Episode 374: The Underperformance of Target Date Funds

24:36So it's not really a fair choice to say those are necessarily coupled. That said, it could be that active fund managers, some TDFs are actually more active in managing their glide paths than others. And we'll get to that in a minute. So the other big consideration is that we really don't know what an optimal glide path looks like. in the academic literature, there's general consensus that it should be downward sloping, so less risk over time. But some people have proposed it could actually be upward sloping. And one of my colleagues here at the University of Arizona who's been on your show recently argues for essentially an all equity retirement portfolio split between domestic and international funds because of some long-term return properties.

25:13And it's a fascinating paper by Scott Cederberg and co-authors. But essentially, the jury is still out on what the optimal glide path is. While you might think you want a riskier glide path, sure, you can go for that. You can clearly see some are going to have more risk than others. But again, I think that can be separated out from how active your manager is at the end of the day. Like you said, we don't know what the optimal glide path is. So it's a bit of a tricky question to ask. But if we believe that a higher equity allocation is good, as Fidelity suggests it is, and as Scott Cederberg's research suggests that it is, what do you think about the argument that the active management in Fidelity's active target date fund actually allows the plan participants to feel more comfortable with a higher equity allocation.

25:55It's like the money doctor's paper in Journal of Finance, where even if it's not working, the end investors trust that the active managers are doing something good for them that allows them to take more equity risk, and that's not a good thing. What do you think about that? I think there's definitely something to be said for that. There are all sorts of behavioral considerations that have to be accounted for when thinking about target date funds, because these are people making real decisions, not in a vacuum of an academic model. That said, with the money doctor's perspective, the assumption is you're working with somebody that you can trust and you can develop that relationship.

26:27In these cases, somebody is picking a plan off of a menu in a 401k and they have no idea whether there's a person doing anything in the background there. So I'm not sure how much it really matters in this setting. There's a small slice of investors who access TDFs directly through a financial advisor. But if you're going through a financial advisor, odds are that they're going to be more actively managing your portfolio, or at least managing the asset allocation more than just putting you in a plain vanilla TDF. They could, hopefully they're not charging you too much if that's the piece they're doing there.

26:57I don't love that argument about active management allowing people to take more equity risk. We on this podcast typically advocate for index funds, but it is a comment that I've heard with respect to target date funds. Like, yeah, active management might underperform, but it's going to let people feel more comfortable with more equity risk. Therefore, it could be actually a good thing. Your comments made a lot of sense. So in designing an alternative solution, how would you address the dispersion in glide paths across TDF fund families? You have all these different TDF families that have big research teams that they've employed to design these optimal glide paths.

27:32So we have a lot of different people arguing over this. Again, it's fascinating how distinct these glide paths can be. Again, they're generally downward sloping, but they change frequently and they can have very different slopes and they're all over the place. So my perspective on this is we have a bunch of people, let's use the wisdom of the crowds. This has come up in lots of other contexts and shown to work well. So essentially, if you take the industry aggregate asset allocation and use that as a way to drive a TDF, I think that could actually be a very valuable product. and that essentially you're indexing the indexers almost.

28:06You're taking the index fund idea to an asset allocation level rather than to an individual asset class level, which has been what's been very successful up to this point. That's a super interesting idea. Do you asset weight that or just equal weight the allocations of other target date funds? I think there are a lot of questions on how you want to do it. The first level question is, do you give Vanguard 40 % of the weight? Vanguard is a very particular asset allocation. they use four to six funds rather than many of the sub-asset allocations. They're just going to be very high level. They have 40 % of the assets.

28:39They're generally on the conservative side. That's where some careful thought can be put into it. And we actually might see multiple index providers come out with something like this that all have a different flavor to them. Because the other big question is how quickly do you react to the industry? Because like we'll talk about in a minute, some of these funds are changing their glide paths very frequently. And do you necessarily want to be chasing these quick changes in asset allocation if you're more of a stable long-term index type idea. Yeah, especially given that those tactical changes are not doing so hot.

