The Target Date Dilemma: Why Low-volatility Stock Strategies Can Be The Solution
February 15, 2013
The failure of pre-packaged target date solutions to protect investors' assets during and after 2008 made headlines across the country.
During the financial crisis, many of these products were caught holding large chunks of equities, which suffered dramatic declines even though they were designed to slowly reduce risk as investors got closer to retirement. Clearly, 2008 showed there is room to improve these strategies.
Articles on target date strategies since 2008 have all implicitly asked the same question: How can a retirement plan sponsor possibly balance the need to keep an equity allocation high enough to ensure participants can navigate treacherous waters of shortfall risk with the need to keep the equity allocation low enough to protect against big drawdowns and market risk? Currently plan sponsors must choose between these two conflicting goals creating what we are calling the "equity dilemma." You can see the effects of these conflicting goals in the large disparity of equity allocations within the asset allocation frameworks of the major target-date providers.
One solution to this problem is to leverage what we think is the greatest anomaly in finance: the low-volatility phenomenon. Several studies over the last few decades have found a persistent outperformance of low-volatility and low-beta stocks relative to their riskier counterparts. This runs counter to what the traditional capital asset pricing model tells us, that higher risk leads to higher returns in the equity markets. That is clearly not the case.
While plan sponsors cannot control the contributions and time components of their participants, they can control investment volatility, again making target date portfolios ideal beneficiaries of a low-volatility strategy. The ability to provide increased downside protection to weather the financial storms of the future while also permitting participation in market rallies provides plan participants with an equity profile more likely to ensure not only that they do not outlive their savings, but also that they can enjoy more financial security in their retirements.
Low-volatility strategies are uniquely designed to solve for these competing objectives as they contain the following two dominant characteristics: downside protection and upside participation. Downside protection serves the dual role of smoothing returns (e.g., protecting in volatile markets) while also quelling investors' emotional reactions (e.g., discouraging investors from selling low and buying high). While we do expect low-volatility strategies to lag the market in big short-term market rallies, over full market cycles, low-volatility equities will participate with an equity profile.
This upside participation is a crucial component of the success of low-volatility solutions. Historically bonds have also provided downside protection, but low-volatility equity is unique in its ability to not only protect on the downside, but to keep pace and participate in longer-term equity rallies.
Downside protection and upside participation are also two important characteristics of low-volatility strategies that can support achievement of two key investment goals for plan sponsors and their participants: de-risking and risk-budgeting (both of which we discuss in more depth in our recent white paper).
So how can plan sponsors benefit from this investment strategy? There are three main approaches to lower the volatility of an equity sleeve in a target date portfolio:
1. Utilizing defensively-oriented value managers.
2. Hiring managers who use a quantitative approach to produce a portfolio designed to have the lowest expected volatility for a given set of constraints.
3. Utilizing alternatives in conjunction with traditional equity strategies to smooth returns and create a low-volatility effect (examples are commodities, managed futures, real estate and hedging strategies).
If recent market turbulence has taught us anything, it is that we need to find better ways to equip plan sponsors with the right tools to build more effective target date solutions.
As assets pour into target date strategies, they must evolve in a way that efficiently balances the need to grow retirement savings while also effectively protecting assets in troubling times. Employing a low-volatility strategy within the equity part of these portfolios is an effective tool to achieve these goals.
Michael Raso is a Senior Vice President of Institutional Retirement and Subadvisory at Old Mutual Asset Management in Boston.