Morningstar - Q1 2020 - 45

75
50
25
EXHIBIT 2

2060

Vanguard 500 Index VFINX from November01991
2050
2040
2030
2015
through October 2019.

Sweet Spot An aggressive portfolio using long-duration bonds earned superior
returns without increasing overall risk relative to other aggressive portfolios.

Although
all three funds have positive returns
Equity/Bond
Allocation:
on
average
30/70 50/50 when
70/30 the S&P 500 has a down
Returnmonth,
long duration gives the biggest boost when
10
equities struggle the most. In December 2018, for
example, the S&P 500 lost 9%, its biggest
monthly loss since February 2009. That month,
8 the
long Treasury fund returned 5.5%, while the
intermediate- and short-term bond funds gained
Bubble size indicates duration:
1.9% and 0.88%, respectively. Conversely, when
the
6
Long-Term
S&P 500 hasIntermediate-Term
its best months, the long Treasury
fund tends Short-Term
to have its worst months.

Equity/Bond Allocation:
30/70
50/50
70/30

2
4
6
8
10
Target-Date Funds Use Long-Duration Funds
StandardHow
Deviation
The trade-off of having the best returns when
equities do their worst and vice versa is
why asset-allocation teams we rate highly from
StateAllocation:
Street, Fidelity, and T. Rowe Price use
Equity/Bond
30/70 long-duration
50/50
70/30
Return
fixed income in their target-date
funds when investors are furthest from 10
retirement and the allocation to equities is at its
highest. Consider State Street's target-date
series, which earns a Morningstar Analyst 8Rating
of Silver for its cheapest share class. Its fixedincome glide path takes the boldest approach to
Tint indicates duration:
using long duration.
It holds long duration 6
Long-Term
as its sole fixed-income
holding until 30 years from
Intermediate-Term
retirement, whenShort-Term
the portfolio's allocation 4
to equities
starts
90% starting
2
4
6 to lower8from its 10
Standardpoint.
Deviation
It continues to hold a 10% weight in
long duration until five years before retirement,
when equities fall to about 60% of the portfolio.

2
Standard Deviation

Return
10
"Goldilocks" Portfolio

8
Tint indicates duration:
Long Term
Intermediate Term
Short Term

6
4

The managers of the Fidelity Freedom target-date
series and the T. Rowe Price Retirement series,
both rated Silver, blend long duration with
other fixed-income asset classes, like intermediate
duration and high yield, which play a larger
role as the series moves away from equities closer
to retirement. Fidelity Freedom 2055 FNSDX,
for example, has a 3.3% allocation to long-term
government bonds, which is half of the total
fixed-income exposure, and it remains the largest
fixed-income position until investors are roughly
10 years away from the target retirement date
and the portfolio's allocation to equities is roughly
66%. T. Rowe Price Retirement 2055 PAROX
has a 2% allocation to long duration, which equals
20% of the fixed-income allocation, and it

Data from November 1991 through October 2019. Source: Morningstar Direct.

remains the second-largest fixed-income allocation
until approximately 10 years from retirement,
when the equity allocation falls to 70% from a
high of 90% in the longer-dated funds.
Putting Long Duration to the Test
Investors should seek to maximize their level of
return for a given level of risk. To see where
long duration gives investors the biggest portfolio
boost, we built model portfolios using each
of the three Vanguard Treasury funds with 30%,
50%, and 70% allocations to the S&P 500 to
represent conservative, moderate, and aggressive
investor portfolios. EXHIB IT 2 shows the
portfolios plotted by their annualized return and
standard deviation over the period from
November 1991 to October 2019.

The blue dots represent the 30/70 equity/bond
portfolios, the red dots represent the 50/50
portfolios, and the green dots represent the 70/30
portfolios. Tint indicates duration. Of the
conservative 30% equity portfolios, the portfolio
containing the long-duration bond fund (the dark
blue dot) is far more volatile than the others.
It is even more volatile than the moderate 50%
equity portfolios containing the intermediate- and
short-duration funds. This is because with
a small allocation to equities, the long-duration
bond fund drives the portfolio's overall
performance. With the moderate 50% equity

portfolios,Tintthe
portfolio containing
indicates
Long-Term the long-duration
Intermediate-Term
fund (theduration:
dark red dot) did
marginally improve
Short-Term
risk-adjusted returns, but it also was significantly
more volatile than the other 50/50 portfolios-
which may be more volatile than a moderate
investor is seeking.
The "Goldilocks" portfolio is the aggressive
70% equity portfolio using the long-duration
bond fund (the dark green dot). The long-duration
fund didn't increase overall risk compared
with the aggressive portfolios using intermediateand short-duration funds, and because of its
strong diversification characteristics, the
long-duration bond fund led to a significant boost
in returns over the nearly 30-year period.
Endgame
Long-duration bond funds have been the best
ballast for equity-heavy portfolios in sell-offs.
There's always a risk that historical correlations
and relationships between asset classes will
change, especially over short time periods, but
diversification remains the best protection
against the uncertainty of future returns. K
Megan Pacholok is an associate analyst, global multi-asset
funds research, with Morningstar Research Services.
Jason Kephart, CFA, is an associate director, alternatives
funds research, with Morningstar Research Services.

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