How Target-Date Funds Stabilize Markets

One of the most significant financial innovations over the past few decades has been the rise of target-date funds (also called lifecycle funds), with assets under management rising from less than $8 billion in 2000 to $3.2 trillion in 2021 before falling to $2.8 trillion in 2022 because of negative returns in that year. The growth of target-date funds was facilitated by the Pension Protection Act of 2006, which qualifies both target-date funds and balanced funds as default options in defined-contribution retirement savings plans. As a result, many 401(k) plans and other retirement plans now offer target-date funds as a default option for participants because they help providers meet their fiduciary obligations: providing participants with a diversified and appropriate investment vehicle for their retirement needs. According to the Investment Company Institute, at year-end 2019, 31.3% of 401(k) assets in its database were invested in target-date funds, with 90% of employers offering them as the default option.

Target-Date Funds Offer Important Benefits

Target-date funds are designed to provide investors with an age-appropriate portfolio of stocks and bonds that depends on the investor’s expected retirement date (their “target date”). They provide important benefits, including allowing investors to hold in one fund a diversified portfolio that can include exposure to both U.S. and international (typically international large and possibly emerging-markets) equities. They can also include exposure across the asset classes of small, large, value, and growth.

Another benefit is that target-date funds slowly reduce risk over time by lowering the allocation to stocks and increasing the allocation to bonds. And competition has driven expense ratios down. For example, both Schwab and Vanguard have a suite of target-date index funds, all of which have a net expense ratio of just 0.08%.

An important feature of target-date funds is that, in order to undo the changes in portfolio allocations caused by differential returns across the assets within the portfolio, they must systematically rebalance—the funds trade against excess returns in each asset class, selling stocks and buying bonds when the stock market outperforms the bond market and vice versa. Thus, they provide the important benefit of discipline that many investors fail to exhibit when self-managing a portfolio.

Given that investors now hold trillions of assets in target-date funds, an interesting question is: Given that target-date funds have converted a significant share of retail investors from performance-chasers (affected by recency bias, they are momentum traders) to market contrarians, how does the systematic rebalancing of target-date funds affect markets?

Empirical Research Findings

Jonathan Parker, Antoinette Schoar, and Yang Sun contribute to the literature with their study “Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds,” which was published in the October 2023 issue of The Journal of Finance. Their sample of target-date funds was from the Center for Research in Security Prices Mutual Fund Database and spanned the period from the third quarter of 2008 to the fourth quarter of 2018. They found:

• Target-date funds rebalanced across equity and bond funds within a few months, behaving as predicted by their desired equity shares given realized asset returns.
• Following high returns in an asset class, funds in that asset class experienced outflows in proportion to their target-date fund ownership shares—reducing the relationship between past fund performance and inflows to that fund. Importantly, investors did not move funds into or out of target-date funds to offset those flows.
• Stocks with higher target-date fund exposure (through the funds held by target-date funds) had lower returns after higher market performance. This correlation appeared to be driven by target-date funds’ price impact and was not simply the result of target-date funds investing in stocks that had less exposure to market momentum. Specifically, when the excess return of the equity asset class was 10% in a month, stocks with a one standard deviation (0.6%) higher share of target-date fund ownership had a 0.24% lower return in the following month.
• Consistent with price pressure from target-date fund rebalancing, they found lower returns following high equity market returns for stocks included in the S&P 500 index relative to similar stocks not in the index. Following a 10% excess return on the stock market in a month, the index stocks had a 1% lower return in the following month compared with similar nonindex stocks.
• Time-series momentum (trend) in the S&P 500 index declined from the pre-target-date-fund to the post-target-date-fund period. They hypothesized that this was due to the rise of target-date funds damping aggregate market fluctuation via contrarian rebalancing.

The authors concluded that their findings implied that target-date funds, “by trading across asset classes, reduce the price response to asset-class-specific changes in demand from other sources.”

They added: “Our results suggest that to the extent that momentum or other anomalies are (or were) due to trend-chasing by retail investors, these anomalies may disappear (or may have already) as more retail investor money follows market-contrarian strategies.”

And finally, they said: “Because [target-date funds] actively rebalance between stocks and bonds, they add to co-movement in returns between these markets. An implication of this is that [target-date funds] propagate movements in interest rates from bond markets to stock markets. Thus, [target-date funds] automatically transmit expansionary policies such as quantitative easing from the bond market to the stock market.”

Following up on their prior work, in their August 2023 study, “Target Date Funds as Asset Market Stabilizers: Evidence from the Pandemic,” Parker and Sun examined the rebalancing effects of target-date funds during the coronavirus period and its aftermath (2019 to 2022). Here is a summary of their key findings:

