Asset Allocation Funds Post Strong 2013 Performance
February 3, 2014 (PLANSPONSOR.com) - Target-date funds had an average total return of 5.4% for the fourth quarter of 2013, according to Morningstar data.
However,
returns were significantly less than the 10.5% return of the S&P 500 due to
poor performance in non-U.S. equities and bonds, the “Ibbotson Target-Date Report 4Q 2013” shows.
For the 2013 calendar year, the average total return for target-date funds was
a very strong 16.3%.
Dispersion
of returns across target-date fund families was large relative to past
quarters’ variance. Equity-centric target-date funds, particularly those with a
tilt toward U.S. equities, tended to achieve the highest returns. Those
funds with exposure to real return asset classes such as real estate investment
trusts (REITs), commodities, and Treasury inflation-protected securities (TIPS)
struggled relative to peers.
Flows into
target-date funds bounced back in a big way from the anomaly seen during the
third quarter of 2013 when estimated net inflows were a mere $2.3 billion, the report
says. During the fourth quarter, estimated flows into target-date funds neared
$13 billion, more in line with the recent past.
According
to the “Ibbotson Target Risk Report 4Q 2013”,
target-risk funds gained 5.0% on average for the fourth quarter and 14.9% over
the past 12 months.
Flows
into target-risk funds were healthy with more than $2.0 billion flowing into
the category during the quarter. Growth-oriented funds gathered the majority of
the flows.
Target-risk
funds continue to see total assets climb to all-time highs. As of the end of
Q4, total assets in target-risk funds were near $713 billion, an 18% increase
from a year ago.
The
firm analyzed durations and found few target-risk funds are actively lowering
interest rate risk ahead of expected tapering of the Federal Reserve’s bond
purchase programs.
Josh Charlson, a
strategist for the fund of funds research team for Morningstar, discusses
target-date fund performance in 2013 in an article here.
February 3, 2014 (PLANSPONSOR.com) - Year-end reflection has led many defined benefit plan sponsors to revisit a perplexing problem they have been facing all year: what should be done with fixed income allocations in light of the expected rise in rates due to Fed tapering?
Fixed
income has enjoyed a great run in recent years. In the five years to March
2013, the Barclays US Treasury Long Duration Index annualized return was 8.3%
with a Sharpe ratio of 0.6. The Barclays Aggregate Bond Index (the Agg) had an
even higher Sharpe ratio of 1.3 with an annualized return of 5.5%. By
comparison the S&P 500 had annualized at a 5.8% return with a Sharpe ratio
of 0.3. Recent years have been truly good times for bond managers, and during
this period plan sponsors have generally increased allocations to fixed income.
According to JP Morgan, G4 pension funds and insurance companies (including the
U.S., UK, Euro area and Japan) increased their bond allocations from
approximately 43% in 2008 to 51% in 2013.
However,
the previously benign fixed income market environment quickly changed last year
following a series of speeches and statements in which the Fed indicated that
the roughly $85 billion per month bond purchase program (QE) would not be a
permanent policy feature, and in fact tapering of these purchases was expected
before year end. This led to a tumultuous second half of the year in fixed
income markets. The 10 Year Treasury Note quickly jumped 100 bps and mortgage
rates climbed even higher. Outflows dominated price action in bond markets,
with about $70 billion of outflows from bond mutual funds in 2013, leading to
poor performance across almost all fixed income sectors. The Agg ended the year
down 2.02%. In December the Fed announced that it would begin tapering, and
outlined a path towards broader policy normalization (rising rates) in years to
come. Suddenly what was for decades a comfortable overweight in fixed income
portfolios is now leading to some sleepless nights.
Generally
speaking there have been three primary responses to the shift in monetary
policy among plan sponsors. The first is simply to do nothing. The thinking
here is that a well-diversified portfolio features elements that should do well
in any environment, thereby relieving the long-term investor of the requirement
to correctly anticipate which asset class will do well in the immediate future.
After all, accurately predicting the future is something that human beings have
historically struggled to do well.
However, even without
a crystal ball, basic bond math would seem to indicate that forward looking
returns in fixed income will not be the same as they were prior to 2013. A
simple back-of-the -envelope calculation suggests that with today’s 10-year
yield of just under 3%, rates would need to collapse to Japan levels (10 year
JGB at 0.7%) for fixed income to pull off another five years of great
performance like it did between 2008 and 2013—a move like that is certainly not
in line with the Fed’s forward guidance or recent economic data. It also seems
likely that as monetary policy becomes more hawkish, volatility in interest
rates should also increase because of policy uncertainty. Therefore, the
prospect of doing nothing with long duration fixed income portfolios
probabilistically points to lower returns with higher volatility.
