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Diversification Pays Off for Target-Date Funds

2012 leaders were well-served by global, real estate stakes. 

Josh Charlson, 01/17/2013

It was a very, very good year for target-date funds.

Target-date funds boomed in 2012 on both the growth and performance fronts. In many respects, of course, these investments--key tools in so many investors' 401(k) plans--were just partaking in the general success of the markets. But the funds' highly diversified nature also gave the offerings an additional edge last year, and true disappointments were in a distinct minority.

Healthy Returns Across Categories
Investors in most cases did well in target-date funds in 2012 whether they were just starting out in their working years or getting close to the retirement end line. The target-date categories for investors at least 20 years from retirement (that is, dated 2035 or later) produced average calendar-year returns of 14.7% and higher. That's a solid absolute return by any measure, and within spitting distance of the S&P 500 Index's 16% total return for 2012. The ranges of returns in these long-dated categories were not terribly extreme, either; while the top fund in the 2045 category, JPMorgan SmartRetirement 2045 JSAAX, returned a sparking 18.1%; the bottom performer, Franklin Templeton 2045 FTTAX, still earned a solid absolute return of 10.6%.

Perhaps more surprising are the strong results from shorter-dated funds, intended for investors planning to retire within a few years: The average return of funds in the target date 2011-15 category was 10.7%. Those funds have an average strategic allocation to stocks of 52%, which certainly helped, but the Barclays US Aggregate Bond Index brought in only a 4.2% gain last year. Most target-date managers aren't just sticking to the index, however. Their diversification into areas such as high-yield bonds, Treasury Inflation-Protected Securities, and, in some cases, emerging-markets debt pushed returns ahead. With high-yield bonds last year producing returns on par with those of the stock market, many target-date funds got some extra juice from their fixed-income sleeve.

And although the more aggressive tendencies of some shorter-dated funds produced unexpectedly severe losses in 2008, results since then have worked in favor of investors who were patient. From the pre-crisis peak in 2007 through the end of 2012, all but one of the currently extant 2015 funds have recouped their losses, and most have produced double-digit positive gains.



Top Performers Held More Stocks, More Varied Asset Classes
A deeper look into the leaders and laggards within particular target-date categories reveals the trends that drove relative success in 2012. In the longer-dated categories, the variance in stock allocations is relatively small, so there's not much to be gained by holding more than the average peer in equities. Even so, it's not surprising to find one of the industry's strongest proponents of high equity weightings across the glide path, T. Rowe Price, near the top spot among 2040 and 2045 funds. Among the laggards in the category are those with defensive-oriented strategies, including Invesco, PIMCO, Allianz, and John Hancock's Retirement Choices series. PIMCO RealRetirement, for example, is focused on inflation protection and generation of real income and thus has in its funds for early savers a heavy allocation to commodities--one of the few major asset classes to do poorly last year.

Perhaps the more-defining feature of the leaders from 2012 was their willingness to venture abroad or into asset classes like REITS and to implement tactical overweightings in outperforming areas. The MSCI EAFE, MSCI EME, and REIT indexes topped U.S. stocks in 2012, and most of the top-performing funds in the 2045 category had 30% or more of portfolio assets in foreign stocks. Many of the leaders, including JPMorgan, T. Rowe Price, TIAA-CREF Lifecycle, Putnam, and American Funds Target Date, also employ tactical allocation programs or allow their managers the flexibility to tilt their portfolios opportunistically.



Similar themes drove return patterns among shorter-dated funds, such as those intended for workers planning to retire in 2015. In this category, the asset-allocation approaches vary much more widely. Firms that believe retirees will need to generate capital growth well into their retirement years allocate higher amounts to stocks--in some cases 60% or more of the portfolio--and those stock-heavy target-date series tended to populate the top of the chart for the 2015 category. The five top performers in the category average a 59% strategic allocation to stocks, while the bottom five averaged 34%.



When to Worry
With the markets' rising tide lifting most target-date pontoons last year, even if your own fund finished in the bottom tiers of its category, there's probably little reason for concern. That's especially the case if your manager is simply standing by the fund's philosophy; more conservative strategies implemented in series from Wells Fargo and PIMCO should be expected to trail in bull markets but to prove their defensive mettle during downturns. Wells Fargo held up extremely well in 2008, for example, and its five-year returns through year-end 2012 still rank in the 2015 category's top decile.

There's greater reason for concern--or at least reason to ask further questions--if a target-date fund's performance was out of sync with its professed asset-allocation philosophy. AllianceBernstein's target-date funds, for instance, have long maintained one of the industry's most stock-heavy approaches, yet in 2012 its 2045 fund finished in its category's bottom quartile and the 2015 fund finished just at the category median. In cases like this, blame for poor performance may lie with weak-performing underlying strategies or tactical approaches that cause the series to deviate from its strategic asset allocation. AllianceBernstein added a volatility management program in 2010 intended to rein in stock weightings during turbulent markets, but it may also have left the funds light in stocks relative to their neutral glide path in 2012.

Ultimately, one year is a blip in the long-term period over which an investor commits to a target-date fund. But it can give you important clues to the character and performance patterns you can expect. Make sure your target-date fund is dropping the hints you expected.

Assets Keep Flowing
Assets continued to flow into target-date funds at a healthy rate in 2012, garnering $4 billion in new investor dollars. Organic growth rates, which measure the net flows of assets into funds excluding market appreciation, averaged 14.9% across all target-date categories on an asset-weighted basis. As should be expected, vehicles intended for younger workers grew the fastest: the 2045 category had a 28% growth rate, and the smaller 2050 cohort grew at a 34% clip.

Even target-date categories for older investors showed impressive growth. For instance, the 2025 category (aimed at investors planning to retire in roughly 12 years) grew nearly 18%. Such numbers show that the appeal of these easy-to-own, professionally managed investments is not lost on retirement investors.

Josh Charlson is a senior fund analyst with Morningstar.
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