Redefining Retirement Potential Advantages of Risk-Managed Portfolios VS. Target Date Funds Brendan McCarthy Senior Vice President, Retirement Solutions INTRODUCTION Between October 2007 and February 2009, the Morningstar 2001–2010 target date fund (TDF) category lost 31% of its value1, destroying a significant chunk of retirement savings for millions of American workers who were invested in these “set it and forget it” plan options. Although the U.S. equity market increased by more than 200% between March 2009 and December 2014, plan participants who panicked and sold at or near the bottom of the market downturn — and neglected to get back into the market — have seriously jeopardized their retirement security. This simply reflects the cold, hard math of investment losses: participants who lost 50% of account value would have to achieve a 100% return to recover their investment. Of all the factors that contributed to investors’ realized losses during the Great Recession, one of the most visible was a structural deficiency in target date funds. Target date funds, widely offered in plan investment menus, are a type of hybrid mutual fund that automatically resets the asset mix of stocks, bonds and cash Source: Morningstar, Inc. 1 For use with institutions (Plan Fiduciary, Investment Professional and Authorized Agents of Plan Fiduciary) only; not for use with retail investors or the general public. alternatives in their portfolios according to a particular time horizon — typically an investor’s retirement date. Because investment policies regarding glidepath (that is, how the asset mix changes as the target date approaches) vary significantly from fund to fund, many aggressively allocated portfolios failed to protect shareholders during an extreme period of market volatility. A marketing success, an investment failure Target date funds have enjoyed significant marketing success since their introduction in the early 1990s. Today, they account for 80% of the default investment options in defined contribution plans. There are several good reasons for their popularity among plan sponsors. First, a typical target date fund’s asset allocation policy is likely better than what most participants would do on their own. Second, glidepaths impose investment discipline by adjusting the asset mix to be more conservative as the investor approaches retirement. This helps to mitigate point-in-time risk. In addition, plan fiduciaries are legally bound to select investments that will satisfy certain ERISA criteria (i.e., plans must offer at least three materially different asset classes with different risk-return characteristics). These tenets of modern portfolio theory (MPT), while not always able to mitigate market or timing risks, nevertheless can be useful in setting general asset allocation policy frameworks. Although target date funds fill myriad needs of plan sponsors and their advisors, we would argue that they have been an investment failure for participants. Recent performance has shown how target date funds are ill equipped to meet the objectives of most plan participants, including the following: ■ ■ 2 3 Target date funds have significant limitations on their ability to protect investors from severe market downturns. The challenge to investors posed by the 2008 market downturn should not be considered a rarity. Since 1950, there have been 10 bear markets, defined as those having a market drawdown of 20% or more.2 As a category, target date funds exhibit wide variation in returns that run counter to investor expectations — especially for pre-retirees. Investment losses for funds with a target date of 2010 averaged nearly 24% in 2008, ranging between 9% and 41%. The three largest issuers of target date funds extended losses to between 32% and 37% in March 2009 — less than 10 months before the target retirement date.3 Funds with target dates approach- ing the retirement target date failed to protect investors when it mattered most. ■ For virtually all investors, the most important aspect of risk management is very straightforward — “try not to lose my money.” Most fund managers’ incentives are not aligned with this dictum. Furthermore, agebased, static, or gradually declining equity exposures imposed at or after the target date typically are designed to address diversification requirements and hedge inflation risk over a 40-year horizon. The drawback of this approach is that these products usually do not take into account current market environments in setting and/or changing investment policy. In the absence of risk-sensing and de-risking mechanisms, target date funds can potentially experience big losses in severe market downturns. Participants rely on plan fiduciaries to select investments that will help them retire on time and live in retirement with some level of confidence. What’s needed for plan participants are core or default options within a new category of plan investments that (i) consider investor experience over full market cycles; (ii) put the investor’s experience at the center of investment decision-making; (iii) incorporate downside risk management (that is, a defensive bias); and (iv) de-risk and re-risk as market conditions dictate using a consistent, repeatable process. F-Squared is a leader in the development of a new category of retirement plan investments based on these four principles. We believe risk-managed portfolios are a more suitable alternative to target date funds because they offer better alignment between the goals of plan sponsors and their participants. Risk-managed portfolios are designed to target relative returns in healthy markets and provide risk controls in down markets. Before discussing the benefits of this approach, it is useful to understand the risk management limitations of target date funds. Flawed design, imperfect results Target date funds typically do not take into account factors beyond target date and single-serve measures of risk tolerance. Indeed, the only clear differentiator among most funds is the end-to-end structure and contour of the glidepath. Designed to perform well in rising markets, few target date funds offer investors protection from periodic bouts of extreme, value-destroying volatility. In fact, many of the flaws of target date funds reveal themselves when we examine their 40-year performance S&P Capital IQ Insights, “History of the Financial Markets”. http://fc.standardandpoors.com/cms/Custom_Site/57488/gallery/S&P_Chart_FINAL.pdf. Robert Boslego, “Why target date funds fail in the one area they’re supposed to succeed — downside protection,” www.riabiz.com, 