Rob Arnott’s Problem with Target-Date Funds (and Why I Disagree)
Human capital theory says young people’s wealth is mostly in the form of future earnings, giving them the liberty to invest their relatively smaller portfolios more aggressively. This capacity tends to diminish with age. It is here that target-date funds find their basis, and it is also where Rob Arnott and I disagree about the value of such funds. But first, a little context may be beneficial.
Mr. Arnott recently presented “Problems with Target-Date Funds and What Advisors Can Do About It” at the Financial Advisor Retirement Symposium in Las Vegas. The presentation consisted of two major components: his “Glidepath Illusion” — previously known as the “Portfolio Size Effect” — and what he perceives as four limitations of current target-date funds. I disagree with some of Arnott’s conclusions and will explain why.
With the “glidepath illusion,” Arnott returns to an old argument that can be boiled down to this: In the accumulation phase of financial planning, a rising equity glidepath performs better than a declining equity glidepath. [Note: This discussion has nothing to do with whether rising equity glidepaths are advisable for post-retirement distributions.]
Arnott compares an equity glidepath moving from 80 percent to 20 percent over one’s career (from, say, age 25 to age 65), to a fixed 50/50 asset allocation, to an inverse equity glidepath starting at 20 percent stocks and increasing to 80 percent stocks. He argues that when simulating these glidepaths with U.S. historical data, the inverse glidepath always provides more wealth by the targeted retirement date. The inverse glidepath creates little downside risk. The same conclusion was reached by Anup Basu and Michael Drew in their 2009 Journal of Portfolio Management article “Portfolio Size Effect in Retirement Accounts: What Does It Imply for Lifecycle Asset Allocation Funds?”
My rebuttal to the idea of using inverse glidepaths in the accumulation phase was published in the Spring 2011 issue of Journal of Portfolio Management in an article called, “The Portfolio Size Effect and Lifecycle Asset Allocation Funds: A Different Perspective.” In it, I found that the inverse glidepath results don’t fair well when comparing wealth accumulations on a pairwise basis in each simulation rather than simply looking at the distribution of outcomes for each individual glidepath. I also found that the results for inverse glidepaths are weakened when considering more realistic glidepaths. I further examined results for 17 countries, not just the USA. Finally, I used the expected utility framework popular in academic economics to quantify the degree of risk aversion needed for savers to accept the lower expected returns of traditional glideapths in order to obtain greater downside risk protection.
I found traditional glidepaths preferable for reasonably moderate and conservative investors. I don’t think the mere notion that inverse glidepaths generally perform better in the historical data is sufficient to move real-world savers away from them.
Arnott’s presentation added one critical detail. Basu and Drew did not advocate using an inverse glidepath. They merely showed how it could create more wealth than a traditional glidepath, while simultaneously making a meaningful comparison in terms of both glidepaths sharing the same time-weighted stock allocation. In reality, their article suggests that the only way to see absolute wealth increases is to keep stock allocation high throughout the accumulation phase, even when approaching retirement.
But the Arnott team goes one step further and advocates using the inverse glidepath in practice. Their argument: Young investors should not invest aggressively until their true risk tolerance is revealed in the fires of a significant market downturn. Some may swear off stocks for life, while others who hold their positions may add more stocks after they prove themselves to be true long-term stock investors.
The final part of Arnott’s presentation provided four criticisms of how target-date funds are created in practice:
1) Target-date funds are poorly diversified. Arnott wants to see inflation protection built up through assets outside the core stock and bond asset classes by including more commodities, high yield bonds, TIPS, and REITs.
2) Target-date funds have inefficient asset-class exposure. This point is at the core of Arnott’s investment philosophy. He believes capitalization-weighted indices are an inherently bad idea as they increase exposure to overpriced assets and decrease exposure to underpriced assets. He seeks to break the link between the price of an asset and its portfolio weight, allowing for more of a tilt to smaller and more value oriented stocks.
3) Target-date funds use constant risk-premia assumptions. During his presentation, Arnott reviewed how current bond yields are excellent predictors of subsequent bond returns. He also covered how Shiller’s price-earnings ratio provides decent explanatory power about the level of subsequent stock returns. I believe his point to be that target-date funds should respond to these factors with increased tactical asset allocation.
4) The fees for target-date funds are too high. Morningstar’s analysis of target-date funds reveals an average asset-weighted expense ratio of 0.84 percent. That’s a high price for something with no customization beyond age and target date.
I don’t dispute these four general points. We can always work to improve the design of existing target-date funds, but I still find target-date funds to be reasonable default for the accumulation phase for individuals with little interest in investing and little to no working relationship with a financial advisor. An inexperienced investor could do much worse. When we know more than just someone’s age, better strategies can be created. When we have only their age to work with, target-date funds do just fine.