Edwin J. Elton paper

Target Date Funds:

Characteristics and Performance

Edwin J. Elton
Stern School of Business, New York University

Martin J. Gruber
Stern School of Business, New York University

Andre de Souza
Fordham University

Christopher R. Blake
Fordham University

AUGUST242015

Christopher R. Blake, formerly Joseph Keating, S.J. Distinguished Professor, Fordham University, is deceased prior to publication.Send correspondence to Martin J. Gruber, Stern School of Business, New York University, 44 West 4th Street, New York, NY 10012; telephone 212-998-0333; fax 212-995-4233. E-mail: mgruber@stern.nyu.edu

Abstract


As a result of poor asset allocation decisions by 401 ( k ) participants , 72% of all plans now offer target date funds , and participants heavily invest in them . Here, we study the characteristics and performance of TDFs , providing a unique view by employ ing data on TDFs holdings . . We show that additional expenses charged by TDFs are largely offset by the low – cost share classes they hold , not normally open to theirinvestors . Additionally, TDFs are very active in their allocation decisions and increasingly bet on nonstandard asset classes.However, TDFs do not earn alpha from timing or their selection of individual assets. ( JEL G11. G23. ) .

There is a vast literature in financial economics that finds that participants in 401 ( k ) and 403 ( b ) plans generally make suboptimal asset allocation decisions. 1 In response to this evidence, plans have started to offer options in which the asset allocation de cision is made for the investor and in particular options in which the allocation changes as a function of time to retirement.These la t ter options are referred to as target date funds (TDF).

Target date funds have become an important component of pension plans. The growing use of TDFs i s no doubt helped by the Department of Labor expanding the set of acceptable default options to include TDFs. In 2011, 72% of the 401 ( k ) pla ns offered target date funds, and by 2012 , 41% of 401 ( k ) investor s held target date funds, and 20% of all 401 ( k ) assets were inve sted in target date funds (VanDerhei et al. 2012, 2013 ; Barons 2014 ). T arget date funds are rapidly growing in importance for 401 ( k ) investors. From 2008 to 2012 , the funds grew from 160 to 481 billion in assets , with 91% of these assets in retirement plans . In addition, 43% of the assets of recent ly hired employees in their 20s with 401 ( k ) plans are invested in tar g et dat e funds ( VanDerhei et al. 2012, 2013).

All of the target date funds that exist have a goal of reducing the percentage invested in stocks over time; yet, t he theoretical and empirical support for this asset allocation pattern is mixed. Samuelson (1963) and Merton (1969) derive results demonstrating that constant proportions are optimal. A number of subsequent authors have derived conditions in which a change in stock proportions is optional. These conditions often involve assumptions about labor income (see, for example, Bodie, Merton , and Samuelson 1991 ; C ampbell et al. 2 001 ; Campbell and Vic e ira 2002 ; Cocco, Gomes , and Maenhout 2005). Based on assumptions about labor

1 See, for example, Ameriks and Zeldes (2004), Benartzi and Thaler (2001), Madrian and Shea (2001), Agnew and Balduzzi (2002, 2003), Liang and Weisbenner (2006), Huberman and Sengmuller (2003), and Elton, Gruber , and Blake (2007).

income , the authors derive an optimum decrease in stock al location over time. On the other hand, Shiller (2005) has postulated con ditions under which an increase in stock proportions is optimal.

There is little empirical evidence for the optimality of decreasing stock allocation and increasing bond allocation over time. Poterba et al. (2005 , 2009 ) simulate wealth and utility of wealth at retirem ent and find for most investors 100% in equity or a fixed proportion strategy dominates increasing the proportion invested in fixed income as the target date nears.

This paper does no t attempt to add to the important literature on the optimal pattern of allocation over time.Rather , it addresses a second set of issues: given the intended allocation of a TDF is the investor well – served by management ‘ s selection of assets .

Several papers are related to ours .Bhattacharya, Lee , and Pool (201 3) show th at fund s of funds (which include TDFs) increase their investment in funds with in their fund family after experienc ing large outflows.We ex amine only TDFs , and we do not fi nd similar results.Balduzzi and Reuter (2013) (using a two – index model) show that TDFs with th e same target date have very different bond stock mixes , total returns , and residual returns .We also find great variation in the bond stock mix across funds with the same target date.However, our analysis goes well beyond Balduzzi and Reuter ‘s (2013) in that we examine many other characteristics of TDFs and place great emphasis o n understanding their expenses and performance . Sandya (2011) exa mines several of the issues we also examine. She compares the performance of target date funds and balanced funds. Her conclusions principally use the alpha from a time – series regression of returns of TDFs on bond and stock factors to examine performance and infer management behavior. We collect data on and use the holdings of TDF s to directly see management actions.We e mploy a methodology estimating alphas and factor sensitivities that corrects for the changing risk profiles of TDFs over time and explicitly adjusts for the increased use of new asset categories by TDFs 5 over time.Using this methodology , our results on issu es that are in common differ from man y o f those reported in Sandya.