29:09Can you keep going on? How often do target date funds tactically deviate from their glide path designs? Before I get too deep in this, I want to talk about the glide path design and what we can do and what we can't do. Glide paths are something that we can observe from time to time. That's essentially what we do each quarter. We see the asset allocation, and we see it across different vintages within a TDF series. A TDF series will have a 2025, a 2030, a 2035, all the way out to 2070. And I think there might be a 2075 on the market now, but there aren't many of them. So you can essentially piece together the glide path by seeing how that asset allocation changes at one point in time across the different vintages.

29:49Is that their intended glide path? Not necessarily. They oftentimes put a graph in their prospectus that comes out once a year that kind of shows here's our glide path, but they also say we can deviate from that. And oftentimes that picture doesn't change much from year to year, even if their asset allocation did change from year to year. What they're intending to do in their glide path is very different than what we can capture. What we can capture is just how did the asset allocation change? When we look at how did the asset allocation change, and we can do that relative to how we expected it to evolve along the glide path, we see that within from one quarter to the next, they're changing their glide paths by about 4%.

30:29What that means is say you just had a two asset portfolio, stocks and bonds, 50-50. That means by the end of the quarter, you've gone to 54-46. So that's a pretty big shift. And if you go out a year from that initial point where you measured it, now it's 9%. So very big swings in the glide path. again, on average over either one quarter or over the course of a year. How do you measure the intended glide path of a fund family? That's what's really hard to understand. What is the strategic glide path versus the tactical glide path? The strategic asset allocation versus tactical asset allocation.

31:06Strategic generally is thought of as these long-term shifts of, okay, we've done a bunch of research and we've decided that we do want to increase the overall equity exposure. This happened with Vanguard. I think it was back in 2016, but they made a big strategic shift and all of their glide paths shifted up, essentially. Versus tactical changes are, ooh, our capital market assumptions have changed for this year. We really think US equity is going to outperform international equity. And so we're going to switch and up US by 5 % and decrease international by 5%. That'd be more of a tactical change.

31:39So the problem is as researchers, we can't get in the TDF managers heads and they don't put out press releases that say exactly what they're thinking when they make these changes. So I think it's really important to note that we are not capturing the intent really at all. It's just when they made changes, did those changes end up to be good moves or not? That's kind of the analysis that we can do. You're estimating what their intended glide path was, but you don't actually know what it was. Exactly. And then you're measuring whether they deviated from what you are estimating their strategic asset allocation to be.

32:11It's a couple layers here. The basic idea is that we know the glide path is downward sloping. We can see how it changes from 2025 to 2030. And so as we go from 2025 to 2026, we can expect a little bit of that drift to be incorporated into their asset allocation over time. We expect equity to go down a bit, almost zero if it's a long out retirement vintage like 2060s. If it's 2025, we expect a more significant decrease in equity. And so then we can say, okay, we expected equity to go from 50 to 49%. What actually happened? And that's really where this next level of research goes is to say, how much was that change?

32:51What direction was it? And did it actually lead to better returns or not? What effect are increasingly active tactical glide path changes having on the target date fund returns? On average, not a good effect. These are not huge effects. In the last paper, we were talking about 1 % per year. We find about a 10 basis point effect here. On average, because they're changing their glide path, it's hurting returns by about 10 basis points. Not huge, but when you think about Vanguard, 10 basis points is about what their fee is. And if all of a sudden you're layering an extra cost on top of investors by essentially being active when you didn't have to be, these managers could have essentially said, hey, here's our glide path.

33:36We're going to stick to it. And they would have done better. That's the overall industry picture. That's not true for every manager at every point in time, but that's what we've seen on average over the last 20 years or so. The managers, they're not saying that they're doing this, if I understand correctly, because you're estimating what the intended glide path was and then measuring deviations from that. Fidelity is not coming out and saying we're overweight, whatever, in our asset allocation this year. Certainly not with the target date funds. I think, again, you get some of this discussion when they talk about their capital market assumptions, and that's more fund families overall putting these kind of assumptions out there.

34:11but you don't see it in a narrative from the target date fund managers. It is a question of, I still wonder exactly why they're doing this. And some of the managers, you get a chance to talk to them and they have convictions around those capital market assumptions. They really believe that they know what they're doing and that this is gonna better position their investors. I've never gotten the sense that anybody is trying to do this against their investors. Everybody's trying to help the investors and get them better returns and get them successfully to retirement. So all the good intentions in the world are there.

