Have Target-Date Funds Improved Their 'D'?

Target-date fund providers have gotten the message. One of the chief complaints about target-date funds since the 2008 market collapse was that 2010 category funds--those aimed at that time for investors planning to retire within a couple of years--had not adequately protected nest eggs. Many portfolios, often loaded with stocks or high-yielding, lower-rated bonds, surprised investors with significant losses prompting politicians and federal regulators to hold hearings and issue reports. While the government hasn't decided to mandate risk levels as a result, many mutual fund firms have made changes on their own anyway.

This year's correction is the first opportunity to test whether those revamped strategies have made a difference. Although the swoon has lasted only a few months and may not yet be over, the drop has been steep enough and long enough to warrant doing a gut check on this group.

Formulating the Comparison
In choosing time periods to compare, I took the peak-to-trough period of the S&P 500 during the recession (Oct. 9, 2007, to March 9, 2009) and the S&P's peak-to-trough so far for 2011 (April 29 to Aug. 8). And to measure how resilient the funds were, I opted for a simpler, homespun version of downcapture ratio. For each target-date fund or category, we divided its return for the period in question by that of the S&P 500, arriving at what we can call a "loss ratio" versus the S&P 500.

More than three years since the onset of the crisis, more funds than those in the 2010 category have investors nearing retirement, so we blended the returns of the 2010 and 2015 categories. That's not perfect, but it's reasonable to assume that investors in those groups of funds on average expect more downside protection at this stage of their investment lives.

Fewer Extremes, More Moderate Losses
The numbers support the premise that target-date funds have gotten more risk-averse. As the table below shows, from 2007-09, 2010 funds suffered 60% of the S&P 500's losses, while 2015 funds' incurred 74%. In the 2011 downturn, our blended group of 2010 and 2015 funds captured 49% of the S&P's loss. These vehicles still have plenty of equity risk. Indeed, in both periods short-dated target-date funds were more susceptible to losses than Morningstar's moderate-allocation category, which had a loss ratio of 47% in the previous downturn and 36% in the current. But target-date funds clearly have reined in risk. There have also been fewer outliers during the recent downturn, and none of the implosions that raised alarms in 2008.  Oppenheimer Transition 2015 , for instance, which lost about as much as the S&P 500 during the bear market, reduced its loss ratio to 67% in 2011.

Peak to Trough Loss Comparisons, Target-Date 2010 and 2015 Funds

Several factors have contributed to this improved resilience:

Revised Glide Paths: Several firms, including American Funds, Schwab, and Oppenheimer, decided in 2008's wake that they had misjudged the degree of potential market losses and/or investors' tolerance of them and made strategic shifts in their glide paths. Indeed, the actual equity allocation of target-date funds in the 2015 category declined on average from 57% in September 2009 to about 49% prior to the recent correction, more than their original glide paths would have predicted.

Less Risky Business: The introduction of innovative risk-reducing strategies for target-date funds has been a notable trend. The PIMCO RealRetirement series, for instance, emphasizes real returns over the long term and employs a tail-risk hedging strategy. The Invesco Balanced-Risk series is structured around funds that practice a risk-parity approach, which involves considerable bond leverage and commodity exposure. PIMCO RealRetirement 2010 was one of the best in its peer group in the 2011 correction, losing only 0.55%.

Other firms, including Putnam, Vantagepoint, and AllianceBernstein, have introduced risk-management strategies within traditional target-date structures. AllianceBernstein Retirement series--which has one of the most aggressive glide paths in the industry--added a "volatility-management sleeve" to its glide path in 2010, giving managers the ability to pull back on equity exposures when quantitative models tell them to.  AllianceBernstein 2015 Retirement  still suffered a steep 12.6% loss in the recent correction, but it didn't do as badly in relative terms as it did in the financial crisis. The fund experienced 90% of the S&P 500's losses in the financial crisis, and 73% in the most recent correction.

Tidied-Up Bond Portfolios: A number of target-date series have moved their bond funds toward higher-quality securities. Big helpings of nonagency mortage bonds and other low-quality paper in ostensibly conservative bond funds exacerbated many short-dated target-date funds' pain in 2008. Oppenheimer was the prime offender, but others, including ING, Principal, Putnam, Schwab, and John Hancock, were stung, and some have either added higher-quality funds to their portfolios, cast out poor performers, changed management, altered the underlying funds' mandate, or some combination of the above.

Proceed With Caution
Despite the improved resiliency of 2010 and 2015 funds so far in 2011, investors should keep the risks of target-date funds in mind. Most still hold ample stocks, and there's no telling what a future shock to the bond market--whether a sharp uptick in interest rates or another credit-driven panic--might do to these funds' fixed-income sleeves. Bear in mind, too, that high-yield bonds have held up far better in the recent correction than in 2008's credit-driven crisis. 

Investors also shouldn't become overly enamored of risk-averse target-date strategies. Longevity risk is still real. Many retirees will need to keep building capital over 20-30 years and could shortchange themselves by taking too conservative a stance. Even with the extreme volatility of the past few years, some of the best-managed target-date series with aggressive glide paths, such as Morningstar Analyst Pick  T. Rowe Price Retirement 2015 (TRRGX), have produced strong relative and absolute results over the long term. As always, it pays to match a provider's glide paths and investment philosophies to your own risk tolerance, time frame, and investment goals.