This is the first study to examine in detail the holdings of TDFs to determine what they are doing and how well they are doing it. Our study is unique in that we have data on the exact hol dings of each target date fund , as well as return and expense data not only on each target date fund but also on each of the funds h e ld .This impacts the type of analysis we perform and the conclusion s we reach throughout this paper. In the first sectio n we will discuss our sample . T his is followed by a section discussing the holding s of target date funds and the expenses associated with their holdings . More specifically , we examine the co mposition of the assets held by target date fund s and how this has change d over time. We find that the actual composition is substantially different from how TDFs have been characterized.

Most t arget date funds hold a series of other funds: either publicly traded mutual funds or master trusts. T hese t arget date funds are funds of funds , and investors pay fees on the underlying funds and usually pay an added fee to the target date fund itself , the size of which depends on the share class that an investor purchases. In the second part of Section 2 we examine the size of these f ees.

We find that most target date funds invest in low – cost share classes of mutual funds which are not available to all but very wealthy investors or institutional investors. We show that the underlying share classes have su fficient ly lowexpense ratios so that for most investors the cost of buying the target date fund with its added expense ratio is on ly slightly higher than if an investor bought the underlying funds directly.

In the third section we examine performance.There are two aspects of performa nce : tim ing and asset selection. Most target date funds start with a planned series of asset allocations over time, but then vary from the plan depending on perceived market

conditions . we show that the stock bond timing decisions do not enhance the performa nce of TDFs . They detract from it , if anything .

The other aspect of performance is asset selection. We find that TDFs have negative al phas similar to those found for mutual funds in general. Finally , we find that a simple strategy of investing in index funds at the initial allocation of the TDF provides lower risk, higher returns, and higher Sharpe ratios than those associated with the TDF.

A number of authors have provided evidence that some mutual funds behave in ways that hurt shareholder per formance but help to meet fund family objectives.Given that we have holdings data, we can examine some of these issues directly and we do so in Section 4 .

1.Sample

There are cl ose to 1,100 target date funds listed in Morningstar. Many of these represent dif ferent propo rtions of the same underlying mutual funds. For example, a fund family might offer TDFs for 2020, 2025, 2030 ,. . . 2050 , with several share classes offered for each of these horizons .The different dated TDFs from one fund family will usually hold most of its assets in the same underlying funds, though in different proportions. The principal difference is that the funds with target dates close to the present hold more in debt – type funds and less in equity – type funds. 2 The planned pattern of ass et allocation over time for a particular fund is usually referred to as its glide path. Table 1 shows the glide path for the Vanguard Target Date Fund. 3 If a particular TDF deviates from its glide path , a ll TDFs with different target dates from the same fu nd family are likely to deviate in a parallel manner from their glide paths since there is

2 In addition, TDFs sometimes hold more risky securities, such as commodities and futures.
3 Vanguard is unusual in that it is one of the few TDFs that gives numeric data for its intended glide path. Most TDFs simply present a picture of their glide paths.

normally one management team handling all the fund families’ TDFs. Given this high commonality, we selected only one dated fund from the dates offered . We chose 2035 if it e xisted, and 2030 otherwise. Our final sample contained one target date from each fund family that offered target date funds. There are fifty families offering target date funds:40 of the funds ha ve a target date of 2 035 , and 10 have a target date of 203 0.There are intotal 229 funds in our sample , representing d ifferent share classes of the fifty distinct funds. 4 We chose 2035 as our baseyear as a trade – off between being on a part of the glide p ath where changes in the e q uity allocation are fairly constant and yet some changes do occur. We have data from 2004 through 2012.However , many of the funds started after 2004.