• Passive target-date funds rebalanced more rapidly and more completely than active target-date funds.
• During the financial crisis period (before the growth of the target-date-fund market) and its aftermath (2008 to 2011), flows to U.S. domestic-equity funds tracked the equity market returns. The correlation between flows and returns was 0.78, implying possible destabilizing effects.
• During the COVID-19 period, a period of high volatility, contrarian trading by target-date funds (and target-date-fund-like entities) stabilized the funding of equity funds and even stabilized the prices of the underlying stocks that target-date funds held (indirectly). For example, after the stock market crash of March 2020, there was significant investment by target-date funds into equity mutual funds during March and April, consistent with 70% of target-date-fund rebalancing in equity being completed within the contemporaneous month and month after a differential asset class return.
• Mutual funds with large ownership by target-date funds had more stable funding through the pandemic.
• Stocks that had greater indirect ownership by target-date funds had lower co-movement with the market and lower volatility during the pandemic period—stocks with the lowest target-date-fund holdings at the beginning of the period on average had a standard deviation of monthly returns of 14% as opposed to a volatility of 11% for stocks with high target-date-fund holdings.
• Trend-chasing behavior was significantly reduced for funds with higher target-date-fund ownership.
• Higher target-date-fund ownership was associated with lower sensitivity to market momentum—when the overall stock market did well, stocks that had a large indirect target-date-fund ownership performed worse than they should have given their (pre-target-date-fund period) risk factor exposure and the movement in those risk factors. This lower return was consistent with their underperformance because they were being disproportionately sold by target-date funds when the overall stock market return was relatively high.
• Feasibly trading against target-date funds would have generated a loss of 30% over four years—sophisticated institutional investors would not have been able to exploit the actions of target-date funds by trading against them.

Their findings led Parker and Sun to conclude: “Though this was not the primary intent of the product design of [target-date funds], which was simply to improve the individual-level portfolio choices of inattentive or unsophisticated retail investors, the contrarian behavior of target-date funds has started to generate market-wide impacts.”

They added: “Most [target-date funds] start with a large desired share of equity—on the order of 90%—until roughly 25 years before retirement. The desired equity share declines smoothly over time to reach roughly 40% 10 years after the target date. Therefore, an aging population (such as for the U.S.) can generate stronger counter-cyclical rebalancing demand, according to life cycle models, than a young population does.”

Investor Takeaways

Target-date funds are an important innovation for investors saving for retirement. They relieve investors of the burden of choosing the allocation between equity funds and bond funds in their portfolios, replacing that decision with an automatic age-dependent rule. They also provide the discipline of rebalancing that many investors fail to exhibit when self-managing a portfolio. The evidence reviewed shows that retirement savers in target-date funds (and similar strategies) have become contrarian traders who reduce market fluctuations even in times of extreme market stress and volatility (such as during the COVID-19 crisis). In addition, the evidence that trading against target-date funds would have produced a cumulative loss of 30% suggests that target-date funds have made retail investors “smarter.”

The findings discussed demonstrate that the growth of target-date funds has significantly changed the patterns of fund flows and the time-series dynamics in stock returns. And given the increasing popularity of these funds, it seems likely that the AUM invested through target-date funds will continue to grow. The result would be that their market stabilizing effects will be even more pronounced. Adding further to this effect is that similar strategies that automatically stabilize the asset allocation of an investor’s portfolio have been incorporated into a broader set of investment products, such as automated advisory programs (for example, model portfolios).

Another result could be that the growth of target-date funds (and other strategies that systemically trade in a contrary manner in order to rebalance portfolios) might also result in a weakening of momentum in aggregate stock prices caused by trend-chasing.

Postscript

While target-date funds do provide some significant benefits, investors should be aware that there are negative features that should not be ignored:

• Unless the target-date fund is an all-equity fund, combining equities and fixed-income assets in one fund results in the investor holding one of the two assets in a tax-inefficient manner. If the “fund of funds” is held in a taxable account, the investor is holding the fixed-income assets in a tax-inefficient location. If the fund is held in a tax-deferred account, the equities are being held in a tax-inefficient location (losing the benefits of long-term capital gains treatment, the ability to loss harvest, the ability to use the asset as a means of making a charitable contribution and avoid the capital gains tax, and losing the potential for heirs to have a step-up in basis upon death). For investors who have only tax-advantaged accounts and do not have taxable accounts, the fact that target-date funds combine equities and fixed income is not a concern.
• If the fund is held in a taxable account, the investor loses the ability to loss harvest at the individual asset-class level. An offsetting benefit is that the fund should be able to rebalance internally, using cash flows and dividends, which is a more cost- and tax-efficient way to rebalance than buying and selling individual asset classes.
• If the fund is in a tax-deferred account, the investor loses the ability to use any foreign tax credits that are generated by the international equity holdings. Even in a taxable account, if the fund is a fund of funds, the investor loses the ability to utilize the foreign tax credit. For investors who have only tax-advantaged accounts and do not have taxable accounts, the fact that target-date funds combine equities and fixed income is not a concern, as it is better to have international diversification in a tax-advantaged account than to not have international diversification at all.
• If the fund is held in a taxable account, the equities should be in funds that are tax-managed or held in exchange-traded funds, which are generally highly tax-efficient. I am not aware of any balanced or target-date fund that tax manages the equity portion (which makes sense because the fund does not know which location it will be held in).
• If the fund is held in a taxable account, for many investors the fixed-income allocation should be in municipal bonds, not taxable bonds. Unfortunately, almost all these funds hold taxable bonds.
• Investors can typically earn higher returns on riskless (from a credit perspective) FDIC-insured CDs than by investing in riskless Treasuries typically held by target-date funds. And they can avoid the expense ratio associated with that allocation. Note that CDs may not be available in a retirement plan. The offset is that they lose the convenience of the fund, the benefits of automatic rebalancing, and the age-related automatic changes in their asset allocation.

The views expressed here are the author’s. Larry Swedroe is head of financial and economic research for Buckingham Wealth Partners, collectively Buckingham Strategic Wealth, LLC and Buckingham Strategic Partners, LLC.

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