One of the complaints about target-date funds is that they have a tendency to be too rigid. They have glide paths that are pretty much set in stone, and typically don’t make any strategic changes to their portfolios despite the current environment.
That may be starting to change as TDF providers look for ways to enhance returns, lower risk or just tilt the fund’s composition a certain way. Investors are constantly on the lookout for higher risk-adjusted returns, and smart beta strategies may be the path to getting there.
Be sure to explore our Retirement Funds section to learn more about these funds.
What Are TDFs and Why Do They Need to Change?
Target-date funds are a collection of funds under one umbrella that focus on long-term growth in the early years and become progressively more conservative as the target-date approaches. They’re ideal for folks who want an all-in-one solution and who don’t want to deal with ongoing portfolio management.
There is still a need to address, however, some of the weaknesses inherent in TDFs. They focus mainly on appropriate asset allocations, and not so much on risk management or opportunities for outperformance. As market valuations get stretched and we near a ninth straight year of gains, strategies for minimizing risk should be considered.
How Smart Beta Strategies Get Incorporated Into TDFs
Smart beta strategies differ from traditional market cap–weighted strategies in that they attempt to modify the fund’s composition in a way that reduces risk, improves return potential, or both. Popular smart beta methods include targeting high-dividend stocks, investing in traditionally low-volatility stocks or focusing on companies with strong balance sheet characteristics. Managers looking to employ a smart beta strategy can couple the low-cost benefits of an index fund with the strategic tilt of active management in order to produce superior risk-adjusted returns for the investor.
BlackRock provides a nice blueprint for building a target-date fund using smart beta ETFs. The BlackRock LifePath Smart Beta Retirement Fund (BLAIX) mostly passes on traditional index funds in favor of single- and multi-factor strategies. Take a look at the fund’s holdings below.
The fund establishes its equity positions using the iShares Edge series of factor ETFs. It’s currently favoring a low-volatility theme, with 20% of fund assets going to each of the iShares Edge MSCI Minimum Volatility USA ETF (USMV) and the iShares Edge MSCI Minimum Volatility EAFE ETF (EFAV). Another 7% goes to multi-factor funds, which tilts the portfolio on an ongoing basis based on conditions at the time. The fixed-income portion of the portfolio is largely committed to the iShares Edge U.S. Fixed Income Balanced Risk ETF (FIBR), a fund that looks to minimize exposure to rising interest-rate risk. The remainder is invested in traditional long-term Treasuries and TIPS.
In this situation, the use of smart beta products allows exposure to all of the traditional asset classes, but focuses on minimizing overall market risk. It’s essentially looking to produce market returns with below-average risk.
Make sure to check out our Target-Date Funds section to learn more about these funds.
Why Smart Beta Within TDFs Might Not Work
Using a smart beta TDF can be a good way to produce above-average risk-adjusted returns, but it’s by no means a certainty that the fund will be successful. Part of the problem is the very definition of “smart beta” itself. Different TDF providers have different ideas as to what the appropriate glide path should be for a particular target date. There are also differences of opinion with respect to what smart beta even means, and every manager may focus on different factors for producing outsized returns.
As is the case with any actively managed product, the biggest risk is that the fund will underperform. Active managers have long had a difficult time beating the markets over most time periods; it’s possible that smart beta funds could have similar difficulty. Contributing to that challenge is fees. Smart beta is designed to combine the benefits of both active and passive investing. Many smart beta funds have low fees, but still trail those of a market cap–weighted index fund. That difference in fees can put the smart beta fund at an immediate disadvantage.
Vanguard, in particular, is not convinced that smart beta strategies within a TDF are a good idea. John Croke, Vanguard’s head of multi-asset product management, is not a fan of the additional layer of risk that’s involved. He says, “What holds us back with adding smart beta to a target-date fund is that over time there can be severe periods of underperformance that would cause investors to abandon the strategy. And we’re not comfortable introducing an additional degree of risk and uncertainty.”
The Bottom Line
Smart beta has grown quickly as investors look for ways to outperform the market at index fund prices. The fact that the trend has spilled over into target-date funds isn’t surprising, but it’s unclear if the strategy will work. Many attempts at outperforming the market have failed over time, and smart beta could just be next in line. Still, it’s an interesting concept that deserves the opportunity to play out.
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