Smart Beta Seeks Next Generation TDFs

Asset managers are taking the next steps in TDF innovation and many are eyeing strategic beta for higher returns and lower risk.  

The defined contribution (DC) space is currently dominated by target-date funds (TDFs). These professionally managed portfolios rebalance participant assets over time by shifting more weight toward bonds and other income-driven investments as opposed to more volatile securities like stocks. But, critics argue that these funds don’t account for individual risk tolerance and they can’t always protect against volatility especially during a market downturn —  a matter that’s especially threatening to those nearing retirement.

In response, fund managers are redesigning these widely-used funds and turning to new strategies including smart beta. According to global research firm Cerulli Associates, 38% of asset managers surveyed believe it is highly likely for smart beta to become a feature of next-generation U.S. target-date products. Fifty percent believe it is somewhat likely.

Strategic beta or “smart beta” strategies aim for enhanced, risk-adjusted returns by tracking an index based on specific rules or preferences. As opposed to conventional market-cap-weighted passive allocations, these funds weigh securities based on specific factors such as performance, dividends, value, volatility and more. In this sense, smart beta seeks to outperform passive indices by taking an active investing approach.

“In a target-date market dominated by low-cost, passive providers, strategic beta strategies are a way for active managers to compete with pure passive on cost while retaining some of the value-add tenets associated with active management,” explains Dan Cook, analyst at Cerulli. “For the larger target-date providers, strategic beta series can also serve as another option in their target-date product suite, giving plan sponsors the choice between passive, active, and strategic beta.”

Cerulli notes that the increased scrutiny of investment management fees in a low-return DC environment has supported the argument to incorporate smart beta strategies into TDF innovation. Add to that the uncertain interest rate climate and reports indicating overall low returns for the foreseeable future, and smart beta may seem appealing to some fund managers.

Some providers have already rolled out smart beta TDFs. Blackrock recently ran an analysis comparing the performance of several market-cap indices through a hypothetical working lifetime against its smart beta portfolios. It found that in each case, the strategic beta portfolios outperformed their indices.

According to the latest report by Cerulli, “Asset managers incorporating strategic beta into their target-date series could find success by positioning their products as cost-effective strategies capable of reducing volatility and sequencing risk for retirement investors when markets decline.”

Cerulli puts the general cost of smart beta at 25 to 50 basis points depending on the complexity of the strategy.

But while smart beta strategies may help TDF investors mitigate risks and improve their retirement readiness, it likely would complicate the due diligence process at the plan level. This is especially important for DC plan fiduciaries who would have to navigate the ever evolving regulatory space following the implementation of the Department of Labor’s Conflict of Interest Rule. The fiduciary scope will likely tighten as TDFs continue to grow as one of the main drivers behind Americans’ retirement readiness in the DC space. Cerulli finds that as of 2016, TDFs accounted for $1 trillion of 401(k) assets or 52% of all 401(k) contributions. The firm projects that figure will jump to 75% by 2020. Thus, asset managers bringing new TDF products into the DC market will also have to bring all the necessary material to help fiduciaries administrate these products through a well-structured due diligence process.

Cerulli concludes that “Innovation from industry players and increased focus from plan participants could move the retirement readiness needle in the right direction.”

These findings are drawn from the second quarter 2017 issue of “The Cerulli Edge – U.S. Retirement Edition.” Information on obtaining a copy of the report can be found at