34:41On average, the industry just doesn't seem to be delivering where they think they can. Man, so why are they still doing it if it's leading to underperformance? I think this comes back a little bit to you talking about behavioral things earlier. We are people. One of the biggest things we see is that the underperformance from being active tends to concentrate when people chase returns. I see that equity is overperformed in the last quarter. and rather than rebalancing back towards my intended or my previous glide path, at least, instead I end up chasing that and saying, okay, just again, as an example to make things concrete, you're 50-50 to start the quarter and equity outperforms bonds.

35:22So maybe you end up just because of returns at 52-48. The rebalancing would have you go back to 50-50 and maybe actually decrease equity slightly to follow that glide path. Instead, a lot of these fund companies are actually chasing and saying, well, let's go 54 % equity next quarter. To an extent, there is a momentum effect. So they might be trying to pick that up, but they don't seem to be doing it successfully over time. I don't think people using targeted funds realize this is happening. No, not at all. Whenever I present this paper, people are generally shocked that there's that much change in the glide path because glide paths are thought of as very stable.

35:59We're just basically giving you this asset allocation and making small tweaks per quarter. But when you actually go to implement these things, there are all sorts of money flowing in. There's all sorts of money flowing out, depending on which vintage you're in. As a result, there's a lot of management that has to happen to keep that glide path where you want it to be. And returns are going to be different across asset classes. So you do have to think, how are we going to rebalance? And that's a very active choice in managing the fund. With all that, it introduces scope to make these other changes as well.

36:29It's really hard to keep the human bias out of this systematic platform. especially when you're getting paid to manage the fund and the pressure to come up with your best ideas and put them into the fund, even though those best ideas might be really hard. Predicting macroeconomic trends is not easy. Active managers picking stocks is hard. I think it's generally accepted it's even harder to pick macro moves. So how do you know you're not just observing incomplete rebalancing at your sampling intervals? Again, we only observe quarterly, so we can't fully rule out rebalancing. This is the academic in me.

37:02However, what we can show is look at people making that move from 50 to 52 % because of returns. We can ask what percentage of the time do they actually continue on and chase the return versus rebalance it? 38 % of the time, people are actually gonna chase that return. About 24 % of the time, they're in the middle and the rest, they're actually going rebalancing the other direction. Essentially, we can show how often people are chasing returns, and we're pretty confident that most of it is not driven by a lack of full rebalancing. And you can actually see big patterns across different fund companies.

37:39Vanguard, they almost entirely rebalance every quarter. American Funds is another that rebalances most of the time, whereas JP Morgan or Fidelity, they tend to be much more active and more likely to be in that return chasing category. It's really interesting that it shows up by fund grouping like that. What's your big picture main conclusion on how these tactical glide path changes are affecting target date fund performance? For right now, it's not good. It's that when fund managers are active, they are doing so to the detriment of investors. It would be better if the whole industry decided to just set the glide path and implement it rather than making these tweaks.

38:19Does that mean they shouldn't have researchers working on this and trying to figure out better glide paths? No. But I think there should be some tempering of how aggressive they are in making these changes. Another stat that I find crazy is that in any given quarter, 40 % of TDFs either add or delete a fund holding. So they're taking a fund out and replacing it with something. Maybe it's large cap for another large cap, or it could be that large caps switching out for a bond fund. But the fact that they're switching out that frequently tells me maybe we should all just say, hey, it's okay to not do too much.

38:53Maybe that could just be a mantra in the industry for a little while. And hopefully investors will do a little bit better because of a lack of activity. Okay. Our final few questions for you. So based on all your research, what are your views on the state of target date funds? I want to start out by saying I am a big proponent of target date funds. When they became a QDIA in 2006, what they replaced were basically money market funds. So 20 years ago, investors, if they didn't pick any other asset allocation, would just have their money in cash. They would earn very little, no stock market exposure, not going to set you up for a very good retirement.

39:29So shifting to TDFs has been a massive positive improvement for investors. There are huge trends in the industry that are decreasing the costs, and there are more and more really great products out there for people to use. That all said, there's this huge dispersion, so there's still a lot we can do to make TDFs better. And that's what I view as my role as an academic is to help people understand, one, there is this dispersion, but two, there are ways to find out whether your fund is performing well or poorly. And then you can make a change based on that. So my co-author and I want to get our data out there.

