How to Improve Your Portfolio's Results

Christine Benz: Hi, I'm Christine Benz for Morningstar. Investors in target-date funds tend to have good outcomes based on dollar-weighted returns. Joining me to discuss how investors can use target-date concepts to improve their take-home results is Josh Charlson. He's director of manager selection for Morningstar.

Josh, thank you so much for being here.

Josh Charlson: Great to be here.

Benz: Josh, let's just start with a really basic question. What is a target-date fund, and how are they different from funds that might focus on just a single asset class?

Charlson: Sure. So, target-date funds are professionally managed funds using a fund-of-funds structure, usually, that are essentially asset-allocation funds investing in different asset classes, very diversified, but they roll down the allocation over time. So, they're adjusting it as the investor ages to sort of accommodate the different risk profiles--and typically found in retirement plans.

Benz: Our colleague, Russ Kinnel, every year does this study where he looks at dollar-weighted returns, which measure the funds' returns married with cash flows, when investors bought and sold, with an eye toward determining: Where do investors do well in terms of capturing most or all of a fund's return? And where do they do not so well? And one finding that has been pretty consistent in Russ' research is that all-in-one investment types tend to look pretty good from the standpoint of investors being able to capture a lot of the fund's returns; target-date funds look especially good. Can you talk about why you think that is? And of course, there are a lot of different factors in the mix. But what are your leading assumptions?

Charlson: As you mentioned, target-date funds look very good. They tend to have positive investor returns. A lot of asset classes have negative investor returns. So, they encourage good ownership. Reasons for that, I think, one has to do with the level of diversification, both equity and fixed income, and then weaving in other asset classes, just tends out to smooth out the region profile over time. And so, investors don't tend to react as much to the ups and downs in the market. A second factor is--investors are typically dollar-cost averaging into them in their retirement plans, which helps smooth out their cash flows over time in a positive effect. And I think they just tend to sort of "set it and forget it." That's the way these investments are designed. So, they tend to see that they've got an allocation investment and leave it in there.

Benz: So, one thing we know, with 401(k) participants is that they oftentimes are sort of naturally inert. They might make their initial selections, or maybe they're even opted into a target-date fund. Sounds like they don't really do anything and that turns out to be a good thing for target-date.

Charlson: Absolutely.

Benz: So, let's talk about, say, I'm an investor who isn't investing in target-date funds, maybe I want to customize my own asset-allocation mix and pick my own funds. You say that there are still some takeaways that I can gain from looking at the success of target-date investors. One is simply to maintain adequate equity exposure--that that's been a key to target-date funds' long-term success.

Charlson: You'll see that almost all of the target-date series have very high allocation to equities early in the investor's lifetime. So, that early compounding of value is really important. So, not being afraid to take equity risk early in your career, I think, is one of the big lessons you get from looking at the way professional allocation experts design these target-date funds.

Benz: So, oftentimes for people who are, say, in their 20s and 30s, they might have upward of, what, 90% in equities…

Charlson: Typically, the average is around 90%. There are some series that go as high as 100%. Historically, there have been a few that are more conservative and have lower allocations, but more and more of those tend to be in the minority.

Benz: And then it stays pretty high throughout the investor's lifecycle. But as you said, Josh, when you were talking about how target-date funds are constructed, they do begin to take risk off the table later on. And you say that's another takeaway. I would say, that's probably top of mind for a lot of people approaching retirement today, de-risking at the appropriate date or around the appropriate date is really important.

Charlson: You tend to see a curve, it's called the glide path in the target-date lingo, where it remains pretty level at that high equity level for 15 to 20 years. But then they'll start to bring in fixed income to moderate the risk. You'll see the most variance between target-date series as you get closer to retirement 10 years out into retirement where there's more difference in philosophies. But you'll see all of them rolling down that risk. Some of them choose to do it later. Some of them choose to do it earlier. But really, that area around retirement is where there's greater risk if you were to have a sharp drawdown in that period. So, you will see a much lower equity allocation and higher fixed income during those periods.

Benz: Another thing that you say investors can take away from the success of target-date funds has been the importance of diversification. It sounds so basic, but when you look at the better target-date funds, what you see is that the managers kind of keep the faith in asset classes that have underperformed a little bit. How can investors use that intelligence?

Charlson: I would just say that diversification has been a little bit of a tough sell in recent years, because you've seen U.S. stocks really primarily doing better than most foreign markets, equities doing better than fixed income, etc., diversifying asset classes, in general, not adding as much value. But you'll see that most target-date managers have stuck to their very diversified portfolios, you know, emerging-markets bonds, emerging-markets equities, some of the smaller asset classes in smaller allocations. They're not backing away from them. And so, I would say that the long-term story about diversification remains very much in place. So, that's one of the lessons I take: not to run away from diversification, but to stick with it as a long-term investor.

Benz: You say another takeaway that investors can think of when they manage their own portfolios is the fact that target-date funds can seal a lot of their individual holdings' returns into kind of a neat package where you just see that bottom-line gain and so, investors shouldn't focus so much on the performance of their constituent holdings.

Charlson: I think one of the things that happens with target-date funds is, even though there are many funds underneath--it could be 10, it could be 20, it could be 30 with some managers--as an investor, you're not paying attention to what those individual funds are doing. You're looking at what the overall return of the portfolio is, and again, that tends to be smoothed out. So, you're seeing generally a nice steady return from target-date funds over time. The same with our own portfolios. We tend to look at what an individual fund is doing, and we might be encouraged to say, "Ooh, that fund is underperforming. Maybe I should yank it for something else ..."

Benz: "Or this one is really good and I'm going to put all my money into it."

Charlson: Right. Right. Exactly. Either way. So, that idea of just stepping away and thinking about what the portfolio is doing as a whole and not worrying so much about the intermediate parts, you know, month-to-month, quarter-to-quarter, that's another lesson that we can take from target-date series.

Benz: Josh, great to get your perspective. Thank you so much for being here.

Charlson: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.