Conventional Target Date Design Becoming Obsolete, Says Folio Investing

Brokerage's Innovative Risk-Based Structure Better Serves Target Date Investors' Needs

McLEAN, Va., July 18, 2011 /PRNewswire/ -- While many leading Target Date Funds have adjusted their asset allocations to repair recently identified deficiencies, the largest funds still appear to follow an outdated design approach, according to online brokerage Folio Investing.

Target Date investments are popular with individual investors and retirement plan administrators, due to convenience and the assumed protection for the investor.  Over the life of a Target Date Fund, the asset allocation mix automatically becomes more conservative as the investor's targeted retirement year approaches.

But Target Date Funds were severely tested during the stock market meltdown of 2008 when the funds dropped more than expected, and one 2010 Target Date Fund fell even further than the stock market itself.

Recent moves by several of the fund companies to incorporate some non-traditional assets into their fund allocations, along with strong stock market performance in 2010 and 2011, has led to a sense that Target Date Funds have solved their shortcomings.  But there is room for more improvement, according to Folio Investing founder Steven Wallman.

"Most Target Date Funds apply an approach to asset allocation that can be enhanced," said Wallman. "Our analysis shows that these funds are not as well diversified as they could be beyond stocks and bonds – which are correlated with those stocks – thereby leading to a high exposure to risk from a decline in stocks."  

In a refinement of this approach, Folio Investing launched its own series of Target Date investments in late 2007.  The design of the Target Date Folios was driven by what the brokerage calls "relational diversification" – an advanced institutional-level strategy which focuses on managing a portfolio's risk level and the evolving relationships between asset classes.

"Achieving true diversification requires much more than simply combining stocks and bonds in a portfolio," said Wallman. "Financial research over the past two decades (and subsequent changes in strategic asset allocation by institutional investors) suggests that better results can be achieved by analyzing the relationships between sectors over time, and diversifying to a far greater extent than is traditionally done. We utilize the correlations – actually the lack thereof – between asset classes and sub-asset classes to help increase diversification and target appropriate risk levels.  This helps to provide more consistency in performance, reduces risk for a given level of expected returns and lowers the impact of economic variability."  The initial research on the Target Date Folios in 2007 suggested that others' traditional Target Date strategies might be losing 1% or more in annual return due to under-diversification(1) and, more importantly, taking on higher risk than needed.

In addition to the standard equity and bond components, the Target Date Folios include allocations to:

• commodities;
• inflation-tracking bonds (TIPS);
• real estate assets;
• explicit allocations to infrastructure stocks such as utilities; and
• other asset classes.

(See graphs depicting asset allocation glide paths.)

The performance of the Target Date Folios validates this innovative approach to asset allocation.  Since their inception in late 2007 (a period of just over 3.5 years), the average return of the 2010, 2020, 2030 and 2040 Moderate Target Date Folios was 1.13% higher -- per year -- than the average return of the corresponding Target Date Funds(2) from the three dominant mutual fund companies, and 1.87% higher per year than the average of all corresponding Target Date Funds that have been in existence over this period.  [Note: Target Date Folio performance numbers include the expense ratios of the underlying ETFs held in the Folios.  Results also have been reduced by 0.75%, to reflect brokerage fees(3).]  

"The long term impact of a performance improvement of 1% a year is significant," Wallman noted.  "The Department of Labor and others have estimated(4) that a 1% increase in return over an investor's working lifetime results in almost 30% higher wealth at retirement – in other words, 30% higher retirement income."

According to Wallman, the need for Target Date Funds to achieve superior and intelligent diversification constitutes a key public policy issue.  "Target Date Funds are the default core investment in 401(k) and other defined contribution plans," he said.  "A more perfected design will improve the chance of a financially secure retirement for hundreds of thousands of Americans – and we can do better."

About Folio Investing

Online brokerage Folio Investing is a division of FOLIOfn Investments Inc. The company enables investors and financial advisors to manage stocks, ETFs, and mutual funds as integrated investment portfolios called "Folios" that deliver control, transparency, and low cost. Investors can create their own Folios, much like creating personalized ETFs or mutual funds, or invest in over 150 Ready-to-Go Folios representing market indices, industry sectors, geographical regions, target dates, and more. The Folio Unlimited pricing plan features unlimited commission-free trading in twice-daily windows for only $29 per month or $290 per year.

Ready-to-Go Folios can be managed or unmanaged, are not registered investment companies, and are offered by FOLIOfn Investments Inc., a registered broker-dealer. FOLIOfn Investments Inc., member of FINRA/SIPC, does not provide investment, tax, or legal advice.

(1) Folio Investing White Paper: FOLIOfn and Target Date Folios, Dec. 22, 2007 (available on request).

(2) A total of 12 return figures are used to calculate the average return: the returns of the 2010, 2020, 2030 and 2040 Target Date Funds from the three dominant fund companies.

(3) Brokerage fees at Folio Investing are charged as a flat annual fee of $290.  If an individual investor has $75,000 invested in the Target Date Folios (comparable to the current average balance of 401(k) plans), the $290 annual fee equates to 0.38% per year, for example.  Our higher cost estimate of 0.75% is representative of an investor with a $40,000 balance.

(4) Employee Benefits Security Administration, U.S. Department of Labor, publication: A Look at 401(k) Plan Fees:  http://www.dol.gov/ebsa/publications/401k_employee.html.

As with any investment, investments in Target Date Folios are subject to investment risk including the loss of the principal amount invested. Investors should consider the investment objectives and risks of the Target Date Folios before investing. For more information regarding the Target Date Folios, please visit the website: www.folioinvesting.com.  Past performance is no guarantee of future results.

SOURCE Folio Investing