Alpha unmasked: Differentiating skill from market risk in active TDFs

In this paper we provide an in-depth analysis of the challenges associated with measuring active target date fund performance. We seek to highlight the importance of using custom or investable benchmarks, rather than third-party industry benchmarks or category averages to accurately assess the value added by active management in target date funds.

Target date funds have become the most popular solution for retirement savings, allowing retirement plan participants to automate the time-varying risk budgeting and asset allocation associated with a long-term investment objective ¹. Active target date funds combine this long-term strategic asset allocation with short-term tactical asset allocation and security selection to seek consistent incremental excess returns that can compound over a participant's working years, thus leading to improved spending outcomes in retirement.

Unfortunately, measuring active target date strategies’ “active” performance (or returns in excess of a passively-implemented asset allocation using index funds) can be challenging. The document outlines best practices in active target date benchmarking, emphasizing the need for custom benchmarks that reflect a manager's strategic asset allocation. It argues that third-party benchmarks, while useful for regulatory and peer comparison purposes, may not accurately represent a manager's strategy and can lead to confusion between active returns and market returns.

The analysis includes a comparison of active target date funds against both their stated prospectus benchmarks, and custom benchmarks that more closely resemble their strategic asset allocations. It seeks to demonstrate that third-party benchmarks commonly used by active managers can be misleading, as they may not account for the varying levels of market risk taken by different managers. In short, they can confuse glidepath risk with active risk. Custom benchmarks, on the other hand, may provide a clearer picture of a manager's true skill in delivering excess returns.

Trailing-period results can be a useful starting point, but they may not show whether alpha has been delivered consistently over time. Because alpha compounds, evaluating active target date strategies should consider both the magnitude of active return and how reliably it has been generated across market environments. To provide a more complete view, we analyzed rolling periods to assess how frequently active TDFs produced positive alpha relative to their custom benchmarks.

We conclude by suggesting that plan fiduciaries consider incorporating custom benchmarks into their review processes to more accurately measure the potential value added by active management. We also suggest steps for plan fiduciaries to take, such as ensuring robust review processes, asking for custom benchmarks, and tracking the drivers of returns.