As a senior multi-asset class portfolio strategist for Charles Schwab, Jake Gilliam is regularly called on to help formulate the strategic direction and management of multi-asset class portfolios across Charles Schwab Investment Management and Charles Schwab Bank.
Recently, this work has involved the creation of a new white paper on the timely topic of passive target-date funds (TDFs), dubbed “Passive target-date funds: Separating myth from reality.” Sitting down to review the research with PLANSPONSOR, Gilliam stressed the importance of retirement plan officials and fiduciaries taking time to build a more erudite understanding of the evolving TDF marketplace, especially as it pertains to the often misleading terminology of “active versus passive.”
As he explains it, the term “passive TDF” refers specifically to portfolio implementation, rather than the overall TDF design. His point is that a TDF may invest its assets into index-based securities that do not make tactical adjustments as the markets change—but the act of managing even an index-based portfolio according to a glide path that ramps down equity risk over time will always be at least in part fundamentally “active.”
“Just as with active TDFs, passive TDFs vary widely in risk/reward profile based on the many decisions that go into portfolio design and glide path design,” Gilliam says. “Passive TDFs can offer an effective retirement investment solution for many investors, but it is important to follow a TDF evaluation process that assesses how strategy choice aligns with investors’ specific needs, not focus solely on cost.”
According to Gilliam and paper co-authors John Greves, head of multi-asset strategies, and Natallia Yazhova, senior research analyst, all passive, active, and blended TDFs offer pros and cons that plan sponsors should consider when deciding which TDF makes the most sense for their specific needs.
“All TDFs have tremendous freedom in terms of design and portfolio construction,” Gilliam notes. “Glide path, slope, sub-asset class allocation, underlying index selection, investment vehicle, and use of security lending are all active decisions that can have a significant impact on a TDF’s risk/reward profile. As such, the only things truly passive in a so-called passive TDF are the strategies used in implementation.”
Gilliam and his Schwab colleagues stress that prudent TDF selection is about process, not just pricing.
“Selecting the lowest cost TDF should not lure plan fiduciaries into a false sense of security,” he adds. “There is no free pass when it comes to TDF evaluation—active, passive, or blended—the choice must be prudent. Simply going passive and low cost may seem like the easy choice, but it does not absolve fiduciaries of their due diligence and ongoing monitoring responsibilities. Fees are certainly an important consideration in this process, but not the only one.”
The analysis goes on to offer a series of questions plan officials can post to make sure they “know what they own.” These include the following: “What are the TDF’s asset class and sub-asset class allocations, and how do they shift throughout the glide path? Is the TDF implementation all active, all passive, or a blend of both? Why? How steep is the equity slope and when does it begin its descent? Does the TDF use third-party managers, proprietary funds, or a mix? What is the equity allocation at the target date and end date? How are underlying strategies selected and monitored, and have any ever been removed/replaced? Why, and what was the process?”
Other questions to ask include, what is the allocation to international and emerging market equities near and in retirement? And how much security overlap is there among holdings? Are there other riskier exposures to consider? What is the portfolio management tenure and assets of underlying strategies? How many years of roll-down does the TDF provide after the target date? What is the manager’s reasoning for these decisions? How have they affected drawdown risk (particularly near retirement), returns in various market cycles and long-term retirement outcome potential?
Gilliam also encourages plan officials to study the phenomenon of “blended TDFs.”
“Blended implementation combines the two approaches by investing in both low cost index funds as well as active managers to gain select market exposures,” he explains. “Typically, active managers are utilized to expand asset class diversification or to boost return potential in more inefficient markets where active managers tend to outperform, for a generally modest fee increase over a pure passive implementation approach. Using both types of strategies can allow the TDF manager to refine active risk levels at different parts of the glide path and may also provide diversification as markets cycle.”
The Charles Schwab experts conclude that “open architecture processes with thorough institutional governance” become increasingly important when a TDF utilizes more active exposures in implementation.
“Actively managed strategies have greater discretion around investment decisions, and it is crucial to select a skilled manager with a demonstrated ability to take appropriate investment actions as markets evolve,” Gilliam notes. “Combining different active sub-advisers or strategies into a single solution creates a diversity of thought and intellectual capital that can be lacking in a proprietary active solution. Furthermore, it may reduce the headline risk or conflict of interests associated with investing all assets with a single firm.”
Gilliam adds that Charles Schwab Investment Management has long been an advocate for offering a range of investment solutions.
“We believe that passively implemented TDFs can be a very effective retirement investment solution for many investors. However, it is important to remember that when the term passive is applied to a TDF, it can be misleading as it refers specifically to portfolio implementation,” he concludes. “Glide path design, including asset class exposure within the glide path, is the most important decision and is always the result of active choices by the manager. Because of this, a passive TDF approach does not necessarily reduce risk or offer more reliable performance on its own. Nor does it automatically offer a safer fiduciary choice.”