Our sample is more recent than that used by Balduzzi and Reuter (2013) , and the majority of our data occur after the passage of the P ension Pro tection Act of 2006 .Our sample consists of two types of data.The first type is data at the TDF level.This includes monthly return data , yearly expense data , and the monthly investment by the TDF in each underlying fund.The second type is data at the level of the underlying fund .For each fund held by a TDF , we have monthly return, yearly expenses, and the Morningstar classification . The collection of underlying data allows us to perform analysis that ha s not been previously done .In particular , we preform four types : First , we calculate expenses on the TDF and the funds they hold and compare them to what an investor would have to pay if s/he constructed the TDF directly . Second , it allows us to see exactly what TDFs are investing in at a point in time and over time. Third , it a llows us to measure performance more accurately because we can account for change s in the betas on any TDF that occur because

4 The difference between the 1,100 target date funds (with each share class counted as a fund) and the 229 in our final sample is due to our selecting one target date (2035 or 2030) from each fund family.

of changes in the underlying fundsheld by the TDF . Fourth, by examining change s in holdings , we can explore the rati onale for management ‘s choices.

2. Characteristics of Target Date Funds

In this section we examine both the types of investments made by target date funds and the nature and size of the expenses associated with these funds.

2.1 Holdings

The typical TDF in ou r sample invests in 17 funds on average with 68% holding 10 or more and 24% holding 25 or more funds. This understates the actual diversity in holdings because the funds with few holdings generally hold master trusts , which themselves hold multiple types o f securities. Most target date funds are not the simple mixture of debt and equity envisioned in many paper s . This can be seen clearly from Table 2 . In addition to th e normal domestic and inte rnational debt and equity funds, a high percentage of target date funds have added emerging markets debt and equity funds, domestic and international real esta te funds, and commodity funds to their holdings. While one of these new investments, domestic real estate, was first held by TDFs i n 2004 , others appear later: comm odities appear in 2006 , and emerging market debt appears in 2007. Furthermore, a large percentage of target date funds that h eld these categories did not do so in their first year of existence. At the extreme , 81% of the fun ds that held international real estate added this category of investments one or more years after the fund started . T he percentage of TDF funds holding any category increased over time .For 2011 , the percentage of funds holding these new categories varied fro m a low of 22.2% for emerging market debt to a high of over 75% for emerging market equity. Recall that the majority of th e se funds have a target date of 2035 (or , in a few cases, 2030 ) , so that these target date funds are holding and increasing their inve stment in investment types that are thought of as being 9 inherently more risky as the target date approaches . In addition to the categories shown in Table 2, a number of funds made sector bets (19%) or count r y bets (8%) or held long – short funds (4%).

What could account for these additional asset categories ? One explanation is that some TDFs were trying to differentiate themselves from other s . A second explanation is that these investment categories were identified as hot investment vehicles by the financia l community in general. A third explanation is that they added these investments with the belief that they lowered risk through diversification. 5 However, in the case of country and sector funds , this has to be a bet on a particular small subset of assets.

The funds held by a TDF may be offered solely by the same family of funds as the TDFor include funds from another fund family . However , 63% of TDFs only hold funds offered by the fund family to which the TDF belongs. Most funds held outside the family a re ETFs or index funds. Only 13.7% hold any active funds outside the family, and these are almost always specialized funds , such as commodity funds , not offered by the family.In every case , funds held outside the family represent a very small percent of an y TDFs’ total investment.
Each target date fund family chooses a glide path for each target date fund.The glide path specifies the percentage to invest in equity and debt over time.Across target date funds with the same target date offered by different fu nd families , the percentage invested in equity or debt has wide variation. The percent invested in debt and equity for TDFs with a target date of 2035 as of December 2011 is presented in Table 3.The lowest percent in equity held by any fund is 62% , wh ereas th e highest is 89%.Most 2035 target date funds hold equity in the range of 70 % to 85%.The amount invested in debt also varies with the bulk of targe t date funds holding between

5 Although TDFs may be adding additional asset categories in an attempt to lower risk , it doesn o t seem to succeed. Sixty percent of the TDFs have higher risk than Vanguard , which only invests in stocks and bonds. Furthermore , in Section 4 we match the asset allocation of each target date fund with a portfolio only containing stocks and bonds , and in 75% of the cases , the TDF h as a higher standard deviation.

8% and 20% of their investments in the form of debt with a low 4% and a high of 27%.Thus , at a point in time, target date funds vary widely in their debt and equity percentages , even though they are managed to meet the needs of the same age group. 6

2.2 Expenses

One of the key elements determining the performance of target date funds is th e expenses incurred by the holders of these funds. Since the individual or institutional investor can often construct (mimic) a target date fund, a question remains : how much is the investor paying in total expenses by holding a target date fund rather than holding a matched set of mutual funds ?

