A look at diversification and risk in target-date fund glide paths

Target-date fund providers often use long-term averages to create diversified glide paths, she added, noting it’s something she warns against. “To us, that’s a bit like looking in the rear view mirror and making assumptions about what’s in front of you.”

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Since the 1980s, Canadian equities have averaged an 8.5 per cent return for members and Canadian short-term bonds have averaged seven per cent. While those averages could “generate a nice outcome for members,” said Pritchard, the averages hide “extended periods of time in history when the return, volatility and correlation of one asset class to another differs markedly from the long-term average — and this holds true for virtually all asset classes.”

Focusing on regimes is a better way to consider asset class behaviour and results in stronger glide-path diversification, she said. Fidelity has identified five regimes through history: labour market, geopolitical events or macroeconomic changes that caused shifts in returns, volatility and correlations among asset classes.

“We believe that a target-date fund needs to be aware of and understand each of these distinct regimes,” said Pritchard, arguing that it can help identify complementary asset classes, resulting in a glide path with greater diversification and more resilience against capital markets uncertainty.

Read: Comparing a ‘to’ and ‘through’ approach to target-date funds

The regimes fall into the categories of persistent and transitory. Persistent regimes occur more often through history and generally see equities outperform bonds. A persistent regime with low volatility and falling interest rates has existed 44 per cent of the time in history, while one with low volatility and rising rates has existed 22 per cent of the time.

Meanwhile, transitory regimes occur less frequently and are generally shorter, often representing the shocks between one regime and the next. A transitory regime with inflationary stress, where inflation sensitive assets like Canadian equities, gold and commodities perform well, has only occurred eight per cent of the time in history. A deflationary stress environment, where bonds have a positive return and equities are negative but U.S. equities outperform, occurred 12 per cent of the time. And a recovery environment, which generally produces the strongest performance for most asset classes in a high-volatility environment, occurs 14 per cent of the time.

Risk also takes on a different meaning in target-date funds than other investments, said Pritchard. She noted that looking at the amount of equity at different points along the glide path and using it as a proxy for risk is a common practice when evaluating target-date strategies, but it’s not that simple.

While equities are a primary contributor to risk and volatility in most portfolios, other asset classes that are in the portfolio for diversification purposes may not show up on the equity line in a provider’s overview of the fund. Pritchard provided the example of high yield bonds, which exhibit equity-like properties, thus introducing more risk to the portfolio than other fixed income instruments.

Read: Constructing the glide path to tackle any market environment

“In thinking about the total risk that your members are exposed to, you have to ask yourself, ‘Did the addition of high yield change the level of risk? Did it change the composition of risk? Did it change how I might need to go about comparing this provider to another provider that doesn’t hold high yield?’ Our response to all of those would be yes.”

Plan sponsors should also be aware of how a provider considers a member’s risks, needs and behaviours along the glide path, a risk that Pritchard said is often disregarded or overlooked. Each provider has a different take on how to build portfolios to make trade-offs across these risks, which include inflation and deflation, market drawdown and longevity.

While younger investors face the primary risks of deflation and longevity, pre-retirees are more exposed to market drawdown and inflation or deflation risks. Retirees, meanwhile, particularly need protection from inflation and market drawdown.

“Every provider is going to solve for these and account for these risks differently in their portfolio, but they play an important part in understanding the goals, objectives and implementation of any target-date strategy,” she said.

Read more coverage from the 2022 Defined Contribution Investment Forum.