7/21/13. http://www.riabiz.com/a/22831965/why-target-date-funds-fail-in-the-one-area-theyre-supposed-to-succeed----downside-protection projections and simulations. In our view, many target date glidepaths typically ignore short-term market “interruptions” (that is, extreme market disruptions in which the core assumptions of MPT do not hold). In addition, many target date return projections are based on the belief that markets are rational, and therefore do not incorporate risk management mechanisms when investors behave irrationally. One only need consider the lack of ‘true’ diversification protection that occurs when investors in all asset classes exit all at once. We recall during most of the 2000s, traditional or otherwise non-correlated assets tended to move in sympathy during periods of extreme volatility. a retirement account, risk-managed portfolios better align the objectives of plan sponsors, participants, and advisors. The AlphaSector® Risk Managed Portfolios, collective investment trust funds offered through a partnership with Reliance Trust Company, are also designed to provide at least two other potentially significant benefits to retirement-focused advisors: ■ Some plan providers unintentionally mischaracterize target date funds as “do it for me” investments, suggesting that participants in those funds are receiving some level of personalized advice beyond the glidepath. Experience shows that the commonly made claim that TDFs qualify as investment help is not entirely accurate, as participants tend to cycle out of funds during down markets. Moreover, target date funds tend to ignore the potential for significant market drawdowns in setting their long-term glidepath policies. In particular, few target date fund designers consider the heteroscedasticity of volatility (i.e., changing volatility levels over time), volatility clustering (persistence of volatility), and predictability of future volatility when formalizing their glidepaths. Instead, the glidepath rules remain static throughout the time horizon set for each fund. We believe this design characteristic may be inconsistent with ERISA guidelines that require plan fiduciaries to adapt to changing circumstances. The AlphaSector Risk Managed Portfolios, on the other hand, can function more like professionally managed accounts. Used as a qualified default investment alternative (QDIA), these portfolios also can easily scale to large groups of plan participants. In addition, by adjusting dynamically to changing risk regimes, they are one of the few available investment options that clearly demonstrate an advisor’s steadying hand, and “value-for-service-provided.” As a way to differentiate an advisor’s business, risk-managed portfolios stand out from commoditized, passively managed target date funds. A better solution: Risk-managed portfolios We believe that plan sponsors who are responsible for assembling risk-appropriate investment menus should use strategies that accurately identify and measure changing levels of risk — especially near those inflection points when volatility regimes move from normal to high-volatility environments. Such strategies are designed to help investors avoid the fallout from severe market downturns. Whether used as an investment option, managed account, or a tactical overlay that can be applied to a pre-set portfolio of funds, the AlphaSector Risk Managed Portfolios may help mitigate or reduce the magnitude of material losses because they dynamically de-risk during periods of significant volatility. ■ Increasingly, plan sponsors are being drawn to a relatively new category of risk-managed portfolio strategies that seek to address the drawbacks of target date funds. In these approaches, managers dynamically adjust portfolio allocations to reflect the current market environment in such a way as to limit the risk of large losses. At F-Squared, we use tactical management or dynamic asset management to actively adjust portfolio risk as markets become more volatile by de-risking (that is, by exiting certain industry sectors and moving to significant positions in cash alternatives) and re-risking when markets become healthier. We believe our risk management approach enables investor portfolios to recover much faster than those that do not make such dynamic adjustments. In addition, by reducing the long-term negative impact to They address misperceptions of target date funds as “advised” products. They are designed to offer two critical layers of risk management. Broad diversification across multiple asset classes and active asset allocation designed to protect against significant market losses are two goals most investors share. This is critical to participants’ engagement with their plans, as countless studies show that participants rarely understand how to appropriately manage the risks they bear. Risk-managed portfolios dovetail with advisors’ need to offer risk-conscious solutions in the DC space that were formerly only available to DB plan managers. These include tactical asset allocation, risk parity, and a broader set of asset classes such as commodities, real estate, and so on. For use with institutions (Plan Fiduciary, Investment Professional and Authorized Agents of Plan Fiduciary) only; not for use with retail investors or the general public. Conclusion A growing number of plan sponsors are looking to identify the next evolution in 401(k) investment menu design — one that will enhance their plans and improve participant outcomes by adding downside risk management as a fundamental component of their investment policy. As a category of investments previously available only to high net worth and institutional investors, risk-managed portfolios have the potential to satisfy participants’ needs for volatility-dampening strategies. They are also designed to reduce the risk of loss during economic downturns, while providing good upside in healthier markets. For plan sponsors, downside risk management investments such as risk-managed portfolios may provide a better match for their participants’ risk tolerance. In these portfolios, advisors may discover a pathway to a more innovative investment menu design that delivers what investors really want — increased participation in healthy markets, and limited losses in down markets. F-Squared Investments is an asset manager that provides next-generation investment indexes and strategies based on its AlphaSector® and Portfolio Replication Technology capabilities. The firm seeks to provide an investment approach that repeatedly protects clients in down markets and helps them participate as much as possible in up markets. F-Squared focuses on delivering powerful and innovative investment solutions to help meet investors’ expectations and financial goals. The firm serves clients in the advisor, institutional, retail and retirement markets. F-Squared Investments is based in Wellesley, MA, and Ewing, NJ. www.f-squaredinvestments.com Important Information “AlphaSector®” is a registered trademark of F-Squared Investments, Inc. and is used with permission. