Sports marketplaces aren’t all that different from the investment arena.
Two Steps Backward
In 1997, the National Basketball Association decided to make 3-point baskets more difficult to score. The 3-point line remained the same distance at the corners, but was extended another 21 inches in the middle of the court. The stated reason: The league wished to increase scoring.
The league’s explanation was that the 3-point line was intended to “stretch” opposing defenses, by pulling them away from the basket, so that offenses would profit by having more space with which to operate. With the 3-point line having been placed too close, not enough stretching had occurred. Pushing back the stripe would move shooters further from the basket, which would then force defenses to respond, thereby giving offenses the desired amount of space.
But, here’s the thing—the players didn’t need the line moved to step backwards two feet before shooting. They could do that already. Thus, from an economist’s perspective, the NBA’s decision was silly. The league was a multibillion-dollar enterprise. Yet somehow, per the NBA’s logic, teams couldn’t figure out what was best for them, without receiving the most obvious of prompts. Whether they thought in those terms or not, NBA league officials viewed their marketplace as being deeply inefficient.
The central planners appear to have been incorrect. The year before the new rule, the average NBA game score was 96.9 points. In 1998, when the rule was first implemented, that score slipped to 95.6. During the next year, 1999, the average score plummeted to 91.6 points. That 1998-99 decline was the biggest single one-year drop (measured in percentage terms) in league history. Whatever the league officials intended, the opposite occurred.
The point of this playtime parable is not that sports (or investment) markets are inevitably more efficient than is appreciated. Major league baseball shows otherwise. In the late 1970s, Bill James and other outside researchers claimed that the sport was inexpertly managed. Stolen bases were overrated, as was the damage caused by strikeouts, and the value of walks was underappreciated. Their arguments were appreciated by many fans, but not by the baseball industry itself, which ignored them when it wasn’t hooting. Today, baseball teams steal fewer bases than back in the day, strike out more often, and seek hitters who walk frequently. The critics were right; the giant, 100-year old industry had it wrong.
No, my intent instead is to demonstrate that the character of marketplaces is unpredictable. Sometimes, marketplaces are reasonably sound and rational, as described by economists’ models. That looks to have been the case with the NBA’s 3-point shooting, which was inadvertently harmed when the central planners attempted to “fix” its problem. At other times, as with baseball, the prevailing habits are indeed flawed. In those areas, market participants operate by “common sense” precepts that fail reality’s test.
The Target-Date Consensus
Which, finally, leads to my investment topic: target-date funds. They all invest in pretty much the same way. Oh, there are some modest variations, but the basic structure remains intact. All long-dated target funds own almost nothing but stocks. The funds gradually diversify into fixed-income securities early in their lifetimes, then more rapidly as the retirement date approaches. Unlike just about every other type of mutual fund, no target-date funds use fixed allocations. Neither do any target-date funds purchase stocks as time passes, rather than sell them.
It could be that the category reached its Great Investment Consensus because dozens of parties did their homework, and independently arrived at the same conclusion—as NBA coaches appeared to have done in using their 3-point shooters correctly, before the league meddled.* Or, as with major league baseball managers, those who designed target-date funds might have done so with a finger to the wind and an eye to their neighborhoods—following rules of thumb that shielded them from criticism, but which weren’t the best policy.
*As basketball nerds know, the matter is a bit more complicated than that. Over the past 20 years, NBA coaches have learned that their teams should take more 3-point attempts. Thus, the 3-point marketplace was not fully efficient when the league changed the rules. Then again, the 3-point rule was relatively new, and the league’s intervention did not work, so it seems that NBA coaches were roughly on the correct track.
Therefore, when a paper is published stating that target-date funds do it all wrong—as is the case with the article featured in my June 30 column, “Target Wealth: The Evolution of Target Date Funds," by two professors from the University of Waterloo (Peter Forsyth and Kenneth Vetzal) and an industry practitioner (Graham Westmacott)—the proper response is “maybe.” It is possible that the industry needs fixing; that the industry is fine and that the paper is misguided; or that the truth lies somewhere between.
I vote for the latter.
Target-Wealth versus Target-Date
The authors recommend that, instead of being managed with pre-determined glide paths, target-date funds be run adaptively, by seeking a given amount of wealth. If the financial markets perform well early in a fund’s history, the fund will make strong progress toward its target wealth, and thus will lock into its gains by shifting into cash and bonds. If, on the other hand, the fund gets off to a poor start, then it will buy more stocks, in the attempt to make up lost ground.
The authors show that, for a given level of expected return, their target-wealth approach is considerably less risky than conventional glide paths. The standard deviation of returns for their scheme, over the long term (short-term volatility is a different matter), is much less than with existing target-date funds. As a result, the target-wealth portfolios have higher median values, with significantly lower probabilities of falling short of the expected mean.
Sounds great—but there are significant asterisks.
For one, the analysis assumes that investors hold the fund for its investment lifetime. That will mostly not be so. More likely, an employee will join a company and enroll in a target-date fund during mid-career, by which time the fund will have already adjusted its asset allocation. That new shareholder will inherit an accidental equity position—one that was created to meet others’ needs, not hers.
Then there’s the challenge of convincing investors to stay aboard. Among the virtues of today’s target-date funds is that they were created to comfort their investors; the process of gradually cutting back on stocks as the investor ages, feels natural. In contrast, target-wealth funds confound investors’ expectations. When the stock market booms, making shareholders feel bolder, target-wealth funds become more conservative. Conversely, the strategy adds equities as the stock market tumbles.
Such contrarianism has its investment merits, but it will not appeal, I think, to most 401(k) shareholders’ concept of prudence. Those survival instincts would not be entirely off-base. Although the target-wealth approach reduces the chances and size of moderate shortfalls, it does not help with severe shortfalls. Indeed, in the very worst long-term scenarios, when the stock market has a long dry spell, target-wealth funds will trail their conventional rivals. (They also will make less money if the markets boom; effectively, the target-wealth approach improves the middle of the distribution, at the cost of weaker tail results.)
In summary, this particular challenge to orthodoxy lands in the middle. The authors’ conclusion that “the vast majority of target-date funds are serving investors poorly,” and can readily be improved by switching to a target-date strategy, overstates the matter. The target-date marketplace is not that inefficient. However, neither is it so time-tested as to deserve unquestioned trust. It is good that the authors threw down their gauntlet; may more inquiry follow.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.