Adding Asset Classes Doesn't Always Improve A Target Date Fund

Khaoula Begdouri
By Khaoula Begdouri, CFA, CAIA
One of the appeals of target date funds is that they give participants access to a sophisticated asset class menu formerly reserved for institutional investors. With the growing availability of new investable asset classes and the increasing demand for improved returns and controlled risk, target date fund providers, including BlackRock, have evolved their strategies to increase the roster of market exposures.

But merely adding more asset classes does not guarantee an improved risk/return profile. To ensure that an asset class is additive, the selection process must have clear inclusion criteria that focus on the potential benefits, risks, and costs.

Recently, BlackRock evaluated both Global bonds and high yield bonds as additional fixed income exposures within the LifePath strategies. While both have potential merit within an actively managed, tactical strategy, LifePath is managed to a strategic benchmark. With that in mind, the question becomes, does the fund gain by including these asset classes on a consistent basis. After rigorous research and careful analysis, we decided they were not additive from a strategic perspective. This article examines our rationale for this decision.

Global Bonds: Currency Risk

The size of the global bond market is estimated at over $41 trillion, with approximately 37% in US issuances and the rest issued by foreign governments and corporations. However, the use of international bonds by institutional investors remains small, with only 5 of the top 10 defined benefit plans holding them in their overall portfolio.

One of the reasons for the comparatively small uptake is that investing internationally exposes investors to currency risk. The volatility of foreign exchange rates can overwhelm the benefit of diversification and hurt the portfolio, especially in times of crisis.

For example, a US target date fund owns €10 million Euros in European fixed income securities. If the exchange rate for the Euro is $1.3, the portfolio would be worth $13 million. However, if the Euro falls to $1.05, the portfolio value drops to $10.5 million, a 24% loss due solely to currency exposure.

Such a currency swing can be detrimental for a participant nearing retirement. Hedging the currency exposure does a good job in ironing out volatility associated with the exposure, making it more prudent for a target date fund. However, the implicit and explicit costs in hedging result in a lower yielding asset class. Therefore, replacing a portion of the domestic bond allocation with a global bond exposure does not necessarily result in a more optimal target date fund.

High Yield: Volatility, Liquidity & Correlations

In the present low-interest rate environment, many investors are seeking out higher-yielding solutions and high yield bonds are one of them. But does this yield hungry crowd pleaser qualify as a diversifying fixed income exposure within a strategic target date fund?

High yield issuers are willing to pay a premium to compensate investors for both higher credit and liquidity risks.

While high yield bonds offer attractive investment opportunities, they raise three concerns from the strategic glidepath point of view:

Volatility: During times of market stress, the credit risk of high yield bonds increases significantly and the "flight to quality" of investors seeking safety drives down their principal value more than comparable investment-grade bonds.

Liquidity: High yield bonds' liquidity may become impaired during a market crisis, causing a spike in their transaction costs. Over the past 5 years, the Liquidity Cost Score for High Yields has ranged from 1.1% to over 7% during the 2008 financial crisis. For the investment-grade corporate bonds, the Liquidity Cost Score ranged from 0.5% to 2.9% over the same period.

Correlations: Finally, High Yield bonds have a high correlation with equities during market downturns. Comparatively, investment-grade corporate bonds maintain a lower correlation with the equity market and tend to do a better job in cushioning the losses in adverse market environments.

Overall, within a strategic target date fund approach, high yield bonds tend to be less optimal than investment grade fixed income securities.

BlackRock introduced LifePath in 1993, and for nearly two decades our philosophy has been to deliver more predictable retirement outcomes with fewer negative surprises. Over that time LifePath's asset allocation has become increasingly sophisticated, with an expanded global reach. But we have only made changes when we could make a compelling case. So far, international and high yield bonds do not pass the test, although we will continue to evaluate them and other potential asset classes.

The LifePath Portfolio mutual funds are distributed by BlackRock Investments, LLC ("BRIL"), member FINRA. BlackRock Fund Advisors ("BFA") serves as the investment adviser to LifePath Portfolio mutual funds, and the Master Portfolios, in which each LifePath Portfolio invests all of its assets and to the Underlying Funds in which the Master Portfolios invest.

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