The expenses on the target date funds consist of the expense ratio on the underlying mutual funds held by the target date funds and the expenses added on by the target date fund itself. This is somewhat complicated by the fact that the target date fund offers different classes of shares to different investors. While not all target date funds off er all classes, almost all offer more than one class. The overlay of TDF expenses differ across TDF share classes, but each share class of TDF holds the same class of underlying funds in the same proportions and incurs the same expense ratio on the underlying funds. For example, the no – load class of a TDF will hold the same class of the underlying funds in the same proportions as the retirement class and incur the same expenses on the underlying funds . The mutual funds held by any one TDF will often be a combination of several share classes: for example, the no – load class for some of its holdings and the investor class for other s.

Table 4 presents the expense ratio for different classes of target date funds , as well as the breakdown of the expenses between the fees paid directly to the TDF and the fees paid to the

6 Measuring heterogeneity of investment performance is the major thrus t of the paper by Balduzzi and Reuter (2013). Although this is not the major purpose of our paper, we find heterogeneity broadly consistent with their findings, even though the range we find for equity is smaller than that reported in the latter years of t heir sample.

underlying funds. 7 The highest total fees are charged by the C class TDF. The second highest expenses are those on A shares. For A shares , the total expense ratio is 114 bp s , made up of 61 bp s of fees on the underlying funds overlaid by 53bp s of fees for the target date fund . Note that the A class shares may have loads and that the loads are not included in the expense calculations. The size of the load is a function of the size of the purchase and is often waived for large purchases.

Examining Table 4 , we see some differences in the underlying fund expenses across different TDF share classes. This is due to the different sample of funds that offer each class. The major difference in total expenses is differences in the TDF fees paid across different TDF share classes. The investor class and the no – load class have the lowest TDF expenses and the lowest total expenses.

The expenses of the underlying funds are low because t arget date funds often holdlow cost mutual fund classes not available to any investo r or only available to some investors. For example, 56% of the funds held by all TDFs are institutional class funds, 6.5% are retirement class funds, and 1 5.93% are master trusts.

Table 5 shows for investors who qualified for A class shares (or alternati vely no load class shares ) how much the investorwould pay to hold the underlying funds directly if he or she duplicated the TDF with A class sharesor no load class shares . 8 For example, from Table 5 , an investor who only qualifies for A shares would have to duplicate the target date fund with A shares and would incur an expense ratio of 102bp s in doing so. Thus , an investor who could only

7 We report two entries for retirement funds: the average and the maximum. Many funds offer a number of classes of retirement funds. They differ in whether the fund or the retirement plan handles some of the administration of the plan. Since we cannot determine how these costs are split, we report the maximum which for most funds means the administrative costs are borne by the mutual fund family.

8 We limit this to A class and no – load class since these are the classes for which we can find un derlying funds of the same class for a meaningful number of TDFs.

hold A shares is only paying an additional fee of 9.6bp s for the services provided by the TDF management. Likewise, we see that for an investor who could buy no – load shares, the additional charge is only 4 bp s . When we make this comparison , the additional charges from holding a target date fund are small. Target date funds provide access to low – cost classes of mutual funds and charge a fee at the TDF level to capture the advantage to investors who would have to buy a more expensive class of the underlying fund. Since TDFs predominantly or exclusively hold funds within the same fund family, the split of expenses depicted in Tabl e 5 between the TDF and the underlying funds is a matter of little consequence to the target date fund sponsors.

One other aspect of expenses is worth examining. We generally expect the TDFs holdings to shift over time from holding funds that invest in mo re risky assets that have higher expense ratios to funds holdi ng less risky assets that have lower expense ratios . We examined what happens to expenses when a retirement is planned for 2025 , 2035, or 2045. The change in overall expenses is quite small, going from 1.119 for retirement in 2025 to 1.139 for retirement 10 years later to 1.174 for retirement 20 years later. The change in total expenses and the change in underlying expenses is consistent with the holding of funds becom ing less risky as retirement comes closer and bond f unds having lower expense ratio s than stock funds.

3. Performance

Managers of TDFs can improve performance by successfully timing deviations from the glide path , timing sector holdings , or selecting superior individual mutual funds . This section is divided into three parts.In the first part we examine how well the fund does in timing.In the second part we examine how well they have done in selecting assets.In the third part we examine

9 The expenses reported in Table 5 differ from those in Table 4 because not all target date funds belong to families that offer A shares that matched the funds the TDF held. A shares have l oad fees. In this calculation we are assuming that the load on the underlying funds is the same as the TDFor that the investor purchases enough so the load fee is waived.

as an overall measure of performance whether a si m ple strategy exists that outperform s TDFs . Note that in all three parts of this section we heavily rely on ha ving composition data for the TD Fs.While holding data are important throughout this section , it is crucial in measuring fund selection ability.Other a uthors have simply run time – series regression s of a TD F ‘ s return on a set of indexes to obtain alphas.The earlier analyses made it clear that TDFs change the weights of different assets in their portfolio over time.By using holdings data , we can estimate b etas that change over time , and we ge t a more accurate estimate of performance.