40:01That way people can make better, more informed decisions. You guys mentioned that these are less of an issue in Canada. And I think similarly in Europe. But I talked to a provider earlier this week that's actually launching indexes in Europe for TDFs. So these are products that are coming out soon. And I think TDFs are going to start bleeding into other spaces as well, making them even more important for us to understand well, and hopefully to make people understand and see exactly what's going on in them. I want to come back to something we talked about earlier, just about the differences in glide paths.

40:32So if someone goes to the website that you've created and finds a fund that's underperforming its asset allocation matched benchmark, if they go and ditch that fund for one that has performed better, but they end up with a more conservative overall portfolio, is that good or bad? Good question. I'm not going to say it's necessarily good or bad. It depends on what market returns are over the next however many years. I'd expect them to generally be positive. Markets go up over time for the most part. But my big question would be, are they going to know which one's going to be riskier or not? And this is a weakness in the data that we have out there so far.

41:07Right now, we are benchmarking to that replicating fund without considering the total risk level. This is something we've realized. And so we're working on developing some new tools. they're really aimed more at plan sponsors and consultants in the industry or people that are trying to provide advice on TDFs to really give you a deep understanding of the asset allocation behind each TDF, how that's evolved, and essentially do risk-adjusted benchmarks in addition to the benchmarking that we've done and talked about today. That's where we're going with the website. We're not there yet, but I think that would be my big thing is say, hey, if you can isolate on risk level, so if you have the risk level you like, now pick the thing that's performing best within that risk level.

41:46And so I think that's a really good question from your perspective to say, let's think about risk level first before we necessarily hone in on how operationally effective you are. That would be super valuable if you could hold the risk level constant, then you could find the most efficient fund at that asset allocation. Safe to say though, you still think targeted funds are definitely a net benefit to investors because it's much better than sitting in cash, but some work to be done potentially, including work to be done on the ability to analyze and compare funds even beyond what you've done so far.

42:16Exactly. Because you do want to do that risk-based adjustment. And then you can start putting yourself into the right category. I mean, there's a whole nother question of, do you know how to put yourself into the right risk category of a TDF? That's a big struggle with the industry. At the end of the day, that comes down to better education, which lots of people are pushing for in this space. So hopefully this can become part of that education as well. I've got to ask, since you brought it up earlier, what are your views? You've done all this work on target date funds. You've been talking to plan sponsors.

42:42What are your views on the Scott Cedarburg 100 % equity lifecycle portfolio research? I think it's phenomenal research that Scott's done. Scott and Mike and I, John, all together. Personally, I have moved more of my portfolio that direction. So in full disclosure, I am much more into the basically half and half US and international equity now. I used to have a bigger bond position. I've followed their advice. part of the reason I've done that is I think I have the stomach to handle downturns. The biggest problem is the behavioral side. If you're going to be all equity invested and we have some big global event like the global financial crisis happen again, it's going to be okay if you can withstand it and you're not going to sell at the bottom.

43:24But time after time, studies have shown that people do. I'm in a very fortunate position. I'm tenured here at the University of Arizona. My income stream is pretty comfortable. I've amassed a decent amount of savings to where if it got cut in half, I'm not going to freak out. Maybe I would, and maybe I'd regret everything I'm saying. But because of that, I think you can invest more aggressively. Is that better for everybody? I'm less convinced. And especially when people can pull the trigger themselves to take money out. Studies have shown that investors are less likely to take money out of a TDF to sell it and move to something else because they're in a TDF versus other assets.

44:01So that's good. People are doing this less. But would that effect go away if we kind of went to these all equity portfolios? So especially if there's a bunch of people that are having not the all equity portfolios, because if you see my buddy down the hall, his fund only went down 20 % and mine went down 40. Now you're going to have even more bad feelings around it. Dealing with these behavioral concerns are paramount to figuring out how to get people better portfolios for the long run. Because I do believe if you can maintain it, the data shows over a huge sample of places in time that that works.