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from F-Squared Investment Management, LLC or one of its subsidiaries (collectively, “F-Squared Investments” or “F-Squared”). F-Squared reserves the right at any time and without notice to change, amend, or cease publication of the information contained herein. This material has been prepared solely for informative purposes. The information contained herein includes information that has been obtained from third-party sources and has not been independently verified. It is made available on an “as is” basis without warranty. The Funds are not intended as a complete investment program, and there can be no guarantee that they will achieve their goals. The Funds’ returns will fluctuate. Each of the underlying ETFs in which the Funds invest has its own investment risks, and those risks can affect the value of the Funds. The Funds are not insured or guaranteed by any government agency, by Reliance Trust Company, or by the Sub-Advisor. The views expressed in the referenced materials are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. The information provided herein does not constitute investment advice and is not a solicitation to buy or sell securities. The ETFs may not meet their own investment objectives. An index ETF may not accurately track the performance of the related benchmark index because of operating expenses, transaction costs, cash flows, regulatory requirements and operational inefficiencies. For example, it may take several business days for additions and deletions to the related benchmark index to be reflected in the portfolio composition of the ETF. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from F-Squared Investment Management, LLC or one of its subsidiaries (collectively, “F-Squared Investments” or “F-Squared”). F-Squared reserves the right at any time and without notice to change, amend, or cease publication of the information contained herein. This material has been prepared solely for informative purposes. AlphaSector Risk Managed Portfolios These Portfolios are bank collective trust funds for which Reliance Trust Company (“RTC”) serves as trustee and investment manager. Participation in these Collective Trust Funds is limited to Eligible Trusts that are accepted by the Trustee as Participating Trusts. As more fully described in the Declaration of Trust, Eligible Trusts include a pension or profit sharing plan that is “tax-qualified” under Section 401(a) of the Internal Revenue Code of 1986 and is not a Keogh plan or a plan that covers any “self-employed individuals” (as defined in Section 401(c)(1) of the Internal Revenue Code of 1986) and is an Eligible Plan as defined in the Declaration of Trust. Reliance Trust Company is chartered by the State of Georgia and regulated by the Georgia Department of Banking and Finance. Reliance Trust Company is a wholly owned subsidiary of Reliance Financial Corporation. Reliance Trust Company is headquartered in Atlanta, Georgia. Reliance Financial Corporation is a holding company headquartered in Atlanta, Georgia, which owns several financial services companies, including Reliance Trust Company. Reliance Financial Corporation and its affiliates have been in business since 1975. Reliance Financial Corporation is an indirect wholly-owned subsidiary of Fidelity National Information Services, Inc. (NYSE: FIS). These Funds are bank collective trust funds for which Reliance Trust Company (“RTC”) serves as trustee and investment manager. The Funds are not FDIC insured and are not guaranteed by Reliance Trust, nor guaranteed by any governmental agency, or by the Sub-Advisor. ETF Risk: Since the Funds invest directly in the ETFs, all risks associated with direct investments in securities made by the ETFs apply indirectly to the Fund. There can be no assurance that an ETF (or the Funds) will achieve its investment objective. To the extent the Funds invest more of their assets in one ETF than another, the Funds will have greater exposure to the risks of that ETF. Target Risk Fund Risk: In addition to the risks inherent in the asset classes of the underlying exchange-traded funds, Target Risk Funds are also subject to asset allocation risk, which is the chance that the selection of underlying ETFs and the allocation of ETF assets will cause the fund to underperform other funds with a similar investment objective. Liquidity Risk: Under certain market conditions, ETFs may not be able to pay redemption proceeds within the normal time period because of unusual market conditions, an unusually high volume of redemption requests, or other reasons. To meet redemption requests, an ETF may be required to sell liquid securities at an unfavorable time. Management Risk: A strategy used by the Funds or by an ETF may fail to produce the intended results. Redemption Risk: A large purchase or redemption of Fund Units could adversely affect the performance of the Funds. See the Funds’ offering circulars for more detailed information about risks. Fund Acquired Fees and Expenses: Funds that invest in other registered, pooled or collective funds incur no direct expenses, but they do bear proportionate share of the operating, administrative, and advisory expenses of the underlying funds, and they must pay any fees charged by those funds. The figure for acquired fund fees and expenses represents a weighted average of these underlying costs. “Acquired” is a term that the Securities and Exchange Commission applies to any fund whose shares are owned by another fund. For more information on the acquired fund fee expenses for these products, please see the Funds’ offering circulars. To request a copy of the Funds’ offering circulars, call (781) 772-2568. The offering circular includes investment objectives, risks, charges and expenses and other information that you should read and consider carefully before investing. CC955 60005-0215-00 For use with institutions (Plan Fiduciary, Investment Professional and Authorized Agents of Plan Fiduciary) only; not for use with retail investors or the general public.
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