Target-date funds are popular with retirement savers. But a London Business School finance professor says these funds could produce better results if in addition to automatically adjusting stockholdings based on an investor’s age, they rebalanced quarterly to account for stock-market risk.
“When there is more risk out there, the return on stocks is going to be higher,” says Francisco Gomes, who has studied the issue. That is when what he calls a “tactical target-date fund” would boost its allocation to stocks. In contrast, “when you expect returns would be low, you can stay away from the markets,” he says.
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Conventional target-date funds typically invest the majority of their assets in stocks when an investor is young, gradually reducing that allocation as the investor nears retirement age. The funds offer easy, one-stop investing, and are now widely used in retirement plans such as 401(k)s.
The tactical target-date funds envisioned by Prof. Gomes and his fellow researchers would typically invest more in stocks when an investor is young, too. But to create extra value, they also would automatically rebalance quarterly using a formula to calculate the premium to be earned for investing more in stocks.
While these tactical funds would have lower exposure to stocks, on average, than a conventional target-date fund and tend to underperform in good periods, they would generate higher returns over an investor’s lifetime, largely by investing less in stocks during downturns, according to the research by Prof. Gomes; Alexander Michaelides, a finance professor at Imperial College London; and Yuxin Zhang, an assistant finance professor at Renmin University of China in Beijing and a visiting researcher at Imperial College London.
“It isn’t that people are taking more risk over time,” says Prof. Gomes. Rather, they are moving in and out of stocks over time and doing better, generally, during downturns.
More to spend
How much better? An investor who employed a tactical target-date fund from age 20 through age 65, for example, would have accumulated enough additional savings to spend 3% to 7% more annually during retirement than one who used a conventional target-date fund, the researchers found.
The researchers drew this conclusion based on historical data, including stock-market returns from 1946 through 2016 and data on the variance risk premium—the premium investors demand for bearing equity volatility risk — from 2000 through 2016. They compared the performance that a tactical target-date fund method would have generated to the performance generated by the average allocation of a conventional target-date fund optimal for the investor.
To be sure, tactical target-date funds would have to engage in significant trading. But even after factoring in a performance decrease of 0.25% quarterly due to the expenses associated with increased turnover, they would still be expected to generate more than a conventional target-date fund annually, Prof. Gomes says. For example, from 2000 through 2016, the cumulative return of a simulated tactical target-date fund would have been 24% higher than that of the average target-date fund, the researchers found.
Would it work?
Jeff Holt, director of multiasset and alternative strategies at fund researcher Morningstar Inc., says the general concept of tactical allocation within target-date funds is already happening. “Many target-date managers currently attempt to improve results by tactically positioning portfolios in some manner,” but predicting how markets will behave isn’t easy, he says.
While new research helps encourage the evolution of target-date funds, investors should be cautious with hard-and-fast conclusions drawn from looking in the rearview mirror, Mr. Holt says. “Just because a study shows a certain approach would have produced superior results in the past, it isn’t a foregone conclusion that it will in the future,” he says.
But Prof. Gomes says that while some existing target-date funds may make changes at the discretion of a fund manager and charge fees accordingly, the tactical strategy considered in the research is 100% automated. He isn’t aware of any funds that currently use the method studied, he says.
To avoid looking in the rearview mirror, the study estimated the performance of the tactical target-date strategy with data up to the year 2000, then tested it from 2000 onward using the historical data up to 2000 to forecast forward.
While it isn’t possible to predict the market anywhere near perfectly, “as long as you can forecast partially, that can help to improve returns,” Prof. Gomes says.