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It's the Equities, Stupid!

A buoyant stock market lifted most target-date vessels in 2013.

Josh Charlson, 01/23/2014

Target-date managers last year might well have put their own twist on James Carville's famous internal campaign slogan for Bill Clinton, "It's the economy, stupid!" Because it was equities' bull run that drove target-date funds' impressive returns for 2013.

The average fund in Morningstar's target-date 2041-2045 category, for instance, returned 22%, the category's best result since the post-crash rebound year of 2009 (see Table 1). The category's top fund, Vantagepoint Milestone 2045 VQRJX, reached almost 28%. Although that gain does not match the 32% leap of the S&P 500 Index in 2013, the numbers are impressive nevertheless, especially considering that the typical 2045 fund held at least 10% of assets in bonds and devoted a significant portion to non-U.S. stock markets, which did not keep up with U.S. equities.

The top performers among longer-dated target-date funds, which included Morningstar Medalist offerings from Vantagepoint, TIAA-CREF, American Funds, and T. Rowe Price, tended to benefit from some combination of higher relative equity weightings, a more pronounced tilt toward U.S. stocks, or particularly outstanding performance from underlying managers. Diversifying into areas like emerging markets did not pay off for managers in 2013, as it did in 2012. Yet because the range of equity allocations among longer-dated funds tends to be rather narrow, even funds that landed in the third quartile, like Bronze-rated American Century One Choice 2045 AOOIX, still provided a 21% return--a solid absolute showing.

It's only when you get to more unconventional designs, like that of PIMCO RealRetirement 2045 PFZIX, that returns really start to drop off. Because PIMCO's funds emphasize real asset growth and downside protection, they tend to hold less in stocks and more in commodities, which suffered badly in 2013. The fund's 8.1% return was the category's worst.

Shorter-dated funds intended for investors nearing retirement, like those in the target-date 2011-2015 category, benefited from similar trends. The category as a whole averaged a 9.7% return, with a substantial range between a high of 15.3% (better than the worst-performing 2045 fund) and a low of 0.7%. Higher-equity funds that shift their asset allocation in retirement, which are known in the industry as having a "through retirement" glide path, again topped the list. Standouts included funds from American Funds and T. Rowe Price. The divide between stocks and bonds was more stark than in past years, as bonds finally took a breather from their long bull run, and the Barclays U.S. Aggregate Bond Index actually lost about 2 percentage points. Thus, series that rely on conservative allocations to protect capital and also track that bond index were in a particularly poor position; Wells Fargo Advantage DJ Target 2015 WFBRX returned only 4.3%, for example. Some series compensated for their bond exposure with shorter-than-average duration (like Vantagepoint) or greater high-yield exposure (like John Hancock Retirement Living Through 2015 JLBOX). PIMCO's 2015 fund was again stymied by its real-return approach, in particular its substantial allocation to inflation-protected bonds.

The Difference a Year Makes
After a year like 2013, the criticisms lobbed at the target-date fund industry after 2008--in particular, that it held too much in stocks, imperiling retirees' nest eggs--may seem like strange mutterings from a distant time and place. But investors should pay heed to the fact that managers who follow a lower-equity asset allocation philosophy or a real-return emphasis face an inherent disadvantage in a market like 2013's. It's all too easy to look at higher-returning funds and assume that yours has simply missed the mark. A target-date series with protective qualities will look smart when the market tanks again (as it likely will).

Another reason our memories may fail us is because of the investment industry's tendency to speak in increments of one-, three-, five-, and 10-year performance periods. The first three of those time periods conveniently lop off 2008, and most target-date series' do not yet possess a 10-year record.

Josh Charlson is a senior fund analyst with Morningstar.

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