Here, we will use a case study to compare two different approaches to assessing active fixed income in target retirement strategies. In highlighting our key findings, we encourage plan sponsors to consider more than benchmark-relative performance for individual asset classes in selecting appropriate allocations for target retirement strategies and recommend the following questions to guide evaluation:
What is Driving Excess Performance?
Is it greater skill, or more risk? Does this align with participant risk tolerance?
Fixed income’s role in a target retirement strategy is to complement growth assets in order to efficiently address key risks that participants face — namely market volatility, inflation and longevity risks. An active core manager may be able to improve returns by overweighting credit and opportunistically expanding the opportunity set to sectors like high yield, but this may lead to undesired interaction with the broader portfolio.
To illustrate this point, we’ve conducted a case study using Morningstar data to compare the fixed income allocation in our retirement portfolio to that of a large, actively managed target retirement series. Taking more risk within fixed income has allowed the active manager to provide attractive returns, but this comes at the expense of higher correlation to credit and equity markets, reducing diversification within the target retirement portfolio.
Are Objectives Aligned?
Are you seeking to improve outcomes or to beat a benchmark?
Fixed income strategies with higher credit risk can increase correlations with growth assets in the portfolio and may ultimately jeopardize the ability of the portfolio to perform in times of market stress. A thoughtfully constructed strategy should take this into account.
Using the same active manager as an example, historical results, unsurprisingly, show a strong dispersion in returns across equity market environments. The active approach has added value, but only during periods where riskier assets have outperformed. The strategies have lagged in down markets, accelerating losses for target retirement investors at a time when downside protection would be quite valuable — especially for participants with shorter time horizons.
The State Street approach breaks out its fixed income exposure across six fixed income indices, seeking to provide a more balanced return profile across all market environments while also considering the objectives of participants at each stage of their careers.
3. Is There a Way to Gain Desired Exposures More Efficiently?
Can you improve outcomes while maintaining low cost and transparency?
Just because active fixed income funds can often beat a benchmark does not inherently mean that those funds improve outcomes when used in a multi-asset class portfolio. But the standard approach to “passive” fixed income — namely concentrated exposure to the Agg — presents its own set of challenges. As an issuance-weighted benchmark, the Agg has become increasingly concentrated in lower yielding, higher duration government debt in recent years. This shift in composition has made the index less ideally positioned to deliver the risk and return profile that it has historically offered. The need for an active decision, however, is not necessarily the same as the need for an actively managed fund.
We believe that the decision to diversify away from the Agg can be done in a transparent, low-cost manner that allows for greater control over the full fixed income portfolio, ensuring its purpose is aligned with the broader target retirement solution. This approach stands out relative to both active approaches — which may overemphasize risky assets in an effort to improve returns — and common passive approaches, which tend to rely largely on an allocation to US aggregate bonds. Strategies concentrated in Aggregate bonds may provide insufficient diversification for young participants, create increased interest rate risk for retirees and ultimately allow for very little control due to their issuance-weighted nature.
Focus on Outcomes
Active core bond strategies may be able to add alpha, but have historically done so by moving further out on the credit risk spectrum. At State Street, we take a different approach. We believe that the optimal design marries strategic asset allocation with a diverse array of underlying index funds. This approach allows us to intelligently manage the key risks that participants face as they evolve over time, while maintaining the low-costs and transparency that plan sponsors desire.
Using the right building blocks makes for a target retirement strategy that is better designed to deliver on the only objective that we believe really matters: successful retirement outcomes for participants.
The views expressed in this material are the views of SSGA Defined Contribution as at 11 December 2018, and are subject to change based on market and other conditions.
This document contains certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected.
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Exp: July 31, 2020