44:35Now, holding the portfolio is a whole nother thing, though. Yeah, I think the behavioral thing is a big piece of that for sure. You mentioned it, but I've seen literature from a couple of different record keepers from Fidelity and I think T. Rowe Price showing the data that you mentioned where they have plan participants changing their asset allocations, the incidence of that happening is much higher for people who don't have 100 % of their portfolio in a target date fund. And it's minimal, like almost zero. And we can put one of these charts in the video for people who are 100 % of their savings in target date funds.

45:11It is pretty interesting to see that. And I think it's a really interesting question to think about, would that change if the target date funds were 100 % equity portfolios instead of whatever their current allocation is? My gut would say no, because most people aren't thinking about this decision. They're getting into the default and they're sticking with it. They're not going to really question it. It's the people that are paying attention that then log in and see how they've done poorly and then decide to make a change. It's one of those if you could just commit to not looking at your account for a decade, you would probably be better off.

45:42I think there actually might be scope for that in the future of providers creating products that people just can't touch. Like a lockbox. Exactly. Exactly. These happen in private equity, and we're talking all about making private equity public now. Maybe we should be thinking about the features of private equity that we can just put on public equity to make it work better for the investors and prevent these behavioral mistakes that happen time after time after time and are probably going to keep happening. Maybe that would break the expected returns though. One of the early criticisms of Scott's paper, they took it out of their paper entirely, I think, was the equilibrium effects of if everybody did this, then the result would not hold.

46:20And I think for the behavioral reasons that you outlined, that that's probably not a risk. But if we created private equity like lockboxes where people could take public equity risk without feeling like they're actually taking it, that might have more significant equilibrium consequences. Well, it might get to the money doctor in a sense that People can feel like they can take more risk if they know they're not going to hurt themselves on the back end. Isn't that interesting? I think to your point, the equilibrium consequences. Scott's paper essentially goes to, would there be a bond market? Right now, there's a huge bond market.

46:50I don't think it's going away tomorrow. For the behavioral reasons, I don't think it's going away. I've asked a bunch of our portfolio managers at PWL. They're familiar with Scott's research. They've listened to him on our podcast. They've heard me talk about his paper. I asked them recently, all of them, why are your the client's not in 100 % equity portfolios. You know what that research says. I got a bunch of really interesting answers, but a lot of them were focused on that behavioral component. Yeah, we know what the research says. The client knows what it says, but they still don't want to be in a really volatile portfolio.

47:17Even if they understand that in the long run, bonds might have their own unique risks and maybe even be a little bit riskier, they still don't want to see that volatility in their account. It helps them sleep at night. It's hard to make that go away. Unless we don't look at it. Yeah, that's true. So after all said and done, what do you hope that individuals and plan sponsors will do with the great research you've done? Use it to make better decisions. Our whole goal is to make the industry more transparent. So if we can give people the tools to make better decisions through both understand the operational efficiency of TDFs, understanding where they're taking the risk and how that compares to other TDFs that are out there, and then ultimately get into better products.

47:57Because we do see such dispersion. I mean, there are still S &P 500 index funds out there that are charging more than a percent per year that still have assets under management. It's all about education and transparency to get people away from these funds that are just too expensive. And so we hope that our research are going to drive people towards that and ultimately make the whole TDF industry better. And hopefully retirement investors are better off in 30 years thanks to the research we've done. Yeah, that's a good answer. On the not looking at a thing, we had a past guest, I can't remember who it was.

48:26I want to say it was Robert Merton, who talked about focusing on payoffs. Instead of focusing on what is the present value, what is the mark to market value of the asset, you can focus on what is the expected future payoff. I think John Cochran talks about that in his paper on portfolios for long-term investors too, where he talks about the inflation index perpetuity is risk-free for the investor, but it's going to be super volatile. But if you focus on the payoff, you focus on the whatever the annuity payment it's going to give you, it feels risk-free. Making public equities illiquid or locking them up or whatever, I don't think people would do that.

48:58I think it would end up being like annuities where nobody wants to buy them because you're giving up control or whatever. But I wonder if there's an opportunity for providers or even wealth management firms like PWL to show the expected retirement cash flow stream and how that changes over time instead of showing the mark-to-market value of the asset. And maybe that helps people stay invested. I think that's a great idea. And I mean, more behavioral research needs to be done. And also think about the policy implications and whether you can get people to go this direction. Ultimately, we got to get people to do it.