3.1 Timing

Target date funds have a glide path that specifies the stock – bond split over time. However, target date funds often deviate from the st a ted glide path because of beliefs about future returns on stocks and bonds.

All target dates funds have a stated glide path. The glide path involves increasing the amount invested in bonds and decreasing the amount invested in stocks over time. Therefore , the manager’s bond – stock timing decision becomes how much to deviate from the glide path. For most funds , the glide path is presented pictorially in the prospectus. Examining the picture, it is impossible to accurately estimate the glide path numerically . Thus , we estim ate the glide path from the data . The picture s show that the glide path is linear or close to linear over the relevant range of years included in our analysis. Thus , we assume a linear glide path. For each target date fund , we calculate bot h the average proportion invested in stocks over all time periods and the average change in this proportion over each period in our sample history. To estimate the glide path for each fund , we use the average proportion it invested in stocks as the midpoint of its history and the average change in stock investment to calculate the glide path on other dates . To measure bond stock timing , we take the deviations from the glide path for stocks and bonds at the be ginning of each quarter and multiply each by the return on that investment class over the quarter. In equation form , this is

Edwin

To measure timing rather than the return on the particular funds held, we use returns on indexes to calculate returns from deviating from the glide path. For domestic stock , we used the Fama – French Market Index plus the riskless rate (since the Fama – French market index is return above the riskless rate). For international stock , we use the MSCI World Index ex – US. For domestic bonds , we use the Barclay’s U.S. Aggregate Bond Index. Finally, f or foreign bonds , we use the Bank of America Global Bond Index ex US. Since a glide path is the bond – stock split , and not how much is in domestic or international, we need a single stock and a single bond index. In constructing a single index for any fund, for computing stock returns , we use the weights for that fund at the beginning of each quarter in domestic stocks , as well as in international stocks with the sum scaled to 100% . We then multiply each by its return over the quarter. The bond return is calculated in a similar manner with cash , which is assumed to earn the Treasury bill rate as one of the bond components. Quarterly timing returns for each TDF are then accumulated to compute over all timing returns for the fund.Timing represents the difference between what the TDF would have earned by duplicating the bond stock mix of the TDF while investing in indexes a nd what the TDF would have earned if it followed its glide path and invested in indexes.In estimating a TDF’s bond stock mix , we only use Morningstar’s classifications divided into five categories. The average return due to timing across all funds is – 11.5 2 bp s per year with a t value of – 1.8. I f we pool all observations that weight funds with a longer history more heavily, the result is – 14.1 with a t of – 2.76. Thus . target date funds do not improve and may hurt their performance by having their stock – bond mix deviate from the glide path. 10 3.2

Measuring fund selection

The mo st common way to measure the asset selection ability of mutual funds is to compute the alpha from the historic time series of a fund ‘ s return s .Below , we describe a general model for doing so, explain why the standard way of estimating performance from such as model is not appropriate for target date funds, describe the method we use to estimate alpha, and p resent performance results : t he standard mode l for estimating performance is from a time – series regression of the type

Edwin1

The use of time – series estimation is inappropriate for TDFs since by design the ir betas are meant to – and do – change over time due to allocation decisions across existing asset categories and the addition of new asset categories. In the case of changing asset weights , and changes in the

10 We also examined timing with respect to domestic and international investment in both the stock and bond investment categories. Within the equity segment switching between domestic and international investments added 8 bps per year, while within the bond segment timing costs 16 bps per year. Neither is close to statistically significant.

asset classes included in a por tfolio , the unconditional betas from a time – series regression would be completely mis estimate d and the computed alphas meaningless.To overcome this problem , we use the bottom – up approach of Elton, Gruber , and Blake (2011), to estimate betas and alpha for a TDF. Sin c e a portfolio’s alphas and betas are weighted averages of the assets that comprise it, we compute the monthly alpha on each fund the TDF holds and then use the proportions invested in each fund at the beginning of the month to compute the TDF’s mo nthly alpha. The importance of estimating time – varying betas a nd the effect on al phas has been established by Fe r s on and Schadt (1996) and Christopherson , Ferson , and Glassman ( 1998 ).While our methodology is different from theirs , the motivation is similar. We can directly measure changing betas because we have monthly holdings data.

More specifically , we start with the three – year alphas computed every month using data ending with the month for which we are computing alpha . Then we calculate the one – month al pha for that month by taking three – year alphas and adding back the residual for the month in question. These are then cu mulated and averaged over the history of the TDF.

