it works against it. Over the past six years or so, diversification hasn’t paid off. No sophisticated investor would invest in a painfully basic plain-vanilla portfolio of only large-cap US stocks and domestic core bonds, but such a portfolio would have outperformed most diversified portfolios.

Many defined contribution (DC) plan sponsors have unknowingly made a similar bet against diversification in their target-date fund selection, though not to the same extreme as illustrated in our example (Display).

While the assets of leading target-date managers are more globally diversified than those of the vanilla portfolio, these managers allocate the vast majority of their assets to just stocks and bonds. They’re significantly underallocated to real assets like commodities and real estate, not to mention newly available liquid alternatives, which can play an important role in reducing portfolio volatility.

Target-Date Fund Diversification

Target-Date Fund Diversification

Target-Date Fund – Is Diversification Dead?

Many DC investment committees have been pleased with the post-financial-crisis performance of their target-date funds without fully understanding why. At the same time, some committees who consciously diversified (for the obvious risk-management benefits) have paid a slight price for their good behavior—they’ve had to constantly remind themselves they were doing the right thing.

Have generations of market wisdom about the benefit of diversification been thrown out the window?

FYI: Pendulums Swing

Perspective and clarity on markets can be a lot like what we can see with the naked eye versus binoculars. Distance—both for what’s ahead and what’s behind—can greatly alter our perspective and understanding. Plain-vanilla investing may seem incontrovertibly right in light of the recent past, but the longer-term perspective of the chart above shows the importance of diversifying.

Today’s preference for plain-vanilla portfolios has big implications for the world of target-date investing. Target-date funds are the most widely adopted of the three qualified default investment alternatives (QDIAs) sanctioned by the US Department of Labor for DC plans. And target-date funds are increasingly becoming the core holding for DC plan participants. Along with an unconscious reliance on plain-vanilla portfolios, most DC plan investment committees still live in the world of simple percentile performance rankings—not in the institutional world of volatility management and risk-adjusted returns.

Maybe the dominance of the plain-vanilla approach will continue. And maybe it won’t. With all the uncertainty in today’s global markets—negative interest rates, the Brexit aftermath, China’s slower growth, a US interest-rate rise on the horizon as well as a contentious presidential election—there are more than enough catalysts to shake up markets for a while. Any or all of those uncertainties could lead to a shift in the investing environment that might favor a more comprehensively diversified strategy.

Interestingly, the display above already indicates a directional shift in the performance of the simple portfolio versus the diversified portfolio. And over the past six months (February 2016 through the end of July 2016), the diversified portfolio has outpaced the simple portfolio by an annualized 1.74%.

What’s in Your Target-Date Glide Path?

However, many plans, given their selection of TDFs from the major providers, are implicitly making the bet that plain and simple will continue to win. And yet their participants are investing for what may be a 30- or 40-year period.

The next time plan investment committees review their target-date offerings, we think they’d be wise to make portfolio diversification and underlying asset-class exposure a specific item on the discussion agenda.

Plain and simple may continue to work…until it doesn’t.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

“Target date” in a fund’s name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested—including at the time of the fund’s target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.