Howard Gold's No-Nonsense Investing: Pioneer of target-date funds looks to the future: hedging and ‘tail-risk’ strategies

Howard Gold's No-Nonsense Investing: Pioneer of target-date funds looks to the future: hedging and ‘tail-risk’ strategies

7 Jul    Finance News

Investment-research firm Morningstar recently bestowed an “Outstanding Portfolio Manager” award on Jerome Clark of T. Rowe Price, a pioneer in developing target funds for the Baltimore-based mutual fund giant.

It was recognition for Clark himself, who along with his team members, launched T. Rowe’s first target-date funds in 2002, a year before Vanguard started its own. (Fidelity Freedom Funds began in 1996.) But it also validated how important these funds — which adjust their asset allocations based on how close they are to the target retirement date — have become.

More than $1 trillion in employer-sponsored retirement plan assets are invested in target-date funds, which drew 59% of new contributions to those plans last year, according to Vanguard. They are among the few bright spots for a struggling fund industry. Vanguard is the largest player, with 37% of that market, followed by Fidelity and T. Rowe TROW, -1.83%, with about 13%-14% each, by some estimates.

Clark is currently transitioning from active portfolio management to a broader, more strategic role with the firm, so I thought it was a good time to get his thoughts on where target funds have been and what’s ahead. (He’s also one of the most prominent African-Americans in the fund industry and has a lot to say about how to address the huge, persistent wealth gap between Black and white Americans. We’ll get to that in a future column.)

‘We don’t expect people to know how to do surgery’

Clark believes, as I do, that target funds remain the best overall way to invest for retirement for most people, who have been given the responsibility to manage their own retirement but not the tools to do it properly.

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“Just like we don’t expect people to know how to do surgery like a doctor would, in a 401(k) plan we ask a lot of people to do things that they’re just not prepared to do,” he told me.

That includes fund selection, asset allocation and rebalancing along the “glide path” to retirement. ”All those different things, you take it out of their hands and you put it into the hands of a professional,” Clark said.

It can also mitigate what behavioral economists have identified as emotion-driven actions including overconfidence, confirmation bias and the fight-or-flight syndrome.

“They’re just not prepared, they don’t have the investment knowledge and investment experience,” said Clark. “We see behaviors that are what we call suboptimal.”

“Suboptimal” is the fund industry’s euphemism for “self-destructive,” but you get the point.

Avoiding big mistakes

Active mutual fund managers have underperformed for years, but target funds have kept investors from making the very worst mistakes, such as selling at the bottom or buying at the top. Much of it is so automatic — direct withdrawal from paychecks, default investing in a target fund — that investors don’t obsess over it when things go bad. In investing, a little knowledge can be a very dangerous thing.

In fact, according to Clark’s colleague, fund manager Joe Martel, since 2006 fewer than 2% of target-fund investors have moved their money even during quarters when the market dropped 5%.

“No matter what environment we’re in, investors at all ages are about four times more likely to react to markets and make trades [outside than] within a target date fund, which is a good thing,” Clark told me.

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A new role

In his new role, Clark will be shaping the future of target date funds. T. Rowe recently announced it would be stepping up its equity allocations throughout the glide path to retirement, but not at retirement itself. That’s a bit surprising, since its target funds are the most aggressively invested of the Big Three. Why? Because they say their clients have big shortfalls in retirement assets, and are more likely to run out of money late in life. (I’ve had issues with that thinking for a long time and still don’t completely buy it.)

That’s why Clark is working on some strategies that could hedge the increased risk of holding more stock. They may include techniques such as call writing and fixed income-like vehicles to cushion volatility and provide some insurance against rare, “tail risk” events (like the financial crisis or COVID-19) that might occur just as people retire.

He’s also looking at some hybrid products that combine the target-date framework with elements of separately managed accounts to provide clients with more personalized solutions for the period shortly before as well as during retirement to help them spend wisely what they’ve built up over the years.

T. Rowe Price isn’t the only firm experimenting with more customized target-date products. They represent the next wave in which standard target date funds before retirement are followed by more sophisticated payout funds afterwards — in other words, a synthetic pension, the kind the 401(k) was supposed to replace.

But people want that certainty and security, which is why what goes around looks like it’s coming around again.

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Howard R. Gold is a MarketWatch columnist. Follow him on Twitter @howardrgold.

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