Your Target-Date Portfolio Doesn’t Need to be That Risky

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Published on November 25, 2019

| 6 min read

Richard Yasenchak, CFA, Head of Client Portfolio Management

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Pensions & Investments recently reported that mutual fund assets in DC plans total $3.19 trillion and target date funds have an $877 billion share of it! Assets in these strategies are surging – including collective-trust versions – given their use as a qualified default investment alternative (QDIA).

A target-date strategy makes a great QDIA, but can fiduciaries improve them to help participants secure retirement? We think so, and the change isn’t that radical.

Like all asset allocation models, target date strategies expose participants to a lot of risk throughout the glide path. Why? Because equities often remain the largest source of risk in any asset allocation model. The key to improving target date strategies is to mitigate that risk.

Common Risk Remedies Fall Short

Typically, you might attempt to solve this challenge through diversification, like adding alternatives, managing factor exposure or adding fixed income. Others turn to tactical decisions. But the risk equities pose to your glide path is so large that all of these avenues have shortcomings.

 

Potential Pros and Cons of Common Remedies, Alternatives, Pros: Lower Equity Correlation, Expanded Opportunities, Inflation Hedge, Cons: Higher Fees, Liquidity Risks, Hidden Equity Beta. Factor Exposures, Pros: Targeted Risk Exposures, Lower Correlation Between Factors, Cons: Transient Performance, Overcrowding Risks, Spurious Modeling. Fixed Income, Pros: Lower Equity Correlation, Capital Preservation, Income Generation, Cons: Interest Rate Risk, Credit Risk, Longevity Risk. Tactical Decisions, Pros: Enahcned Returns, Lower Risk, Cons: Market Timing is Difficult, Implementation Costs, Governance Costs.

POTENTIAL PROS AND CONS OF COMMON REMEDIES_

 

Add to Your Risk Management Toolbox

But what if you could systematically increase and decrease equity beta through risk regimes, participating in the market’s upside yet mitigating downside risk? A variable beta strategy seeks to offer just that. This type of performance contour changes the value proposition of equites in any asset allocation model.

A variable beta strategy is a hybrid of active core and low volatility strategies that systematically adapts to market risk regimes. It attempts to reduce the overall risk of equity investing without sacrificing its return potential. In risk-on environments, the equity beta of a variable beta strategy may be close to 1.0, while in risk-off markets the beta adjusts downward, reducing systematic risk exposure.

Upside participation and lower downside capture helps fuel the “magic” of compounding. Consequently, variable beta strategies offer the potential to change the value proposition for equities in two ways:

  1. Reduce the total volatility of a portfolio while maintaining the same equity exposure.
  2. Maintain volatility levels while increasing equity exposure to improve return potential.

Implementing Variable Beta

We illustrate the benefits of adding a variable beta strategy to a target-date strategy in our short case study. Like all asset allocation models, constant risk premia assumptions limit target-date strategies. These assumptions may subject the portfolios to substantial drawdowns arising from the equity allocation, which reduce compounding benefits and exacerbate poor timing decisions by plan participants. Both have negative long-term return consequences on wealth accumulation.

Our case study compares three uses of variable beta:

 

BC: Base Case, Our Base Case reflects the Morningstar Lifetime Moderate Index with a zero allocation to variable beta. RV: Reduce Volatility, The Reduced Volatility model seeks to reduce Base Case volatility while maintaining total equity exposure. MV: Match Volatility, The Match Volatility models seeks to match Base Case volatility while increasing total equity exposure.

Comparing Three Uses of Variable Beta

 

The Reduced Volatility model might be a helpful scenario for asset allocators who can’t or won’t change their strategic allocations. By substituting one-third of the Base Case equity allocation with a variable beta strategy, we show that we can reduce Base Case volatility throughout the glide path and maintain the overall equity exposure.1

 

REDUCED VOLATILITY (RV) MODEL-

The Matched Volatility model might be a helpful scenario for asset allocators who have the flexibility to change their strategic allocations. By substituting one-third of the Base Case equity allocation with a variable beta strategy, we show that we can match Base Case volatility while increasing equity exposure throughout the glide path.2

 

MATCH VOLATILITY (MV) MODEL-

What’s the Impact on Wealth?

As you might imagine, the RV and MV models might have a material impact on wealth creation relative to the Base Case model. You can see those impacts by downloading the whole study in our eBook, “Are Your Asset Allocation Models Exposed Right Now?

Are Your Asset Allocation Models Exposed Right Now? Learn about an innovative way to address equity risk in your portfolio. Download Now

 

 

1. The full asset history of asset class returns is used to calculate the covariance matrix, and the same matrix is used for each fund (or retirement year); therefore, the change in volatility comes from differences in target-date fund weights.

2. The increase in equity exposure to 100% in the early-career stage creates a bigger gap in volatility between the funds since we cannot increase the equity portion further to achieve the same volatility as the Base Case.

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