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Target-Date Funds Add Stamps to Their Passports

Morningstar research shows increased allocations to foreign markets in target-date funds.

Broad diversification has always been a key characteristic of target-date funds. Indeed, if you're investing in a target-date fund as your sole retirement investment, as many Americans do, broad diversification is likely one of the key features you're counting on. Over time, target-date series' managers have added more asset classes and sub-asset classes in an effort to increase diversification with the aim of improving the long-term risk-adjusted returns. Common additions have included commodities, global REITs, and alternative strategies.

More subtly, but equally important, the managers of these target-date series have over time significantly increased the existing allocations to non-U.S. equities relative to U.S. equities. We've observed this anecdotally over the past few years, as several of the major target-date providers announced increases in their strategic allocation to foreign stocks, in some cases moving up to 30% of the stock weighting from 20% of equities.

We looked at allocations to non-U.S. stocks more systematically as part of our annual white paper on the target-date industry, analyzing the underlying monthly portfolio holdings of target-date funds in Morningstar's universe. Figure 1 illustrates the industry average allocations to U.S. and non-U.S. stocks within the equity sleeve of the 2040 funds from late 2005 to the end of 2012. The average allocation to foreign stocks has increased to 36% of the equity sleeve as of December 2012 from the 24% average at the end of 2005, a fairly sizable jump.


  - source: Morningstar Analysts

Most target-date managers who have increased their series' non-U.S.-equity allocations say they did so to reflect the growing influence of international businesses on the global market. Target-date series also have expanded internationally on the fixed-income side of the portfolios. This has occurred explicitly in the strategic allocations of the series to foreign developed-markets and emerging-markets bonds, as well as in the securities held by the underlying U.S.-focused bond funds.

At the asset-class level, the managers of target-date series have sought ways to diversify their fixed-income exposure away from high-quality U.S. bonds. Some, for example, have added exposures to foreign developed-markets and emerging-markets bonds. Figure 2 shows the number of series that included allocations to world-bond funds and emerging-markets bond funds in each of the past five years. Emerging-markets bond exposure has been on the rise, appearing explicitly in nine series in 2008 and 18 series in 2012. For example, Fidelity decided to add an emerging-markets bond allocation to its Freedom and Advisor Freedom series in 2011. More recently, in mid-2013, Vanguard tacked on a 20% allocation to international bonds within the fixed-income sleeve of its Target Retirement series.


  - source: Morningstar Analysts

A similar shift overseas also occurred within actively managed core bond funds. Portfolio managers who have historically stuck to U.S. bonds now face meager yields for high-quality domestic debt. As a result, managers have been more willing to own higher-yielding foreign sovereign and corporate bonds to offset the low yields available in the United States. Unfortunately, bond-fund portfolio data is notoriously difficult to interpret accurately, so the impact of this trend on target-date portfolios is unclear.

Resetting Investor Expectations
For investors and retirement-plan sponsors, the increasing allocations to foreign stocks and bonds within target-date series create challenges related to setting expectations and benchmarking performance. The most significant hurdle may be a shift in investor expectations for how their target-date funds perform. While foreign securities can improve a portfolio's diversification, those benefits are not always immediately or consistently apparent. Investors who expect their equity stake to perform in line with U.S. stocks may be disappointed if domestic stocks rally and non-U.S. stocks drag on their short-term target-date fund returns. Indeed, that's been the case for many target-date series so far in 2013, a year in which U.S. equities have far outperformed foreign developed- and emerging-markets stock exchanges. More-diversified fixed-income sleeves may prompt similar concerns. Plan sponsors also must adapt how they compare target-date series' returns to benchmark indexes and peers. For those series with foreign allocations that stand out from the industry norm, sponsors can expect the funds' performance to be out of line with their typical peers' as well.

In the past, many plan sponsors have been reluctant to let international allocations in target-date funds run too high, fearing that their workers weren't prepared for the potential risks and unfamiliarity of foreign investments. But the reality is that Americans live within a global economy, and investing is increasingly a global enterprise. The benefits of international diversification will accumulate over the long term, and target-date funds are an ideal vehicle for cultivating that kind of patience in investors.

Investment consultant David Falkof contributed research and writing for this article.

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