Target-date funds: strategic and active management

Strategic essentially means making a long-term commitment to a blend of asset classes and only adjusting periodically or after major, unexpected shifts in the long-term market return expectations of different asset classes and sticking with an overarching philosophy. A fund concentrated on—although not exclusively to—value stocks or high-yield bonds is using strategic management. Active investing attempts to take ongoing advantage of cyclical variations from long-term strategic asset class forecasts.

Target-date funds, although they use a wide variety of underlying asset classes over time, are essentially strategic. They generally commit to a plan that begins with a focus on long-term appreciation, then move toward preservation as retirement approaches. 

This gradual shift from a focus on asset growth toward more conservative investments is known as a glide path. This keeps investors from having to make asset allocation decisions as they get closer to retirement. Target-date funds don’t make major deviations from the plan in volatile markets and don’t typically attempt to anticipate and capture short-term movements.  The latter approach, trying to catch short-term market moves, is the province of tactical management. 

It’s important, though, not to confuse the general avoidance of tactical management with a lack of active management. Managers of target-date funds can and do make active decisions based on expected risk/return potential of underlying asset classes. They base asset class weightings on anticipated returns over the coming years (a one- to five-year horizon is typical), looking at components such as expected growth, income, and valuation changes. The nature of active management with target-date funds involves overweighting some asset classes and underweighting others relative to the essential planned glide path.

Despite the general avoidance of short-term trading, active management monitors critical points in the economic cycle and watches for surprises in key indicators while looking for deviations from the longer-term forecast. The active management component of target-date funds also watches technical indicators, including key levels, trends, momentum, and divergences. In addition, it considers earnings revisions and adjustments in forward valuations while watching investor sentiment changes, including implied volatility movements. Put another way, target-date funds are strategic in nature, but with the considerations and oversight that active allocation decision-making can offer.

A rule of thumb is that target-date funds employing active management still earn most of their returns from the long-term glide path but may generate  additional performance by overweighting or underweighting certain asset classes.  In addition, the funds may be able to pursue further returns by successfully allocating to skilled subadvisors. Of course, there are risks of potential underperformance with active management as well.

There are two general types of target-date funds: “through retirement” and “to retirement.” Funds designed to run through retirement often seek a higher level of growth even after the targeted retirement date to help minimize longevity risk or running out of money during retirement. This typically involves keeping a higher equity exposure at retirement (nearly 50%)¹ and using the active- management approach to seek incremental returns. Using active management can be a key part of one approach to "through retirement" funds. Other funds also run through retirement but maintain a more purely strategic technique.

"To retirement" funds are typically more passively managed, although they can use active management as well, and are more doctrinaire in their focus on capital preservation from the target date forward, keeping closer to 33%² and sometimes significantly less in equity at retirement. In exchange for lowering the risk of drawdowns, "to retirement" funds do less to protect against potential longevity risk. 

We want to emphasize that target-date funds use a wide variety of asset classes over time. Beginning as they do with an emphasis on high-growth equities, the funds gradually reduce exposure to these equities. They may also begin with an allocation to long-duration fixed-income assets, such as U.S. Treasury Separate Trading of Registered Interest and Principal of Securities (zero-coupon Treasuries known as STRIPS), since these may provide support against equity downdrafts when bonds and stocks move in opposite directions. These funds typically reduce their exposure to STRIPS as they cut their high-growth equity holdings.

As time passes, target-date funds tend to move into shorter-duration fixed-income assets; low-beta fixed-income growth assets; inflation-protected assets such as Treasury Inflation-Protected Securities; defensive, low-beta equities; and alternative assets designed to provide diversification and potential tail risk protection in the event of a market sell-off. To the degree that the funds employ active management, they may vary the weights of these asset classes over time.

1 Morningstar, May 20, 2014. 2 Morningstar, July 10, 2012.