While we have discussed the methodology to estimate a general model like Equation (2 ) , we have n o t clarified the indexes used on the right – hand side of Equation (2 ) .Since target date funds hold many different types of mutual funds with different characteristics, we need to use indexes appropriate for the fund in question. For stock funds , we use the Fama – French three – index model plus momentum. For bond funds we use, following Blake, Elton ,and Gruber (1993) , a three – index model consisting of a general bond index, a mortgage – backed index, and a high yield index , all in excess return form . For foreign bond funds, foreign stock funds, domestic real estate funds, foreign real estate funds, sector funds, country funds, commodity funds, emerging market stock funds , and emerging market bond funds, we use market indexes of the appropriate market , al l in excess return form . In cases of low R 2 with the indexes employed , we examine the holdings and classify the fund consistent with its holdings.In a number of cases , the funds’ holdings were not consistent with the Morningstar category. 11

The average alp ha over the history across all t arget date funds is a negative 20bps per year and is significantly different from zero at the 1% level . This is the alpha across all the TDFs holding s and is after all expenses on the underlying funds but before the expenses added by theTDF .

Most studies looking at alphas on the average mutual fund find that the average fund underperforms indexes by about 70 bps . Does this suggest that TDFs display superior sele ction ability , with respect to the funds they hold? The answer is no. E xamining the average expense ratios on the funds they hold (T a ble 4 ) shows expense ratios of about 60 bps . Most mutual fundstudies examine share classes of funds with average expense ratios of 110 to 120 bps . TDFs have better alphas on the funds they hold, primarily because they are able to hold share classes with low – expense ratios . If one adds the difference in expense ratios , the average alpha on the funds they hold is similar to the – 70 bps normally found in mutual fundstudies.

As sta ted above the average alpha on the underlying funds does not take into consideration the expenses added by the target date fund itself. Investors in a target date fund pay total expenses equal to the sum of expenses imposed by the TDF and the expenses on t he underlying funds . Table 6 shows the average alpha , including the total expenses for each target date share class , as well as the percentage of fun ds in each share class that have negative alph as. We see that each class has o n average a negative alpha. The A class are the most commonly

11 The three years used in estimating alpha were the three years ending in the month in question. If three years of data did not exist, we used the longest time frame we had, providing it was at least twelve months. If adequate data did not exist, the fund held by the TDF was excluded and the weights were rescaled.

examined share classes. The target date funds class A shares have alphas consistent with the alphas of A shares of mutual funds in general; about minus 77 bps per year. The C class has mo re negat ive alphas of about 1.37 % per year. No load funds have negative alphas close r to zero (minus 27 bps per year), approximately the alphas for the lower cost index funds found in the market. The investor class is close to that of the no – load class (33 bps per y ear) . However, investor class shares are usually sold through invest ment advi sors, who add their own fees to those charged by the target date fund.

The alpha on retirement accounts is slightly higher than the alpha on A shares. There is a range of alphas on retirement accounts that we believe is a function of whether the fund company, financial advisors , or the retirement account itself handles some of the administrative costs. Many fund families offer several subclasses of retirement shares. For example, John Hancock has R1, R2, R3, R4, R5 , and R6 shares with slightly different expense ratios. When we compare the expense ratio of the highest expense retirement share for each family (where the fund bears the administrative costs) with the average retirement share class , the returns go down , but only by 7 bps per year . There is little difference in expense ratios across different retirement share classes.

4. An Overall Performance Measure

While there are several possible measures of performance , a very practical measure is to see if an investor who followed a simple strategy would obtain better results by holding target date funds.We examine the mean return, standard deviation, and Sharpe ratio for the simple strategy and compare the m to the values For TDFs .

The simple strategy assumes that an investor observes the first reported asset allocation that occurred at least three months after the start of each TDF and holds the same proportions 19 over the life of the fund in five categories of indexes: dom estic stock, international stock, domestic bonds, international bonds , and cash. For cash , we use the one – month Treasury bill rate, and for the other four categories , we use the indexes discussed earlier .

Across all share classes and all funds , we find tha t in 75% of the cases the standard deviation of the returns from the naïve strategy is less than that of the TDF. Thus , the additional types of investment used by the TDF (e.g. , real estate commodities) do not seem to reduce risk.On average , the variance of the naive strategy was 12% less than the variance of the TDF. In addition , t he mean return on the naïve strategy was also higher in 75% of the cases , with a difference averaging 62 b ps per year.