49:27And whether that's through regulatory channels or actually just seeing that the market shows that people want these products better and they want this view better. We've gone to a world where people are looking at their accounts through Robinhood and day trading, single day options and this kind of thing. So we've gone the other direction. Maybe we can start working our way back. It's a tough thing to do in an era where investing has basically been gamified for better or for worse. Yeah, you're right. Things are going in the wrong direction and technology is pushing things in the wrong direction.

49:57That's a tough one to reverse, I think. It's interesting to think about. We do tell our clients what their expected retirement income is and how that might change if the market goes up or down or if bond values go up or down or whatever. and we update our expected returns semi-annually. So we have pretty good information to our clients about this is how much you can spend in retirement, which is really what people care about. But they still want to know what the mark to market value of their assets are. I just don't know if you can make that piece go away. It's a fair point. People want to know what they're worth right now.

50:25And the more you're thinking about it and planning for it, the more you start paying attention to it, especially as you get older and you get to those periods where you really don't want to sell right before you hit retirement when you get a big downturn. And it's a hard problem to solve. And I think that's why we don't have a solution for it yet. Yeah, super hard. You can't go to a client and say, no, no, everything's fine. The expected returns went up. So they don't hear that. Double down. Let's mortgage your house again. Second to last question here and a bit of a change of pace. What can you tell us about the Microsoft Excel collegiate challenge?

50:57Thanks for bringing it up, Ben. I just talked about gamifying and investing. I don't love that. What I do like is kind of my other project I've been working on really for the last four years is gamifying Excel. So Microsoft Excel. I don't know if you guys have seen Excel esports. Have you guys seen that on ESPN showing up occasionally? Oh, yeah. It's a new thing. Essentially, I am the founder of the Microsoft Excel collegiate challenge. There's also a pro competition. The program that I founded is really all about providing education for students to get them ready for their careers. I teach financial modeling here at the University of Arizona.

51:30so it's naturally a finance plus Excel class. But in so many other classes, even across the finance department, it's hard to get real world skills that these students need when they graduate into the classroom. I need to cover Black Shoals in the options class. I don't have time to show them how to build a binomial tree efficiently in Excel. Anybody can do it cell by cell, but can you do it in a very efficient way that saves you time and lets you focus more on the analysis and the thinking part? That's what the Microsoft Excel Collegiate Challenge is all about is gamifying Excel, giving students a way to engage with really just fun, creative problem-solving challenges.

52:07That way they're building up their resumes at the same time as having fun. We currently have over 12 ,000 participants around the world. We have big finals event in Las Vegas. It'll be on ESPN this year. So we're really excited to see lots of teams there. We have a couple of Canadian teams. I don't know if anybody's planning to make the trip down to Vegas yet, but anybody that's out there that is out of school, wants to have a team come, please reach out we'll get you guys involved that is the nerdiest thing ever and i absolutely love it and you're here for it yeah it's very cool it's even nerdier when you put the jersey on send me your sizes and we can get you guys some jerseys that's so funny oh man last question david how do you define success in your life i thought a lot about this one because you guys always ask the question and i feel very very fortunate to be where i'm at in a sense i feel like I have the greatest job in the world for me.

52:59I get to work on what I want to work on, when I want to work on it. I was fortunate enough to have gotten tenure a few years ago. That's when I started the Microsoft Excel Collegiate Challenge. I feel like I've achieved success, but going forward, it's all about balance at the end of the day. I've got a lot of different opportunities, things to work on. I want to make TDF investors better off. I want to do more research just to understand it. I want to make students better off. And so as long as I'm balancing how I'm adding value to the world, then I think I'm succeeding. And the part that I'm really working on more is balancing my own personal interests outside of work, so to speak.

53:35I've actually been able to play more tennis and more rock climbing over the last year because I'm a little bit more focused on balance than I have been in the past. If you ask me in a year or two if I've done a good job of balancing all my interests, that'll be my measure of success going forward. Great answer. David, this has been a great conversation. We really appreciate you coming on the podcast. Thank you guys very much. Really appreciate it. And check out our website so you know whether your TDF is doing well. Yes, we will link that in the episode description so people can check it out. I have used it.

54:04It's a really interesting site to explore. Awesome, David. Great to meet you. Thanks for coming. Thank you guys very much.

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