Morningstar Advisor - Spring 2008 - (Page 50) Spotlight Equity Exposures of the Largest Target-Maturity Families: Target-date funds offer investors a variety of equity exposures. The range widens as funds get closer to their retirement dates. 100% Growth 80 Max 60 40 20 2055 2050 2045 2040 2035 2030 2025 2020 2015 2010 2005 75th 50th 25th Min to work and earn money over time—is like a giant bond that should provide the investor with relatively stable cash inflows. We say “relatively” stable because business cycles, job skills, structural industry changes, and personal quirks can affect income flow. The average investor’s bond-like income stream, therefore, is not usually investment grade, but rather “junk-bond”-like. Not a welcome comparison perhaps, but necessary so the right planning can take place. Due to this overweighting in bond-like human capital, younger investors need to invest the vast majority of their retirement savings, or financial capital, in equities to create a balanced portfolio. How much equity is appropriate? We start with a high-level perspective that determines both an investor’s capacity and preference for risk. Some investors, such as tenured professors, have secure jobs with stable income. We define these investors as those with safe human capital who have the capacity to take on a little more investment risk. Investors with jobs in cyclical industries or those with high levels of variable compensation fall into our risky human capital category. These investors theoretically have a lower capacity for investment risk when it comes to retirement savings. The average investor falls in the middle, with average human capital. To provide solutions beyond arbitrary glide paths or one-size-fits-all solutions, Ibbotson Associates has conducted a significant amount of research on lifetime asset allocation. The Ibbotson model combines Modern Portfolio Theory with annual government survey data on investor wealth and income trends to define the optimal portfolio of global securities that theory says investors should hold over a lifetime. This mix is called the “market portfolio,” and it’s currently defined as 54% bonds and 46% equities. The Ibbotson model then isolates the human capital portfolio from the market portfolio 2000 Income/1999 2005 1 2005 2003 02 2006 2004 The equity allocations between value and Our Asset-Allocation Methodology Given the wide variety of frameworks guiding growth, domestic and international, and large asset allocations today, it is natural, with cap and mid/small cap are also diverse. Figure 2: Current Industry Target Maturity Glidepaths (Total Equity Exposure) so much at stake for investors, to wonder who’s A fund’s management usually has a sound 50th 75th 25th Min Max right. We have to be honest and say that in reason for why the asset class is a legitimate many respects there are several right answers addition, but the rationale behind how and that glide-path diversity is beneficial much to allocate to that asset class remains to investors. The right answer is really relative opaque in many cases. to the individual investor’s situation. The nonequity allocations may also vary; Unfortunately, today’s target-date funds aren’t adding high-yield debt and minimizing set up to meet each investor’s individual needs. cash levels are two popular decisions. Some They assume that all people retiring on a funds might also add a small percentage certain date are in the same financial situation of alternative assets such as real estate, TIPS, and deserve the same asset allocation. There is and commodities to fight inflation and provide no consideration for investors who need the portfolio with a return that is uncorrelated to aggressively catch up on their savings, for to equities or bonds. example, or for investors who desire a more conservative allocation to protect their savings. Security selection to represent each allocation is another hot topic. Most target-date funds This is where financial advisors, and Morningembrace actively managed funds for their star’s new indexes, can play an important security selections in an attempt to outperform role. By fully understanding each client’s unique indexes. Some funds advocate using passively financial circumstances at certain checkmanaged investments such as index funds, points, advisors can select the most asserting that lower expense ratios offset appropriate target-date framework. To start, potential outperformance from active advisors should examine the investor’s most management. Industry research and Morningvaluable asset during the accumulation phase, star’s analysis of active and passive fund which in most cases is human capital. managers lead us to believe that it will likely be asset allocation, not security selection, that We define human capital as the present value drives a significant portion of a target-date of a person’s future earnings. The details can portfolio’s return over time (See Brinson, Hood, vary, but basically human capital—the ability Beebower, 1986; and Ibbotson, Kaplan, 2000). 0.10 0.08 0.06 0.04 0.02 50 Morningstar Advisor Spring 2008
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