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
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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
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not for use with retail investors or the general public.