Monday, July 12, 2010

Target date funds 3.0

By showing declining equity exposure as a retirement date approaches, target date fund managers imply that portfolio risk is automatically being reduced. This seems like a wonderful thing to investors who do not have the time or inclination to make asset mix changes themselves. Well, 2008-2009 showed us that risk for each asset class is far more important than the static relationship that professional money managers use to establish diversification between asset classes. In other words, they buy stocks, bonds, cash, and commodities in the belief that they all won't zig at the same time.

Target date 1.0 offered a date in the future. Target date 2.0 added conservative, moderate and aggressive options to each target date but the flaw remains. Fixed equity glide paths are like staring at a balance sheet; useful in helping to describe a "point in time" but useless in a dynamic capital market with risk that changes...often by a lot!

Target date 3.0 uses a dynamic glide path and constant volatility re-balancing. This means that the RISK of the portfolio is managed to a declining glide path and the asset mix is changed to reflect what is happening in the market right now. In TDF 1.0 and 2.0, the asset mix is managed to a fixed glide path while the risk is allowed to fluctuate. It doesn't make any sense to subject an investor to inappropriate risk. Furthermore, investors working towards a capital accumulation goal should know whether they are ahead or behind their projected growth path. TDF 3.0 automatically shifts risk based on progress towards this goal. Get behind, take a little more risk, get ahead, take a little less. Common sense. How does one do this for a defined contribution pension plan with thousands of members? Mass customization.