This article was originally published on ETFTrends.com.
By David M. Haviland, Beaumont Capital Management
Few investment products currently garner more attention than target date funds. Launched 30 years ago, TDFs are the most common qualified default investment alternative used in 401(k)s today, and they claim a sizable portion of the average investor's retirement portfolio.
It's surprising then that as advisors, we are so bad at selecting TDFs that actually work as our clients believe they will.
By recommending products based on outdated models and assumptions, advisors often lead clients into risks they don't need and traps they don't want. It's time to leave old habits behind and ensure clients avoid typical TDF mistakes: unhelpful diversification, flawed glidepath strategies and unwanted risk.
Diversifying or ‘De-worsifying?’
We've all prayed at the altar of asset diversification. It's the most basic portfolio protection strategy. And in "normal" market conditions, asset allocation and diversity can help. However, markets are not always normal.
During bear markets, asset-class risk often correlates towards one and diversity offers little defensive benefit. In 2008, world equity markets failed as did the diversifiers, such as gold. Today's TDF fund managers are still relying on this "de-worsifying" approach by adding riskier master limited partnerships, real estate investment trusts and other sub-equity classes to funds.
Many are also adding large amounts of junk and emerging-market bonds to compete on performance. But these are not "safe" and they too tend to correlate with equities in tough economic times. All asset classes suffer from bear markets, and many of these so-called diversifiers have performed even worse than the S&P 500.
Each TDF employs a glidepath — a formula to rebalance assets annually to reduce risk as the targeted date approaches. Most glidepaths are set on a predetermined asset allocation trajectory that slowly reduces equity exposure over time. But they are nothing more than a series of diversified asset allocations.
Worse yet, when glidepaths were last tested in 2008, many crashed. The 2010 TDFs of the largest providers lost between 21% and 31% in 2008. If your clients lost almost a third of their savings within two years of retirement, could they still afford to retire? Not most people.
If you haven't reviewed your recommended TDFs' glidepath strategies, do so immediately. You may be saving your clients from a very hard landing.
Possibly the biggest mistake TDF managers make is not listening to what clients want. Thus, we just repeatedly follow our own outdated misconceptions.
Today's youngest investors want and can handle the most risk, right? Wrong! This long-held belief is based only on the long recovery times young investors have. However, this strategy contradicts the fact that most young investors want conservative growth.
According to a recent Cerulli Associates study, only 7% of millennials want aggressive growth early in their investing careers. Two-thirds of those surveyed want to be more conservative, and 77% of all participants said they prefer to "protect my portfolio from significant losses, even if it means periods of underperforming the market."
So why haven't the large TDF shops asked investors of all ages how they really want their money managed? Why are the first-generation TDFs stuck with this egregious assumption? Plan advisors, what liability do you have in going along with this assumption?
The issues with the current TDF options on the market affect every age group. It's our job to listen to them, and provide appropriately for all of them.
Break With Past
We all invest to better our futures. We're only human, and if there's a threat to our future, we tend to react emotionally. Above all, investors want steady growth during good times and for their advisor to protect them against large losses in bad times.
A smart investor knows a good advisor's job is to prevent the investor from doing the wrong thing at the worst time. We can't protect against all losses, but we seek to shelter the majority of our clients' capital through smarter TDFs.
Portfolio construction needs to be aligned with investor expectations in all market environments. We must deliver what investors expect and want: portfolio growth, defensive capabilities designed to kick in only when necessary and unbiased guidance.