The underlying risk factors in target-date funds

New research suggests that style and investment selection decisions can be significant determinants of risk

The underlying risk factors in target-date funds

A popular retirement solution, target-date funds are favoured by investors for their simplicity. All someone has to do is decide on their expected retirement date and these multi-asset funds would be automatically rebalanced to reduce investment risks as one draws closer to retirement.

According to David Blanchett, head of retirement research for Morningstar Investment Management, target-date funds commonly set their glide path based on equity allocation: they slowly shift their weightings away from equities and toward bonds in an effort to dial down risk as they near the end of their lifetime.

“However, using the equity allocation can be a lousy way to differentiate among multi-asset funds,” he said in a column for the Wall Street Journal. Citing research he completed with a colleague, Blanchett said other factors, particularly style and investment selection, could impact portfolio risk even more than equity allocation does.

Style, he explained, refers to the way a multi-asset fund allocates to different sub-asset classes. Two funds might both have 60% allocations to equities, for example, but one might be totally invested in large-cap US stocks while the other could have large positions in emerging markets, small companies, or single sectors. “There’s nothing inherently bad about a very conservative or aggressive approach; investors just need to understand what they’re getting into,” he said.

Investment selection, meanwhile, deals with the question of whether a fund invests actively or passively, or which managers are picked. Two funds might both be “international equity” strategies, but one might focus solely in developed markets while the other could be considerably exposed to emerging markets.

“Similarly, active and passive strategies can take on different risks, and these risks may differ across asset classes,” Blanchett said. “For example, a passive large-cap US stock fund might be a lower-risk choice while a passive high-yield bond fund might be riskier than its active counterparts.”

Based on their research, Blanchett and his colleague found that selection factors accounted for some 45% of return differences in the funds they studied; 30% was attributed to style, and just 25% was traced to equity exposure.

“The upshot: investors should pay careful attention to style and investment selection before investing in a multi-asset fund,” he said.