Morningstar Magazine - June/July 2018 - 58

Spotlight: Packaged Investing

Beyond the Glide Path: The Drivers
of Target-Date Fund Returns
Equity exposure, relatively, has
a small role.

TARGET DATE

David Blanchett and Paul D. Kaplan

Target-date funds are the most popular default
investment in defined-contribution plans today,
largely because they are designed to offer
participants a simple all-in-one investment option.
Their multi-asset structure, however,
means that a variety of factors drive performance,
making performance difficult to assess and
their risk difficult to pinpoint. It can be hard
to compare performance across a single vintage
(two funds with a target retirement date
of 2030, for example), and comparing entire series
compounds the complexity.
Today, plan sponsors generally rely on a fairly
blunt instrument-the glide path-to assess the
risk of a target-date series. That is, a targetdate fund is understood primarily by its equity
allocation. Comparisons among series are
based on the same characteristic. We sought
to better understand target-date-fund performance
by decomposing returns into three components:
equity (or market) exposures (which across
a target-date series combine to form a glide path);
style exposures (mainly due to intrastock and
intrabond allocations); and other investmentselection decisions (such as whether to use active
or passive investments, the specific portfolio
managers selected, as well as any other residual
risk exposures). We did this to understand the
relative importance of each component.
We found (unsurprisingly) that equity exposure is
the primary driver of risk for target-date funds
on an absolute basis, composing approximately

Morningstar June/July 2018

90% of the total variance (versus 9% for style and
1% for selection). The importance of equity
exposure, however, drops significantly on a relative
basis, given the homogeneity that exists across
glide paths today.

Specifically, we found that selection drives about
45% of the variation in returns across targetdate funds, compared with about 30% for style and
just 25% for equity exposure. The impact of
equity exposure increases as vintages approach
their retirement date because of increasing
differences in equity allocations across series.
In contrast, the relative importance of style
decreases as vintages approach their retirement
date, while selection is relatively constant.
Our analysis suggests that while the glide path is
important when considering the risk of a
target-date series, it is an incomplete perspective
given the differences in style and selection
exposures across providers. Therefore, it's critical
for defined-contribution plan consultants and plan
sponsors to look beyond the glide path and
understand the components of risk for a given
target-date series.
Decomposing the Risks

We created a model to decompose the risks
associated with multi-asset strategies into
three pieces: equity exposure; style exposures; and
selection (or other). Equity exposure can
be viewed as the market beta of the portfolio. We
modeled the equity exposure for each vintage
within a given target-date series to be time-varying
to capture moving down the glide path over
time. Style exposures can be viewed as the various
factor exposures within the portfolio, such

as allocations to value, small caps, and
international within equity, or to duration and
quality in fixed income. Selection can be
thought of as the residual return-that not
explained through equity and style exposures-
and represents the risks and rewards associated
with things such as the implementation
vehicles (for example, active versus passive) and
timing decisions.
Understanding the respective exposures for
each of these three components of performance
helps us better understand the risks for
a given target-date portfolio and its respective
series. That's much more intuitive when looking
at absolute returns-if a glide path is more
aggressive than its peers and equities perform well,
we would expect the series to perform well.
What is less clear is how to attribute the
(potential) relative outperformance across different
factors. Just because a glide path is intentionally
more aggressive (or conservative) does
not mean it should necessarily be punished
or rewarded for its market-risk level. Instead, it is
important to understand the drivers of
performance over the long term and benchmark
the decisions accordingly.
Our model uses a factor-regression approach
rather than one based on holdings (such
as holdings-based style analysis) for two reasons.
First, the factor-regression model better
enables us to capture the exposures to the various
sources of risk and return. For example, highyield bonds have a significant equity-market-risk
component but would be generally considered
fixed income using a holdings-based approach.
Second, a factor-regression approach can be easier
to calculate and requires less information about
the investments. While holdings-based information
can be timelier, it may be difficult to obtain
the underlying holdings for non-target-date mutual
fund series, such as for collective investment
trusts. And even when holdings are available,
they may not be reliable (for example, when the
series uses derivative strategies).
We estimated our factor model using an ordinary
least squares regression. We used this approach
rather than a nonlinear optimization (such
as returns-based style analysis) for the same basic

Table of Contents for the Digital Edition of Morningstar Magazine - June/July 2018