Down
The Rabbit Hole…
This
brings us to the second approach to dealing with this rising rates conundrum,
reaching further down the credit curve with fixed income allocations. The key
underlying objective function here is to increase the spread per unit of
duration in the portfolio by either shortening the duration of the portfolio
(e.g., adding in floating rate bonds) or increasing the spread (e.g., lowering
the average credit quality of the portfolio). Corporate balance sheets today
are generally healthy. Economic growth has been sluggish, but doesn’t appear to
be vulnerable and in fact has recently been gaining momentum. Overall credit
spreads seem set to tighten based on the fundamentals. Furthermore, the added
spread to the portfolio can alleviate interest rate increases by providing a
cushioning against rising rates. Plan sponsors following this path have
increased allocations to areas such as U.S. high yield, emerging market fixed
income, CMBS, etc.
The
“going down the rabbit hole” approach can help cushion a portfolio from losses
due to increases in interest rates, but it also has the effect of increasing
the correlation of fixed income allocations to equity allocations. The end
result is that a plan sponsor’s overall portfolio can suddenly become more
sensitive to gross domestic product (GDP) cyclicality.
Additionally,
the scramble for yield phenomena has been going on for a while. In 2009, almost
any spread asset was a good buy. After five years of steady inflows, today most
fixed income sectors appear to be on the rich side. In the few areas where
value can still be found, security selection is paramount. CMBS, for example,
now looks unattractive as a unhedged, long-only trade in light of the looming
debt wall (around $395 billion expected to mature between 2014 and 2017), but
there are still many specific situations that may pay off handsomely. In short,
owning spread product has shifted from a ”wave it in trade” to a more difficult
security selection exercise, and a tactical, trading-oriented approach is also
warranted. (See PAAMCO Viewpoint “CMBS 2014: A Changing Landscape” by Austin
Head-Jones, available on www.paamco.com.)
Exhibit
1: Betas of the S&P 500 TR Index with Credit and Hedge Fund Indices
April
2008 – December 2013 (Source: Barclays and Credit Suisse) *Updated through
November 2013
Crises
Lead to Innovation
Finally,
some plan sponsors are following a third approach to this problem by rethinking
the role of fixed income in the portfolio. By carefully defining the
characteristics that fixed income fulfills for their portfolio (i.e., low
correlation to equity, lower volatility than equity) they can then be creative
about finding alternatives that offer similar attributes but with better return
prospects.
For
example, hedge fund portfolios can be constructed to have low volatility and
low correlation to equities. Some plan sponsors are beginning to include
alternatives within traditional long-only fixed income allocations. While
long-only fixed income prospects are diminished by higher rates and higher
volatility, the return prospects for many fixed income hedge fund strategies
are actually improving. Fixed income relative value trading has become
potentially more lucrative recently because as interest rate curves shift,
pockets of relative value can appear and be exploited. Additionally, the
increased regulatory environment faced by investment banks has led to a
reduction in bank trading activity in many fixed income sectors, thus providing
more relative value opportunities for hedged, trading-oriented strategies in
many bond markets such as RMBS, CMBS, municipals, etc. Finally, after years of
globally coordinated easing monetary policy, the macro environment is also
shifting. There is now greater dispersion of economic performance across
regions as well as in the monetary policy response. This dispersion is benefiting
a range of directional long/short hedge fund strategies in FX and fixed income.
To
conclude, traditional fixed income investors have enjoyed a great ride over the
last 30 years as interest rates have drifted steadily lower. Now, however,
interest rates are simply too low to provide the same returns, and seem poised
to transition to a path of normalization. Doing nothing or going further down
the credit curve have been typical responses but have drawbacks in either poor
prospective returns or lower portfolio diversification benefits. Alternative
investments such as fixed income-focused hedge funds can provide an important
solution here, and innovative plan sponsors are finding new ways of layering
these into their portfolios.
Sam Diedrich, CFA,
CQF is an associate director and portfolio manager for the fixed income
relative value strategy at PAAMCO. He is responsible for manager research and
portfolio construction within the strategy. In addition, he also serves as the
main point of contact for certain institutional investor relationships. Prior
to joining PAAMCO, Sam worked as an electrical engineer for the Johns Hopkins
Applied Physics Laboratory (Laurel, Maryland). Sam received his MBA from the
University of Chicago Booth School of Business, his MS in Electrical
Engineering from Johns Hopkins University, and his BS in Electrical Engineering
(Distinction) from the University of Washington.
NOTE: This feature is
to provide general information only, does not constitute legal advice, and
cannot be used or substituted for legal or tax advice.