UPDATED: May 1, 2011
Including asset classes beyond stocks, bonds and cash within target date funds can benefit investors.
Perhaps as a vestige of the puritan heritage of the United States, many of us take for granted the notion that there’s no such thing as a “free lunch.” Yet, whole industries and academic lives have been dedicated to discovering those free (or at least cheap) lunches. One of the greatest examples of this search is asset allocation — the art and science of combining and adding certain historically low-correlating asset classes to an investment portfolio with the goal of increasing returns or decreasing volatility with minimal negative consequences (see Table 1).
Historically, sophisticated institutional investors have long benefited from the more efficient portfolios generated when adding asset classes beyond stocks, bonds and cash. Even individual investors, to the extent that they participate in their companies’ defined benefit (DB) plans, may indirectly benefit from the diversification effects that asset classes such as real estate and commodities have on a portfolio. However, as the retirement savings landscape continues to shift from employer-directed DB plans to participant-directed defined contribution (DC) plans, employees are losing access to some of the potential benefits of professionally managed asset allocation.
From both the participant’s and plan sponsor’s viewpoints, more streamlined fund lineups in a DC plan makes sense. Numerous studies on investor behavior demonstrate that too many investment options can lead to inappropriate diversification or lower overall participation and savings. To encourage optimal behavior, plan sponsors straddle a delicate balance between paternalism and participant autonomy. This method often leads to highly edited investment menus offering choices typically limited to stock and bond funds. Therein lies a dilemma; many of the DC plan sponsors who subscribe to cutting edge investor behavior research and simplify their fund lineups are often the same DB plan sponsors who invest in cutting-edge asset classes, such as infrastructure, timberland and catastrophe bonds.
As the retirement savings landscape continues to shift from employer-directed DB plans to participant directed defined contribution (DC) plans, employees are losing access to some of the potential benefits of professionally managed asset allocation.
The rise of target retirement date solutions has allowed plan sponsors to reconcile these philosophical differences and has given DC plan participants the opportunity to benefit from the same portfolio diversification that institutional investors have long enjoyed. Offering an asset class such as commodities on a standalone basis within a DC plan would give pause to even plan sponsors with highly sophisticated employee populations. However, including the asset class as part of a professionally diversified target retirement date solution offers plan sponsors the best of both worlds — efficient portfolios via a streamlined investment menu. Although the inclusion of more extended asset classes within a target retirement date option potentially benefits investors, plan sponsors would be wise to understand just which asset classes should or should not be added to a target retirement date portfolio. Economic historian Joel Mokyr, who specializes in the means and ways of technological progress, writes, “When no one knows why things work, potential inventors do not know what will not work and will waste valuable resources in fruitless searches for things that cannot be made, such as perpetual-motion machines or gold from base metals.” Commodities, real estate, inflation-protected securities and a variety of alternatives might be additional asset classes included in target retirement date solutions. DC plan sponsors who know the roles that different asset classes play in a portfolio will be better suited to understand the differences between the potentially free, cheap and expensive lunches.
Many of the DC plan sponsors who subscribe to cutting edge investor behavior research and simplify their fund lineups are often the same DB plan sponsors who invest in cutting-edge asset classes, such as infrastructure, timberland and catastrophe bonds.
While large institutional investors have long invested in commodities, the advent of exchange traded funds (ETFs) and exchange traded notes (ETNs) has essentially democratized this asset class and allowed individuals to access its unique diversification and potential return benefits. With increasing demand from emerging markets such as China and India, commodity prices have risen dramatically in recent years. Investors have had an opportunity to participate in an asset class that has outperformed the S&P 500 by a significant margin over the long term. From 2000 to the end of 2010, the Dow Jones-UBS Commodity Index rose 5.84% compared to the 1.41% return posted by the S&P 500 Index. As “real” assets versus “financial” assets, such as stocks and bonds, commodities also offer unique diversification potential, especially as an inflation-protecting asset. Commodity prices typically rise with rising inflation whereas stock and bond prices generally decrease in rising inflation environments. Table 2 demonstrates the historically strong correlation between commodities and inflation.
