Since suffering significant losses during the financial crisis, target-date funds (TDFs) have been the subject of increasing scrutiny. Problems persisted over the last year, as many funds again fared poorly, even for those investors close to retirement, whose assets should have been invested conservatively. While most of the criticism has been directed to overly aggressive glide paths, that is merely a symptom of the underlying problem – the misalignment of incentives between investors and fund companies.
A 2010 paper, Agency Problems in Target-Date Funds, by Vallapuzha Sandhya, written as part of her doctoral dissertation at Georgia State University, comprehensively identified the problems. In economics, an “agency problem” is a mismatch of incentives in a transaction between the principal (in this case, the investor) and the agent (in this case, the fund company) – the agent is able to profit at the principal’s expense.
For those unfamiliar with TDFs, they are investment products designed to manage the asset allocation for an investor to a specified date; the date may be when the investor plans to retire (in which case it is the “to” date) or, in some cases, beyond that date (in which case it is the “through” date). The glide path determines how assets are shifted to a less risky allocation as the “to” or “through” date approaches.
I am skeptical about some of Sandhya’s findings, as I will explain. But her paper is an important warning to investors who choose a TDF as their retirement vehicle.
Let’s look at her research, which used data from January 2001 to December 2008, over which time the number of TDFs on the market grew from 16 to 280.
In the first part of her paper, Sandhya compared TDFs to balanced funds (BFs), which have a relatively constant asset allocation over time. Both TDFs and BFs are acceptable default options for 401(k) plans.
She found that BFs received more investor inflows following periods of outperformance than TDFs, which she cites as evidence of an agency problem. TDF investors are relatively insensitive to fund performance, she argued, mitigating the need for fund managers to outperform their benchmark.
She also found that TDFs underperformed BFs; their six-factor alpha lagged that of BFs by 46 basis points net-of-fees and by 86 basis points gross-of-fees. But those findings are suspect. First, she did not fully control for the static asset allocation in BFs versus the glide paths followed by TDFs. Second, the alpha for TDFs gross-of-fees exceeded the alpha net-of-fees by 158 basis points. But the expense ratio for TDFs was 113 basis points (an alarming statistic by itself). Those numbers should be the same, an unusual result that demands further explanation. There was no similar discrepancy for BF alphas and expense ratios.
