Following the Great Recession of 2008, the dismal performance of many target-date funds (TDFs), whose 30- to 40-year glide paths are predetermined by age, exposed the risk of adhering to a rigid glide path. This prompted many TDF managers to begin to consider tactical deviations based on market conditions and forecasts.
In fact, the 2017 PLANSPONSOR Target-Date Fund Buyer’s Guide found that 55% of TDF managers now employ a tactical strategy at least to some extent. Of the 18 fund managers that allow for a deviation, 78% may deviate from the glide path in all of their TDF funds, while 23% use a deviation in some funds and not in others, ostensibly shying away from the deviation in the near-term vintages so as to minimize risk in the portfolios of those about to retire.
SEI Institutional has long employed tactical strategies to its defined benefit (DB) plans, prompting it seven years ago to begin to apply it to its target-date series, says Jake Tshudy, director of defined contribution investment strategies at SEI Institutional in Oaks, Pennsylvania. SEI does this by including the Dynamic Asset Allocation fund as one of the underlying funds in the series, Tshudy says, with its contribution to the series never exceeding 10%. As participants approach retirement, the allocation to the Dynamic Asset Allocation fund is brought down to 0%, he says.
The fund manager looks for economic disjoints and places trades that are high conviction for the longer term, he says. For example, “the most recent large bet the fund took was to go short on the Euro. At the same time, if we decide there is a longer-term opportunity with high yield and emerging debt, we might make those trades in the fund if we think we are going to hold those positions for a long time. The fund has a high tracking error because it is meant to exploit longer-term bets.”
In addition, SEI has added “a risk parity fund tied to volatility that takes a similar approach but trades with more frequency,” Tshudy says.
Prudential’s Day One TDF series also “has the ability to react to significant market events,” says Doug McIntosh, vice president, investments, at Prudential Retirement in Newark, New Jersey. “There is a firm-wide reassessment of market environments on an annual basis, and our portfolio managers update their capital markets forecasts every quarter,” McIntosh says. However, the Day One funds typically only adjust their holdings annually.
‘Remaining True to the Glide Path’
“There is a definite place for tactical moves”—to equities, fixed income, commodities, real estate and Treasury Protected Securities—McIntosh says, but because “target-date funds are long-term products, we also want to make sure we are remaining true to the glide path. We are not so stuck on our own projections that we don’t change them as time goes by,” he says. That said, McIntosh adds, “We are focusing more of our intellectual horsepower on the long term to get that right.”
This is why the Day One funds typically only permit deviations in the 50 to 100 basis point range on alpha and 1% on volatility, he says. Like SEI’s Dynamic Asset Allocation fund, this tactical approach is dialed down as people approach retirement. “The 2020 fund ought not to be in a place that leaves it vulnerable,” McIntosh says.
At TIAA, the TIAA-CREF Lifecycle Funds are overseen by a monthly committee of asset class leaders and economists, says John Cunniff, managing director at Nuveen and manager of the TIAA-CREF Lifecycle funds. Four years, ago, TIAA incorporated a tactical component, he says. “The tactical management component makes adjustments on a forward-looking basis and is limited to no more than +5% or -5% of the portfolio,” Cunniff says. “We see ourselves as an extra player on the team adding alpha.”
Like Prudential, TIAA says the overriding principle guiding the TIAA-CREF Lifecycle Funds is the long-term glide path, followed by the relative performance of the underlying portfolio managers and then the tactical element.
As for how much the tactical component boosts performance, Cunniff says TIAA’s “goal is to be within 1/10th of its tracking error, which ranges from 1% to 2.5%.” As a result, the tactical approach has added 10 to 25 basis points to the funds’ performance over the past three years, he says.
Taking Tactical TDFs a Step Further
Francisco Gomes, professor of finance at London Business School, recently issued a report calling for tactical target-date funds to go a step further by relying on short-term market data based on variance risk premiums to adjust funds’ asset allocations on a quarterly basis and permit annual portfolio turnover as high as 213%. By comparison, according to Gomes’ paper, “Tactical Target Date Funds,” portfolio turnover for a standard TDF is 23% and 78% in a typical mutual fund. The goal of the fund is to minimize downside risk, which also results in diminished returns on the upside.
Tshudy says that this approach to minimizing risk is in agreement with its Dynamic Asset Allocation and Multi Asset Accumulation funds. “We agree with the smoothing of risk. The difficulty of this approach, where the rubber meets the road, is that protecting the downside does cause issues when the market is trending upward,” Tshudy says. “There are periods in between when it is hard to make [the case for tactical overlays] when performance won’t look as good.”
In addition, Gomes’ theory relies heavily on variance risk premiums, Tshudy adds. “That could be exploited to the point that the predictive power is minimized as [other] investors become aware [of the approach],” he says.
McIntosh is unsure whether relying on a variance risk premium is well-suited to a target-date series of 12 funds. “The notion of allocating on a changing risk premium is one I have seen used in the defined benefit world,” he says. “That concept is well suited to the DB world, where you are making one single omnibus trade, rather than trading across 12 funds. Across numerous portfolios, it becomes a little bit complex from a trading perspective.” He also thinks a 213% portfolio turnover is quite high.
Cunniff notes that Gomes’ back-tested theory would permit a tactical TDF to trade 10% of its portfolio either up or down to look for “anomalies within volatility in order to find alpha.” This range results in “a band of 30%. That is higher than most of the industry players—more than double the average,” he says.
« Expanding the Credit Universe: Managing Credit Migration Risk for DB Plans