PM Corner: Managing target date strategies through all market cycles
Portfolio manager Dan Oldroyd discusses his approach to target date investing and how he actively manages assets while keeping a long-term focus.
What is your approach to target date investing?
Our primary purpose is to help participants reach the retirement finish line with roughly 90% income replacement, so we take a very long-term view, emphasizing diversification and carefully managing risk, especially as we near the target date.
Our target date funds (TDFs) have an investment horizon of at least 40 years and are diversified within asset classes and across global markets. We believe a truly diversified strategy has the potential to deliver better risk-adjusted returns and provide a smoother investment experience along the way.
As target date investors approach retirement age, we take a more cautious approach to the funds’ exposure to equities and focus on managing sequence-of-returns risk: the risk that a participant experiences a significant decrease in asset value that then reduces the compounding potential of those assets.
How do you manage target date funds over shorter time frames given their long-term goal and design?
While glide paths are designed with very long time frames in mind, we believe it is a prudent approach for TDF managers to think about current market environments. The active asset allocation component of our investment process is key to managing the portfolios over shorter to intermediate time frames.
Our process uses a combination of proprietary quantitative modeling and qualitative strategy inputs from a wide range of asset classes, incorporating rigorous risk budgeting and portfolio construction tools.
Active asset allocation has the potential to generate incremental return for investors while also helping to reduce volatility during periods of market stress, which can preserve value over the long term.
For example, we have the flexibility to address changes in interest rates by underweighting fixed income relative to other asset classes, shortening duration and paring back exposure to rate-sensitive asset classes. We can also under- or overweight our allocations to equities along the glide path, across the capital structure and across regions, if we believe this positioning would add value or reduce risk.
How are the portfolios positioned in the current market environment?
Over the last year, our strategic allocations to high yield and international developed equities have added value during a period of volatility and mixed results from U.S. equity markets.
We are now cautiously positioned and moderately underweight risk assets, given the current environment of persistent inflation, tightening credit conditions, sub-trend growth and the potential for recession. We are underweight both equity and credit and overweight core fixed income.
Do you expect this macroeconomic backdrop to persist?
The Multi-Asset Solutions team constantly revisits its short- to intermediate-term asset allocation views. Currently, the team is keeping a close eye on several indicators, including increasing caution from businesses, consumers pulling back, sharply tightening credit conditions and worsening geopolitics.
We might consider taking a more pro-risk stance with further clarity around the actions of the Federal Reserve (Fed) and other central banks, and evidence that both the consumer and corporate balance sheets remain healthy. We’re also continuing to evaluate a number of signals that could support adding to risk assets, including how the balance of global equity valuations and economic growth potential vs. recession risks may shift.
How do you think about active vs. passive approaches in target date investing?
The defined contribution market has seen a huge shift toward low-cost, passive strategies, and TDFs are no exception. However, we believe the term “passive target date fund” is misleading – all TDFs are actively managed strategies when it comes to the most significant drivers of participant experience, such as asset class diversification, glide path design, underlying investment strategy and portfolio construction.
In reality, “passive” only refers to the underlying strategies used to populate these TDFs’ glide paths. That also means the passive vs. active decision is not an either/or choice. Many TDF providers integrate components of both into their underlying investment strategies: passive investments for asset classes that are easier to index, which can help manage fees, and actively managed investments where managers can add value. We employ this approach in some of our TDFs. Most importantly, the TDF should align with the plan’s objectives and demographics.
Some of your portfolios invest in direct real estate. Do you still see value in the asset class given its recent challenges?
We believe in the power of diversification. The U.S. institutional commercial real estate market is the largest asset class after stocks and bonds. Private real estate has demonstrated strategic long-term benefits within target date funds, despite the current period of reduced liquidity and valuation adjustment.
Within our portfolios that invest in private real estate, we target a 7% allocation to our open-ended, core real estate strategy, which is the largest fund of its kind (based on gross asset value). As an uncorrelated asset class, the portfolio management team expects the exposure to private real estate to reduce portfolio volatility, provide total return and hedge against long-term inflation, all of which has been achieved since the fund’s inception.