Target Date Funds: Notes from Rational Reminder Episode 310

Today's episode of Rational Reminder from PWL Capital Inc with Professor Antoinette Schoar is jam packed with insights. The first 15 min focused on Target Date funds with a ton of nuggets to take away.

Primer: What is a Target Date Fund?

A target date fund is a fund that starts with a predetermined asset allocation. That is they have a pre-set mis of stocks and bonds (usually geographically diversified). From there - based on the "Target date" of retirement - the portfolio will typically shift gradually from stocks to bonds as the investor get's older till it get's to what might typically be a conservative portfolio in retirement.

We can address other nuances & myths/misconceptions in the future but here were some of the cool takeaways from the episode as it relates to Target Date Funds!

Target Date funds led to investors taking more equity risk when they were younger

Before the rise of Target Date funds - the research showed that on average investors allocated only about 40%-50% to Equities when they designed their group retirement plan asset allocations. Now with Target Date funds - that mix is predetermined and usually has a higher allocation to equities early on so investors are getting that equity (or stock exposure) which means larger expected portfolios throughout time. A good thing for investors.

Target Date Funds also led to better rebalancing

Since Target Date funds rebalance back to the target asset allocation (That is they will buy more equities when equities are down or buy more bonds when equities have risen a lot) this was a benefit for many investors. Most investors in group plans don't actively go in to rebalance their portfolio or de-risk it as they get older. That meant they mainly sort of picked one asset allocation and kept it through their working years. Additionally if they invested and the stock market happened to go through a slump - they didn't rebalance back into equities and as such had lower exposure to stocks starting out.

Target Date Funds seem to be muting the volatility of the asset classes they invest in

Since Target Date funds invest counter-cyclically (Buy more stocks when they go down and sell off to buy bonds when stocks go up a lot) they create essentially a counter demand. As such - they would act against the selling/buying pressure of an asset class.

As a result - given that most of the exposure for target date funds is predominantly the largest most liquid stocks - that is where most of the muting of volatility happens

Target Date funds by the sheer size and volume typically are closer to market cap weights. As such - by size that's where most of the volume of dollars go. Consequently - the most dollars are being used to mute the volatility of the larger stocks.

(Aravind wondering to himself - how could this/would this have an effect in terms of how/why Large Caps seem to be doing much better over this extended period of time. If so - is that a permanent feature or not?)

What other effects could Target Date Funds have on Market Pricing?

Because they act in a counter-cyclical manner - there is the potential that they could mute certain market trends like momentum (Stocks that go up in price continue to go up in price). If you have a set asset allocation and some stocks shoot up in price or the equity markets grow quicker in price - then you might sell them off quicker to get back down to the target weight - thus acting agains the momentum trend.

Aravind's thoughts on whether that changes things for advisors/investors

To be honest - not really. The market impacts such as flows and the impact on market dynamics like momentum are tough to determine given these trends of target date funds and indexing have really only started to take off in the past couple decades.

Meanwhile - the persistence of the equity risk premium (that stocks provide higher returns commensurate with the fact that you take more risk) has been around for almost a hundred years in some markets like the USA and multiple decades in other countries.

Investor Behaviour pt 1: Emotions - that is to let their emotions often cloud their judgement and potentially over/under allocate to asset classes is a common issue. It's difficult to keep buying stocks when they go down after all. A mechanism for automatically doing that will benefit most people - especially those who typically won't do it themselves.

Investor Behaviour Pt 2: Habits - It's just MORE WORK. Most people with group plans have the group plan and like it because it's a set it and forget it. Asking them to log in to get statements is already sometimes a hassle for them. Now asking them to log in a couple times a year and fiddle around with something they barely understand to buy and sell funds? It just adds to work they don't want to do. This eliminates that issue for them.

Am I worried about this vs what an advisor does? No. An advisor still serves a role here. Projecting out expected returns to ensure that their savings rate and where they are saving will allow them to hit their goals. Additionally the PLANNING is still a factor. How will they navigate financial milestones in their life? What to do when life changes happen? How to effectively draw down or withdraw their investments? There are all factors here.

I can't wait to listen to the rest of the episode. Seems like it'll be a banger. (Yes - Super nerdy)