For each share class of TDFs , the Sharpe rati o is greater for the naïve strategy in the preponderance of cases, and the difference is statistically significant at the 0 .01 level for most classes. 13 Thus , an investor would be better off using a buy – and – hold strategy that invest s only in passive portfolios and using only domestic and international stocks and bonds and cash . 14

1. Shareholder Objectives or Family Objectives

There are a number of articles that have found that mutual fund managers make investment decisions that hurt individual mutual fun d performance but help fund family objectives.Cohen and Schmidt (2009) find that fund managers overweight a firm when the fund family is a trusteeof that firm’s 401(k) plan and increase their holdings in these firms when other

12 We took our starting point three months after the TDF was started , because the first observation often conta ins an allocation before the fund is fully invested, for example, a very large cash position.In addition we assume d that investment in the ―otherâ€- category wa s allocated proportionally over the five categories named above.The ―other â€- category wa s generally well below 5% of assets , except in three cases not included in our sample.

13 This result holds even when we subtract 15 bps, representing fees on low – cost index funds.
14 We also compared the performance of TDFs before fees imposed by the TDFs with the per formance obtained by an investor investing in the actual funds held by the TDFs. We followed the same procedure described above. The Sharpe ratios of the replicating portfolio are higher than the TDF Sharpe ratios in 67% of the cases, and the average diffe rence is highly significant.

mutual funds are decreasing t heir holdings.Davis and Kim (2007) show that mutual funds are not acting in their shareholders’ best interest in votes they make when doing substantial pension fund business with the firm.Sandhya (2011) shows that TDFs with the greatest potential for confl icts of interest have the poorest performance and concludes that they are adding higher cost funds or poor performing funds with large outflows.Bhattacharya, Lee , and Pool (2013) show that funds of funds increase their investment in individual funds in the ir fund family when the individual funds have large outflows.Gaspa r, Massa , and Matos (2006) and Cas a vecchia and Tiwari (2011) show how intrafamily trading benefits fund families at a cost to individual funds.Evans (2010) shows how fund families pursue their own objectives in setting fees and increasing fund offerings.

What makes our analysis unique is given that we have data on the monthly holdings of individual TDFs , we can analyze hypotheses concerning management behavior by examining their actions directly rather than inferring their actions from overall return results.

TDFs are particularly appropriate for studying potential agency problems between individual funds and fund families, because they primarily hold mutual funds of the fund family that sponsors the TDF. When a TDF invests in a fund outside the family , it does so almost always because a similar fund does not exist within the family. Across our sample , 69.9 % of the funds that were added by the TDF had at least one alternativ e fund in the f amily with the same Morningstar classification. We refer to these funds as the alternatives. The average number of alternatives was 3.8 , and the percentage of tim es there was more than one was 68.1% .

In this section w e examine four variables that might sat isfy fund family objectives but are not necessarily objectives of the target date fundshareholders : 15

1. start date : the family might want to help start – up funds ;
2. management fee : higher – fee funds bring in more money to the family ;
3. total net assets : management might select funds to include that are smaller than the alternatives to help these funds reach a scale at whi ch they are profitable ; and
4. cash flow : the TDF might select funds that were losing assets or growing at a rate slower than alternatives to he lp a fund reach a size that is profitable .

It would be in the interest of fund families to have TDFs invest in recently started funds to help start – up funds boost their ass et size to obtain economies of scale.We find that many target date funds do add an abnormal number of funds that have been in existence for a short period of time. There were 720 cases in which a TDF adding a fund had the option of selecting an alternative in the same fund family with the same Morningstar objective.In 15% of these cases, there was an opportunity to invest in a fund that had existed for three months or less.When the TDFs had this opportunity, 72% of the time they selectedthe fund that existed for less than three months; while if they selected randomly, they would have sele cted a short – lived fund 34% of the time.In 30% of the 720 cases, there was an opportunity to invest in a fund that existed one year or less.When a TDF had this opportunity , 57% of the time it selected the fund that existed less than one year; while if it selected randomly, a fund that existed less than one yearwould have been selected 34% of the time. H ow well have the start – up funds done relative to the alternative funds available in the same family? T he funds added that were in existence for three months or

15 In all analyses in this section we only examine funds that were added by management that are in the TDF’s fund family.

less had alphas over the next three years that were low er by 86 bps per year than the average three – year alphas on alternative funds. This is statistically significantly different from zero (t = 2.14).Management is clearly adding a disproportionate percent ag e of new funds that have three – year performance after addition that is inferior to the alternatives they could have added.

