The Hidden Risk in Target Date Funds

Lately, Target Date Funds (TDFs) have been the subject of intense scrutiny and criticism, because investors have realized (in many cases, after the fact) that these types of funds can be very volatile. In the aftermath of the 2008 collapse of the financial markets, TDFs for investors near retirement (funds with a projected retirement data of 2010, a.k.a “2010 TDFs”) got considerable media attention because some of these funds suffered dramatic losses.

Clearly, investors nearing retirement didn’t understand the levels of risk they were taking by investing in 2010 TDFs.  It has also been widely noted that the percentage of assets invested in equities in 2010 TDFs varied dramatically among funds, which in turn meant that there was little commonality among TDF fund manufacturers as to how much risk investors at or near retirement should have in their portfolios.  Both the lack of investor understanding regarding risk in these funds, and the wide variability in risk levels between funds are substantial issues that have received considerable discussion in the press.  However, there is another issue that has gotten almost no attention that I want to raise here.

Examining Risk in Target Date Funds

A standard approach to examining the risk level in a TDF is to compare the percentage of the fund that is invested in bonds and cash to the percentage invested in equities. As we all know equities tend to be riskier than bonds, and the percentage allocated to equities vs. bonds is commonly used as a proxy for risk. A higher allocation to bonds equates to a less risky portfolio (and vice versa). For many, this approach provides an intuitive and simple metric to use in their portfolio planning. Unfortunately, the approach is also a poor predictor of risk and investors who use it as their guide to build a conservative portfolio as they get closer to retirement can be in for a terrible shock.

The chart below shows the percentage of each 2010 TD mutual fund that is allocated to bonds and cash vs. the fund’s risk level, as measured by the trailing 3-year volatility. Each point on the chart is a different 2010 TDF.

2010 Target Date Funds: Risk vs. Asset Allocation (Source: Author)

The Bad News for Investors

What we expect to see is that 2010 TDFs that have higher allocations to bonds and cash are less volatile (e.g. less risky) and vice versa. And we do, indeed, see a downward-sloping trend to the data that conforms to the idea that more bonds and cash in an allocation equates to less risk.

Now for the bad news.

The analysis above was performed for all 2010 TDFs using data available through the end of April of 2012. What it shows us is that these 2010 TDFs have annualized volatility levels ranging between about 4% and 12%. (As a simplified rule of thumb, I find that the maximum 1-year loss that investors should expect from a portfolio is around twice its volatility). Using this rule of thumb, this means that the potential loss for 2010 TDFs range (approximately) from -8% to -24% in a single year.

The first piece of bad news for investors nearing retirement is that this is a huge range of potential loss.  The second piece of bad news—and the main theme that I want to focus on here—is that while the percentage allocated to bonds and cash (as opposed to equities) is a reasonable proxy risk measure for investors to use in their portfolio planning overall, there are enormous differences in risk levels between individual funds with (almost) identical allocations to cash and fixed income.

For example, look at the TDFs in the chart above with between 50% and 55% allocated to bonds and cash. One would assume that these TDFs would have similar risk levels. However, the trailing volatility for these funds range between 8.1% and 11.7%. To put this another way, the riskiest TDF in this group (the fund with 11.7% of trailing 3-year volatility) is 44% riskier than the fund with the least risk (8.1%). What’s really interesting to note here is that there is only a 0.2%difference in the allocation to cash and bonds between these two funds.

There are also two 2010 TDFs with about a 60% allocation to bonds and cash (look at the two portfolios very near to the 60% value on the horizontal axis) with an even larger spread in their risk levels.

What these results mean is that investors, advisors, and plan sponsors using the percentage allocation to bonds and fixed income as a proxy for risk—a common practice for many—may be comparing funds that are, in fact, vastly different in terms of risk exposure. Folio Investing raised this issue in a comment letter to the SEC in 2011.

Using Historical Volatility to Gauge Risk

The good news here is that the solution to this problem is pretty straightforward. In a 2010 article in Workforce Management, Lori Lucas (the head of Callan Associates Defined Contribution plan practice) proposed that:

“…one of the best ways for plan sponsors to understand the trade-offs of target-date fund structures is to use forward-looking simulations to project possible outcomes.”

This is exactly how we designed the Target Date Folios at Folio Investing. Short of the use of forward-looking simulations, however, an examination of historical volatility is very useful   One of the challenges for the use of forward-looking simulations to understand portfolio properties such as risk is that there are differences between models and there is no single standard that is universally accepted.  Historical risk levels are available from sites such as Morningstar, and there are standard approaches to calculating historical risk.  Morningstar uses trailing three-year volatility as a standard risk measure and my own calculations of trailing three-year volatility match Morningstar’s estimates perfectly.

My conclusion overall is that anyone examining possible portfolios (such as different TDFs) must drill down to look at risk levels (at least historical risk) and not simply look at an over-simplified proxy for risk such as the percentage allocation to bonds and cash.  Without doing so, investors have little hope of understanding how much risk they are actually taking on in a Target Date Fund.

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

5 thoughts on “The Hidden Risk in Target Date Funds

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  2. Fred

    Don’t Target Date Funds, in fact, fall into the Fallacy of Time Diversification? Although the portion committed to equities diminishes, slightly, with time it is still the same old “risk declines with length of holding period”. There may be different definitions of risk but basically it is not true no matter how long Siegel and Bogle say that it is. As k anyone who retired in 2000 for starters. Better yet consult Paul Samuelson, Zvi Bodie or http://www.johnduval.com/MythofTime1.pdf for a clear explanation. Fred

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