Target Date Funds: Marketing Or Finance?
University of Ulm
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University of Ulm
Since Target Date Funds (TDFs) became one of the default investment strategies for the 401(k) defined contribution (DC) beneficiaries, they have developed rapidly. Usually they are structured according to the principle “young people should invest more in equities”. Is this really a good recommendation for DC beneficiaries to manage their investment risk? The present paper relies on dynamic asset allocation to investigate how to optimally structure TDFs by realistically modelling the contributions made to 401(k) plans. We show that stochastic contributions can play an essential role in the determination of optimal investment strategies. Depending on the correlation of the contribution process with the market’s stock, we find that an age-increasing equity holding can be optimal too. This result highly depends on how the contribution rule is defined.
Target Date Funds: Marketing Or Finance? – Introduction
Target date funds (TDF) are investment funds with a prespecified maturity (target date). Because of their structure, these funds place themselves in the category of “life-cycle” funds, rather than in the category of life-style” funds where the target is the risk profile of the investor. TDFs have developed very rapidly, particularly after they became one of the default investment strategies of a 401(k) defined contribution (DC) beneficiary.1 According to Morningstar Fund Research (2012), assets in the TDFs have grown from 71 billion US dollars at the end of 2005 to approximately 378 billion dollars at the end of 2011. These funds are directly coupled with the retirement year of the DC plan investors and have the advantage that the investors do not have to choose a number of investments, but only a single fund. The main mechanism behind these TDFs is: those who retire later shall invest more in equity, while those who retire earlier shall invest less in equity. In other words, equity holding in TDFs shall decrease in age. Therefore, TDFs are usually identified by practitioners with “glide paths”, i.e. the decreasing curve of the equity holding (as a fraction of wealth) over time.
But is this shaping of target date funds really a good recommendation for DC beneficiaries to manage the investment risks? Shall every DC beneficiary who retires in 2050 take the same target date fund, independent of his income, and risk preference? Is the popular financial advice just anecdotal evidence? Or can it be justified by rigorous theory?
There is few literature aiming to find an optimal equity holding which justifies the target date fund.2 At first sight, target date funds are inconsistent with Merton’s portfolio (c.f. Merton (1969) and Merton (1971)), which has sometimes been considered as an economic puzzle. For an investor with a constant relative risk aversion preference, Merton’s optimal portfolio prescribes to invest a constant proportion of wealth in equity (constant-mix strategy is optimal), i.e. the optimal portfolio does not depend on time/age. One of the most famous rigorous economic justifications for the age-dependent (particularly age-decreasing) investment behavior is given in Jagannathan & Kocherlakota (1996). In their paper, by using economic reasonings, the robustness of the arguments justifying glide paths is called into question. They discuss the three prevailing hypotheses supporting it and accept human capital, in form of present value of expected future earnings, as the only valid reason to solve this apparent puzzle. Using a simplified model and some qualitative arguments, they also show the validity of the argument “younger people shall invest more in stocks because younger people have more labor income ahead” under certain conditions, e.g. if the correlation of labor income with stock returns is not too high.
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