The next variable we examine is management fees. If a specific manager is concerned with family objectives rather than investor obje ctives , s he would add funds with higher management fees than the alternative funds of the same type offered by the fund family. In fact , the average manager does not do so . 16 However , specific managers do.W hen a TDF manage r chooses funds that had a much higher management fee than the alternatives , we find that the funds selected had much lower future alphas than the alternatives.For example , there were thirteen funds for which the manager selected a fund whose fees were 40 bps or more higher than the alternativefunds ‘ . For the following three years , these funds had alphas 256 bps per year lower than the alternative funds , with a t of 2.4 .Examining the thirty – three additions for which the manager selec ted a fund in which fees were higher than alternative funds by 30bps or more had underperform ance compared with the alterna tives of 115bps per year with a t of 1.43.TDF managers on average do not seem to be adding funds that have higher management fees than alternative funds , but when a manager add s fund with much higher management fees than the management fees on alternative s in the same fund family , the funds that a re added have much lower performance than the alternatives .Some managers seem to be maximizing family objectives rather than shareholder objectives .

16 This differs from Sandya’s (2011) conjecture. Her conjecture is based on the difference in performance of TDFs that invested in funds within their families compared with funds that invested outside of their families.

If some fund managers were selecting funds in part because of family concerns rather than shareholder concerns, we would expect them to select more small funds than could be justified by future alpha.Since start – up funds are generally of small size, and since we have analyzed start – up funds earlier in this section , we eliminated all start – up funds in the first 6 months of their existence. 17 We then ranked all funds by size. When TDF management selected funds with less than 60 million dollars under management (26 funds) they earned, over the next three years, a monthly alpha 240 bps per year less than the alternatives (t = 2.09).We chose 60 million since the belief in the investment community is this is the minimum size to be profitable.We chose three other breakpoints : 100 million or less resulted in underperformance of 209 bps per year (t = 2.73), 150 million or less resulted in 144 bps underperformance (t = 2 .04) , and 200 million or less resulted in 116 bps underperFormance (t = 2.07).Selecting funds of small size is desirable from a family point of view , but it has hurt TDF performance.

The last variable we examine is growth .If a fund had a large outflow, it would help the family if the TDF invested in these funds.We
find no evidence of TDFs selecting funds with large outflows. 18

We find that in pursuing a number of characteristics that serve fund family objectives, TDFs add funds with poor subsequent alpha relative to alternatives in the same family.These characteristics are new funds, funds with high management fee sand small funds . These findings support the previous literature that funds are managed in part to support fund family objectives rather than to support the individual fund objectives.

17 Including these funds only strengthens the results reported below.

18 This differs from Sandya (2011) and Bhattarchaya, Lee, and Pool (2013) . Although the sample in the latter article includes many types of fund of funds rather than just TDFs.

7.Conclusions

Target date funds (TDF s ) have become an important vehicle for retirement plans: 72% of 401 (k) plans offer TDFs , and over 43 % of new 401(k) money of young employees is invested in them.Despite their importance for the financial health of future retirees, very litt le is known about their characteristics and performance.In this paper we address this lack of knowledge.
Target date funds are usually thought of as holding a mix of debt and equity , while following a predetermined glide path, with the equity proportion d eclining over time.The reality is more complex.Currently , many target date funds hold commodity funds, domestic , and international real estate funds and funds holding the debt or equity of emerging markets. In addition, TDFs take active bets, deviating from their stock – bond glide path . We show that thi s active timing does not add value.

Target date funds are funds of funds.As such , they add an additional fee to the fee charged by the mutual funds they hold.This additiona l fee can be quite high , averaging 53bps for A class shares.We show that this added fee is most ly offset by TDFs investing in low – expense classes of mutual funds not available to most investors.We find that the total fee an investor pays is not that much h igher than the investor would pay for the TDF portfolio by directly purchasing the share class available to that investor .

On average , the performance of the funds selected by target date funds is better than those normally found in mutual fundstudies.Th is difference is due to the lower fees on the classes of shares TDFs hold.When the added fee s of target date fundsare taken into account, the performance of target date funds is similar to that normally found in mutual fundstudies.

Target date funds almost always hold funds of the fund family to which they belong.Normally , a TDF only selects a fund outside the fund family when the family does n o t offer a similar fund (e.g. , commodity, international real estate).In the majority of cases , when the TDF adds a fund, the target date fund has alternatives with the same objective in the fund family.We show that some TDFs add funds that satisfy family objectives but hurt shareholder performance. This is manifested by TDF s selecting new start – ups, some managers selecting funds with much higher management fees than alternatives, and selecting small funds . All of these additions have lower alphas than the alternatives in the fund family

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