Even the arrows that hit the blue circles are closer to the target than target-dated funds. Photo by Paul Gilham/Getty Images.
Recently, some of the biggest target-date fund (TDF) providers revealed they were changing their funds’ asset allocation, increasing both their stake in equities and staying in stocks for a longer time period. But before you high-five them for finally acknowledging the time value of money, we have to break some bad news: The move has nothing to do with raising compound growth potential to position folks better for retirement. Nope, it is simply because the firms’ “research” says folks’ risk tolerance has improved, justifying a bump in equity allocation. Which is sort of a weird, misperceived reason for a product designed to be disciplined to make a change. It also underscores why, in our view, folks investing for retirement can do better: If a product alters its strategy based on a common investor behavioral mistake[i], it probably isn’t a great fit for your long-term goals.
Risk tolerance is an important consideration for investors, but what the TDFs cite here really isn’t risk tolerance, which is simply investors’ ability to withstand market volatility and short-term drops. It’s not like the fund manager is calling his investors and asking whether they’re comfortable with the notion of bouncy times. So what are they looking at? They say “consumers’ savings behavior and asset allocation levels,” which sounds an awful lot like mutual fund flows to us. For most of the bull market’s first four years, equity mutual funds had pretty consistent net outflows—ergo, low “risk tolerance.” But since 2013 began, monthly equity fund flows have been mostly positive—risk tolerance up!
There are more than a few problems here. Fund flows don’t tell you about investors’ true risk tolerance, which doesn’t fluctuate with market movement—they capture one side of a transaction. How can you draw any conclusions without knowing where the money came from or went to? One might try to argue they can get the answer from the Fed’s “Flow of Funds” report, which measures how much households have in stocks, bonds, cash and other assets. But these measures are skewed by market movement. The Fed’s report shows investors’ stock holdings increased by $2.9 trillion in 2013 (a 27.8% increase over 2012), but there is no way to know how much of this was due to new purchases versus that 26.7%[ii] rise in global markets.
And even if fund flows were an airtight indicator of investor behavior, they still wouldn’t give you risk tolerance. They’d mostly give you investors’ emotional reactions to past market movement—the same emotions that make their answers to risk tolerance surveys so fundamentally useless. Feelings about the recent past often don’t square with your true ability to weather volatility. Think about how someone would have described his or her risk tolerance at the Tech Bubble’s peak vs. March 2009—that tells you everything you need to know.
This means TDFs are basing their asset allocation on an imperfect measure of investors’ emotional reactions to recent past performance. Changing your asset allocation—which affects your portfolio’s future returns—because past fuzzy data show investors bought more stocks doesn’t seem to be a winning investment strategy to us. It amounts to crowd-following and letting emotional whims drive decision making. Which we thought was something TDFs were theoretically designed to help guard against. And when you consider the importance of asset allocation—studies have shown asset allocation choices account for around 90% of your portfolio’s return—the reactive shifting seems all the more bizarre.
And if TDF providers can increase equity exposure based on investors’ emotional whims, a natural question arises: Will they reduce equity exposure when folks flee stocks? Say, near the bottom of a correction or bear market? Theoretically, if a TDF manager were to ratchet up equity exposure at any point, the best time would be after a big bear market, to capture the upside of the subsequent bull. However, that would also be the time investors are most averse to stocks—which gives fund providers a huge incentive to bulk up on bonds. It lowers the likelihood their own investors bolt. That would make them the fund equivalent of the yes man.[iii]
Perhaps we’re being too cynical here, but we wonder if this is more a marketing move than a decision designed to benefit fund shareholders. In an environment in which investors are more commonly buying equity funds, maybe these TDFs think a higher equity allocation will make them more attractive to new money? For a product that sells itself as a “worry-free” investment that emphasizes the long term, it’s odd for TDFs to rejigger themselves due to recent (and short-term) investor behavior. It might seem like a totally tubular call today, with the bull market going strong, but it opens the doors for a lot of tomfoolery in the future.
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[i] Basing decisions on past performance, rather than their long-term goals, time horizon and market outlook over the foreseeable future.
[ii] Source: FactSet. The MSCI World index from 12/31/2012 – 12/31/2013. The MSCI World Index is an unmanaged, capitalization-weighted stock index measuring the performance of selected stocks in 23 developed countries and is presented inclusive of dividends and the effects of withholding taxes, and uses a Luxembourg tax basis.
[iii] Yes-man fund? Yes fund? Yes thing?