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Are Some Flexible Funds Proving Academics Wrong?

Tactical target-date funds are outperforming those that don't zig when the market zags.

Janet Yang, CFA, 07/29/2014

Market-timers beware. That's the conclusion of academic studies that suggest it's very difficult for money managers to consistently be correct when it comes to tactical portfolio moves, such as sector or asset-allocation bets on a shorter-term outlook. 

But Morningstar's recently released 2014 Target-Date Research paper has found that target-date retirement fund managers that may tactically deviate from the funds' strategic, long-term asset-allocation paths generally have beaten their peers.

It can be difficult to tell whether a series uses tactical allocation. Often tactical budgets are ill-disclosed in funds' SEC filings and other publicly available materials, so Morningstar only tracks the use of tactical or strategic management for the 22 series under its analysts' coverage. Of that group, nine stick closely to their long-term glide paths, while 13 have varying levels of latitude to opportunistically change their series' shorter-term asset allocations.

Looking at returns through the end of 2013, target-date funds for series that stick to the strategic glide path have an average five-year total return rank in the 54th percentile, while those that use tactical management have a 39th percentile average rank. (On average, the former group beat 54% of its peers, while the latter outpaced 61%).

As a group, tactical series' glide paths also tend to have more equities than those without tactical budgets, which would have provided a tailwind to results during that time. Series that use tactical management average a 63% target equity allocation over 60 years versus strategically managed series' 59% allocation, so the difference is relatively minor. (Sixty years encompasses a 40-year saving-and-working phase from roughly ages 25 to 65 as well as a 20-year retirement from ages 65 to 85.)

The patterns carry through to the target-date series' risk-adjusted results, as measured by their funds' Morningstar Ratings and shown in Exhibit 1. Compared with peers that have similar average equity allocations, series that use tactical management tend to outpace those that do not. (As such, the orange dots tend to fall to the right of the blue dots, even at similar equity-allocation levels.) The typical tactically managed series averages 2.9 stars, while the strategically managed counterpart averages 2.5 stars.

Some of the success has come from series' move to tactically overweight equities. That decision has served the T. Rowe Price Retirement series well, for example, which has had a general tactical overweighting to equities for much of the last decade. That series' suite of target-date funds has an average Morningstar Rating of 4.8 stars. Merely emphasizing equities hasn't necessarily resulted in strong results, though, as the AllianceBernstein series' average Morningstar Rating of 1.4 stars can attest. That series' results have been especially burdened by underperforming underlying strategies, which are represented as pools of individual securities.

For the DIY Investor
Hands-on investors who eschew target-date funds may nevertheless be able to pick up tips from the pro tactical allocators. Exhibit 2 shows the average neutral glide paths for target-date series under Morningstar coverage that use tactical management, as well as the current average equity allocations for those series. As a group, those funds have an overweighting to equities of about 2.3 percentage points.

The gap between Exhibit 2's two lines is wider for investors in or near retirement than it is for younger workers (retiring in 2045, for example). Like many investors, target-date managers are concerned about a probable future rise in interest rates. That conundrum becomes more palpable as target-date funds transition more of investors' assets into fixed income over time. Exhibit 2 suggests one solution is to keep more assets in equities. For those series' 2015 funds, for example, which are aimed at investors just in or on the brink of retirement, their neutral allocation to equities averages 40.0%, but their average current actual weight comes out to 47.4%.

Target-date managers have fiddled with subasset class exposures as well. For instance, in addition to overweighting equities for much of 2013, the team at J.P. Morgan has emphasized less rate-sensitive areas of the fixed-income market, such as high-yield bonds; it also has pulled back exposure to inflation-sensitive assets. The Manning & Napier Target Date series has made similar moves: For the past few years, it has eschewed the lower yields offered by Treasuries by focusing on other areas, such as investment-grade corporate bonds, commercial mortgage-backed securities, and high-yield fixed income. A few series, including Schwab Target Funds, have been shortening their bond sleeves' duration profile so the portfolio is less interest-rate sensitive--a move seen from other target-date managers as well as fixed-income managers generally.

These tactically minded target-date managers have largely done well by emphasizing equities over fixed income in the last five years, as the stock market has resoundingly rebounded from 2008 and 2009's depths. In an era of historically low interest rates and unprecedented intervention by the world's central bankers, it remains to be seen just how well these next moves will protect target-date investors going forward.

Author's note: Exhibit 2 as well as other aggregated average figures presented in this section exclude PIMCO RealRetirement series; the series' significant use of derivatives results in holdings and allocation metrics that skew results and don't reflect the series' actual equity and fixed-income market exposures.

 

Janet Yang is a fund analyst with Morningstar.
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