You are not an insomniac, you have a target date fund

The return of inflation is having far reaching impact on just about everything. One in particular is the target date fund - those who hold one are all too aware but its important to take an objective look at the confluence of moving parts that went wrong.

Readers of my work will be familiar with two simple observations:

• The most disturbing event in wealth accumulation is a large drawdown that upsets one's ability to reach a wealth target.
• The problem should focus on the goal of attaining a future stream of income rather than return maximization. (Robert Merton)

The discussion can be tailored to the problem of endowments or private wealth, but this will narrow the discussion to defined contribution pensions and a critique of target date funds. The very topic that led to my collaborations with Stefano Cavaglia and our first paper, A wealth management perspective on factor premia, and the value of downside protection.

Wealth and age are not the same thing. Target date products allocate by age. Lets examine a representative allocation between equities, long and intermediate bonds.

The equities is the Vanguard S&P 500 (VOO) with a back-filled S&P Total return series with 3 basis point fees. The Long bond is the Vanguard govy VGLT and the intermediate is the VGIT with fees of 4 basis points. The early history splices the GS10 series from FRED calibrated to have the risk of the long bond or intermediate bond.

Diversification when you don't really need it, co-moving assets when you needed diversification. Fund in and out flows in blue. Performance in red. Avoiding the early 2008 draw-down in black.

The inflows are based on a representative investor Jane. She begins saving at 35 with an annual income of 70,000. Her salary grows with the CPI and her and her employers contributions sum to 20% of her after-tax income. Seven years before retirement she is earning 100,000 and decides to add contributions of 10,000 over the months of April and May. She had a mental target of 1,000,000 and an income of 48,000.

She made those contributions because the financial crisis took her off track. Four years of contributions were wiped out. In February of 2009, her pension was worth 73,538. It was last at this level in May of 2005.

As I noted previously, the low inflation and zero risk equities period ensued and things looked up. The allocations to bonds rose but were uncorrelated to equities. The brutal reality was that this ended badly. [1] Her top-up inflows got her over 700,000. Post Covid inflation came and hurt both of the main allocations to the portfolio. Jane, dear reader, could not sleep.

One year into retirement, her portfolio that once reached 751,000 was down 243,000 from the high and only 48,000 of that was outflows.

Now imagine she had avoided the early drawdown in 2008. Her portfolio would have reached 996,000 in October 2022. The inflation period decline would still have occurred but after one year of outflows, the value would have been 684,000 not 508,000. An additional buffer of 176,000

The target date product allocations were built before inflation. Much like the institutions who assumed that structured products in real estate would only see small increases in value in bad times, the returns to long duration bonds reflected events not seen in the markets since the 1970's and 1980's. There was no diversification, since inflation scenarios were unlikely to have driven the choice of assets.

Further adding to the problem, the dynamics do not allow for a change in allocations. It goes to bonds as you approach retirement and pays no heed to wealth decumulation needs. In general, there is little out there that addresses this period.

This critique is what started me on the path to my published work. A solution is an overlay of factor exposures that can provide diversification. My coauthor Stefano Cavaglia has the latest [2]. He describes the use of factor overlays to strategic allocations and manager allocations in what he terms Total Portfolio Management.

Invesco reviewed the paper we published together with Stefano, Ken Blay and Scott Hixton. It turns out, both during the accumulation and decumulation periods, factors enhance and smooth out the ride to retirement.[3] [4]

Research and not an endorsement.

The image is provided by The Metropolitan Museum of Art, New York. Open Access. The Chess Players by Thomas Eakins 1876.

[1] The last 140 years of equity bond correlations, LinkedIn post https://www.dhirubhai.net/posts/louisscott_lets-review-the-last-140-years-of-equity-activity-7125538698946846720-62Qy

[2] Cavaglia, Stefano and Fan, John Hua and Wang, Zhenping, Portable Beta And Total Portfolio Management (June 22, 2022). Financial Analysts Journal, 2022, 78(3): 49-69. Available at SSRN: https://ssrn.com/abstract=4131048

[3] Invesco Risk and Reward, Issue 1, 2021 page 31. (https://www.invesco.com/content/dam/invesco/apac-master/en/pdf/apac/2021/multi-assets/risk-reward-q1-2021/20210329.pdf)

[4] Stefano Cavaglia, Louis Scott, Kenneth Blay and Scott Hixon, Multi-Asset Class Factor Premia: A Strategic Asset Allocation Perspective. The Journal of Portfolio Management Multi-Asset Special Issue 2022