Like commodities, the argument for including real estate in a portfolio centers on the “hard” nature of the asset class. Including global real estate in a target retirement date fund structure provides additional diversification as well as the potential to hedge inflation while providing enhanced return potential. Debate continues regarding how to gain exposure to the asset class — direct real estate investments give pure but hard-to-access asset class exposure to individual investors, while exchange traded real estate investment trust securities (REITS) provide convenient exposure with greater correlation to the general stock market. REITS have traditionally been lauded for their stock-like returns and bond-like income streams. For the 10-year period ending in 2010, the FTSE EPRA/NAREIT Global Real Estate Index returned 9.82%, outperforming both the S&P 500 and the Barclays Capital U.S. Aggregate Bond indexes.
Treasury Inflation-Protected Securities (TIPS), backed by the U.S. government, provide a hedge against inflation’s eroding effect on purchasing power. Principal and interest payments for TIPS adjust according to the CPI-All Urban Consumers, which means that when consumer prices increase, principal and interest payments of TIPS also increase. In addition to inflation protection, TIPS have acted as a powerful portfolio diversifier due to their historically low correlation with other fixed-income assets and equities. For the 10-year period ending in 2010, U.S. TIPS had a -0.23 correlation with the Russell 3000 Index, a 0.62 correlation with the Barclays Capital U.S. Aggregate Bond Index, and a 0.43 correlation with the Barclays Capital Global Aggregate Bond Index.
“When no one knows why things work, potential inventors do not know what will not work and will waste valuable resources in fruitless searches for things that cannot be made, such as perpetualmotion machines or gold from base metals.”
—Joel Mokyr, Economic Historian
Over the long term, the historical effect of incorporating additional asset classes has markedly benefited the overall risk and return equation. We use the asset allocation of the glidepath for the Northern Trust Focus Fundsâ„˘ to demonstrate a before and after simulation of the effect of including these additional asset classes in portfolios. These benchmarks allocate assets to U.S. and international equities, commodities, global real estate, TIPS, core and high-yield fixed income and cash equivalents. Table 3 summarizes how the 2040 and 2010 portfolio benchmarks within the glidepath fared with and without the additional diversifiers. Over the past 10 years, the more diversified portfolio benchmarks delivered higher return with lower risk. Our research also shows that on a three-year rolling risk and return basis over the same 10-year period, the more diversified portfolio benchmarks delivered higher returns with lower volatility than the benchmarks that excluded commodities, REITs and TIPS.
If more closely matching the diversification profile of pension plans helps individual investors, then it stands to reason that adding an even more robust spectrum of the investment universe also should help. DB plans also may invest in more exotic asset classes such as hedge funds, private equity, timberland and infrastructure. Should target retirement date funds used in DC plans emulate this strategy? When considering this question, the plan sponsor and target retirement date manager begin to push the line from a cheap to potentially expensive lunch. These asset classes generally charge notably higher fees for access to the more highly rated managers. Indirect costs of adding such alternative asset classes also materialize in the form of liquidity and psychological costs (investors are influenced by a sequence of psychological beliefs when making buy-sell decisions). For example, the gates invoked by hedge funds in late 2008 prevented large investors from accessing their funds. Imagine the impact such a restriction would have on the average investor who was not aware or did not understand these potential restrictions when they invested in target retirement date options through their DC plan. Similar to how commodities were largely inaccessible to individual investors prior to the widespread use of highly liquid ETFs, we believe the use of more exotic asset classes within DC plans may be limited until financial technology and markets advance further.
The quest for free lunches in the investment world ultimately stems from the desire to expand the efficient frontier. Modern portfolio theory shows that by judiciously adding asset classes, professional investors can construct portfolios offering higher return potential and lower volatility. Plan sponsors using target retirement date portfolios may do so knowing that the funds available to their employees provide professionally controlled access to certain extended asset classes. By understanding how each additional asset class contributes to an overall portfolio, DC plan sponsors can understand the difference between providing a free, cheap or expensive lunch to their plan participants.