For better results, adapt target-date funds to investor reality

If there were ever a set-it-and-forget-it investment, it’s a target-date fund (TDF). Pick your retirement date, and the fund gradually takes you from higher risk (more stocks) to lower risk (more bonds), using what’s known as a glide path.

But do TDFs deliver?

PWL Capital advisor Graham Westmacott tackled that question in a whitepaper he adapted for Advisor.ca, “Are glide path portfolios better than constant equity portfolios?” He concluded that “if an investor is focused solely on achieving a target wealth while minimizing the risk of missing that target, then […] a constant equity asset allocation is likely to be preferable to a glide path strategy, after fees.”

Further, “adaptive schemes using both the time to the target wealth and the current portfolio value can achieve the same cumulative wealth as a constant equity allocation portfolio with significantly lower cumulative and downside risk.”

Westmacott has now co-authored a sequel study, called “Target Wealth: The Evolution of Target Date Funds,” with Peter Forsyth and Kenneth R. Vetzal of the University of Waterloo.

The trio write that because TDFs do not use information about the current wealth of the investor, they can fare poorly when it comes to meeting investor objectives.

But if TDFs are adapted to reflect investor realities, they fare better. “If we allow the asset allocation to adapt to reflect […] current [investor] wealth, and the distance to go to achieve the target wealth, then the risk of missing the target is significantly diminished when compared with even the optimal pre-defined glide path,” writes Westmacott in a blog post. “In one example discussed in the paper, the probability of getting within 10% of the target wealth rises from 45% using a pre-determined glide path to 75% using the adaptive strategy.” He cautions that the adaptive strategy will only work over 20 years or more.

Download the full study here.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.