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Anticipating market dynamics decades in advance is the key challenge facing providers of target-date funds.
While target-date funds and other investment products seek to address longevity risks among retirement-focused investors, the key is a combination of complex statistical modelling and active management.
However, recent market volatility has underscored the need for target-date fund providers to include an element of flexibility in their products that will allow them to pivot fast as a result of the unexpected.
“We want to be able to weather all different types of market environments and regimes, so very long-term market trends,” says Ruthann Pritchard, an institutional portfolio manager with the global asset allocation group at Fidelity Investments in Boston who works on Fidelity’s ClearPath set of target-date funds.
“The question is how do you create something that can solve for asset allocation across an entire spectrum of ages to make sure [the investor] never runs out of money in their lifetime.”
Answering that question, for most target-date fund providers, resulted in what’s known as a glide path. When Evermore Capital Inc. was designing its set of target-date Evermore Retirement ETFs that launched in February, building the glide path was the second step in the process after settling on equities and fixed income as the two primary asset classes.
“The glide path starts at 95 per cent equity and 5 per cent fixed income, then it glides down [all the way] to 45 per cent equity and 55 per cent fixed income once it hits five years after the target date,” says Myron Genyk, Evermore’s chief executive officer in Toronto. “The glide path changes every year.”
Utilizing the Monte Carlo method
To build its glide path, the Evermore team built a Monte Carlo simulator that’s used to predict the probability of different outcomes when there’s a risk of random variables.
Then, they established two different categories of inputs. One set of variables related to markets such as expected returns, volatilities, correlations and inflation expectations. The other category was about the investors in the funds themselves, such as their average savings rates relative to their income levels and age.
“We plugged in all those inputs, ran millions of possible simulations and ended up with 10,000 different possible glide paths,” Mr. Genyk says. “We then ran many different combinations of inputs and every time we did, we looked to see what types of glide paths did well and what types did not do well.”
The goal, he says, was to stress test every potential glide path. In some cases, that meant simulating a 20 per cent market crash occurring right as the target-date investor reached age 65 and faces maximum possible sequence-of-returns risk.
“The glide path we settled on works in most realistic scenarios,” Mr. Genyk says.
When less realistic scenarios occur, such as a once-in-a-century global pandemic, some target-date funds are able to adjust their glide paths accordingly.
“While the glide path doesn’t change often, the asset allocation can be updated if need be,” says Milos Vukovic, vice president and head of investment policy at RBC Global Asset Management Inc. (RBC GAM) in Toronto, which offers the RBC Retirement Portfolios series of target-date funds.
“For example, we could increase the equity or fixed income weight of the portfolio on a tactical basis to take advantage of temporary dislocations in the market.”
The role of active management
Fidelity’s Ms. Pritchard says the firm’s ClearPath series of products has that capacity built into their basic design.
While between 80 and 90 per cent of investment returns in ClearPath products are expected to come from their glide paths, she says, the remaining 10 to 20 per cent come from active management strategies with much shorter return horizons; usually no more than five years.
“As an example, we added commodities to the portfolio a couple of years ago and, recently, they’ve been the strongest contributors to the return,” Ms. Pritchard says.
“We are not going to hold them all the time, but we did believe the market was underpricing the potential for inflation and we knew that commodities have historically done well in inflationary periods, so we brought them into the portfolio as an active decision.”
Fidelity also occasionally updates the glide paths directly, she says. In 2018, her team added Canadian real-return bonds to the fixed income allocation and earlier this year, they reduced their exposure to Canadian investment-grade bonds and added global developed market sovereign bonds and global inflation-linked debt in order to establish more diversification in the face of rising volatility.
RBC GAM’s Mr. Vukovic also notes that holdings are constantly changing in the underlying funds held by the target-date funds. Because of that, he says, “there’s less need for additional portfolio allocation changes in target date funds in between regular glide path-driven shifts.”
Fidelity’s Ms. Pritchard adds there’s no particular cadence to glide path changes, “but when we believe we can improve it for investors, we will update the glide path.”
“They’re meant to be the long-term diversification, resilient foundation for the strategy,” she says, “but they do have to evolve because things change.”
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