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It's the Equities, Stupid!

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

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 , 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 , 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 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.

Consider what would happen if, instead of locking in on the five-year record, we looked at five-year results alongside a six-year period that includes 2008. For one thing, we'd learn that the absolute returns earned by funds during that period look dramatically different (see Table 2). The five-year annualized return for target-date 2045 funds, for instance, is a robust 15%; add in 2008, and 2045 funds' average return is a paltry 3.9% per year. The drop for 2015 funds isn't quite as stark but it's still significant, dipping from 11% for the five-year period to 3% annualized over six years, or a touch better than inflation. Clearly, the financial crisis continues to have an impact on investors' longer-term returns.



Interestingly, though, when one looks at the constituents of each category, bond-heavy funds that held up well in 2008 don't always flip-flop places with more aggressive counterparts when you switch the time frame from five to six years. For instance, Wells Fargo's 2015 fund was one of the category's best in 2008, losing only 16.5%, but it has trailed in many of the subsequent up markets. During the past five years, its 7.78% annualized return is the category's lowest; over the six-year period, a 3.3% return moves it from the cellar but it still lands in the bottom quartile. Its fully benchmarked approach to bond investing is partly to blame.

Meanwhile, equity-heavy  T. Rowe Price Retirement 2015 (TRRGX) is the category's top performer over the five- and six-year periods. Consistently strong underlying funds have helped in both up and down markets, while bull-market performance has been robust enough to overcome losses in 2008.  JPMorgan SmartRetirement 2015 also ranks well in both lists, owing to management's ability to beat the average peer in both up and down markets.

Some funds do face different fortunes depending on the frame. AllianceBernstein's 2015 fund, part of an equity-heavy glide path, has a top quartile return over the past five years but is second-worst over the six-year period, owing to an awful 2008 when both its stock and bond holdings contributed to the damage. Similarly, if not as dramatically, John Hancock Retirement Living Through 2015 drops from the sixth percentile to the 61st when 2008 is added to the mix. Still, these large shifts tend to be the exceptions.

What can we learn from these comparisons? For one thing, yes, it's still about the equities. Equity-oriented managers who stuck to their philosophy and managed assets in a disciplined fashion have been successful, even with 2008's disastrous market. At the same time, it's not always about the equities. Managers who were careless with their bond investments in 2008 got hurt badly and still have not fully recovered (one of the worst offenders, Oppenheimer, took its target-date funds off the market). Many target-date managers have cleaned up their bond acts since then, so investors have less to worry about. But as yields stay low, and the forecast for bond returns dims, managers may be tempted to inch back into riskier fixed-income territory. And from that perspective, target-date investors should surely not let the lessons of 2008 fade too much from memory.

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