Considering TDF Approaches

The current role of strategic vs. tactical asset allocation in target-date funds.

As defined by the online financial encyclopedia Investopedia, “strategic” asset allocation calls for “setting target allocations and then periodically rebalancing the portfolio back to those targets as investment returns skew the original asset-allocation percentages. … The concept is akin to a buy and hold strategy, rather than an active trading approach.” On the other hand, “tactical” asset allocation is defined as “allowing for a range of percentages in each asset class. … These are minimum and maximum acceptable [allocation] percentages that permit the [manager] to take advantage of market conditions within these parameters.”

In the universe of target-date funds (TDFs), the use of strategic or tactical allocation is increasingly being discussed, with emphasis on how TDF managers respond in difficult market cycles, sources say.

As with any financial industry jargon, there is some wiggle room and overlap in these definitions, and different managers will often use different language to talk about more or less the same thing. According to Bob Collie, Seattle-based chief research strategist for Russell Investments’ Americas Institutional business and author of the Fiduciary Matters blog, when considering target-date funds and evaluating their performance, it is crucial for plan sponsors to understand how their fund managers are defining and weighing the possibilities of strategic vs. tactical positioning.

Frankly, Collie says, he is concerned that purchasers of target-date funds fail to see the whole picture when it comes to comparing and evaluating managers, glide paths and, ultimately, performance. Hence, there has been little consideration of what the appropriate role of aggressive tactical strategies might be in the TDF marketplace.

“For TDFs here in the U.S., peer group pressure [to adjust allocations and pursue excess returns] comes not from the formal objectives of funds, but rather as an indirect side effect of the way funds are, in practice, evaluated,” he says. In other words, plan sponsors have increasingly favored those funds with the best short-term performance—perhaps one-year or three-year. This means the best chance of winning new assets is achieved by managers with the right tactical biases in the current, transitory environment, “not by those with the best long-term strategy for participants,” Collie says.

No one is arguing that TDF purchasers should completely overlook shorter-term performance metrics, which are clearly important in their own way. However, Collie stresses, TDFs are meant to be very long-term and strategically minded investments that should maintain their basic conviction throughout different market conditions. Of course, tactically minded investors have been happy to reap the benefits of a banner decade of bull markets, but what will happen when markets inevitably shift? According to Collie’s account and those of other sources, the pursuit of TDFs that strive to outperform the universe of other TDFs has ramped up risk and permitted a measure of market-timing among retirement investors.

“That’s meant having a big home-market bias during a period of U.S. market and U.S. dollar strength,” Collie says.

Sizing Up the TDF Market

Recently, two TDF experts with J.P. Morgan Asset Management, in New York City—Daniel Notto, Employee Retirement Income Security Act (ERISA) strategist, and Dan Oldroyd, portfolio manager and head of TDF strategies—examined a similar set of issues, publishing their findings in a white paper aptly titled “Choosing a Target Date Strategy.” The pair’s analysis, while slightly limited in its scope of the market, is somewhat more optimistic than Collie’s about the role that can be played, within bounds, by tactical thinking in target-date funds.

According to Notto and Oldroyd, “Beyond the basic issue of fiduciary responsibility, a variety of factors must be taken into account in choosing between off-the-shelf and platform model [i.e., open-architecture] TDF strategies. Tactical asset allocation is one important consideration.” The two observe that off-the-shelf, or “proprietary,” mututal fund strategies can much more easily utilize tactical asset allocation than can a recordkeeping platform model—i.e., they can leverage the fact that everything is conducted in-house and can make “calculated, short-term shifts in asset weightings as market opportunities present themselves.”

“Many off-the-shelf managers actually choose not to use tactical asset allocation at this time, although we believe it can provide a benefit to plan participants when it is thoughtfully executed by an experienced team,” Notto and Oldroyd wrote. “On the other hand, the operational challenges of making shorter-term shifts mean that very few, if any, recordkeeping platform models can employ tactical asset allocation.”

Their analysis does not address fully custom solutions, which have different considerations and options for plan sponsors.

From the “strategic” perspective, Oldroyd and Notto also argue that off-the-shelf products might be at an advantage at this juncture: “Some of the best off-the-shelf strategies include extended asset classes, such as real estate, Treasury inflation-protected securities and commodities, along with the foundational asset classes of equities, fixed income and cash. That wider opportunity set may not be available on platform models.”

Given their respective roles at a big-brand proprietary fund manager such as J.P. Morgan, the two experts conclude that these facts “represent a notable constraint” on platform-model TDFs: “We have found that extended asset classes can be a valuable source of attractive risk-adjusted returns, especially in volatile, lower-return market environments. Recordkeeping platform models may also restrict the number of managers that can be included in their target-date strategies.”

Another Word on Tactical Management

Collie’s colleague at Russell, Leola Ross, director of capital markets research, also in Seattle, describes tactical trading as an investment style based on anticipated themes or trends in global equity, interest rate, commodity and currency markets. “Strategies are typically directional, although relative-value approaches may also exist,” she notes. “In a directional strategy, managers take a position, either long or short, on the direction in which they think the overall market will move. A manager who has taken a long position will benefit if the market rises, and one who has taken a short position will benefit if the market falls.”

A relative-value approach involves managers taking a position on the gap between where a security—or, more likely in the TDF space, a group of securities—is currently priced and where it is expected to be priced at some future point. The bottom line, Ross says, is that tactical trading can add real value if executed successfully, but incorrect tactical positioning can easily cut into participant accounts.

2017 Target-Date Fund Buyer’s Guide

The data submitted this year for the PLANSPONSOR Target-Date Fund (TDF) Buyer’s Guide reinforces trends we saw when first compiling this guide, in 2015. One was that asset managers are deeply committed to target-date fund solutions, as indicated by an exceptionally high research participation rate—74 products—which encompasses 99% of the total TDF marketplace by assets. Second, target-date funds, and their managers, continue to evolve their thinking and underlying allocations.

The 2017 TDF Buyer’s Guide represents $1.6 trillion in assets as of June 30. Of the target-date fund market reported, 60% of products are in mutual funds, 37% in collective investment trusts (CITs) and 3% in variable portfolios.

The following analysis is based on the 71 off-the-shelf, or prepackaged, products—custom solutions are excluded—listed starting on page 40. A slightly expanded guide is available online. Key to any plan sponsor due diligence process that involves fund differentiation is to examine the asset manager’s philosophy and methodologies, such as how he may use passive management or unaffiliated investment managers.

About 38% of the off-the-shelf TDF families—28 of those listed in our guide—use a hybrid or active/passive method of portfolio construction. Another 28%—21 suites—primarily use active underlying funds, and 27%—20 suites—favor index or passive underlying funds. The remainder cited something else in that field.

As to strategy, open architecture is the presence of an unaffiliated manager overseeing at least one part of the portfolio. Thirty-seven of the funds in the guide now provide this feature; however, the largest fund investment managers—Fidelity, T. Rowe Price and Fidelity—do not, meaning less than 25% of TDF assets are in funds with unaffiliated managers.

Also interesting, more than half of the products here allow the investment manager some tactical deviation from the glide path when the situation warrants.

Plan sponsors unable to find an appropriate prepackaged TDF solution among those on the following pages might consider a custom target-date fund. Thereby, the plan sponsor can work with an asset manager to specify glide path construction, underlying asset allocation and ongoing advisement. Nine asset managers listed here provide that option.