TDFs Going Global

Target-date funds (TDFs) have quickly become a favorite default option within retirement plans. While the overall split among stocks and bonds within a TDF series, the glide path, is a primary driver of results and therefore participant outcomes, what those asset classes are composed of can also impact results and is worthy of consideration, according to a white paper by Portfolio Evaluations Inc.

As a number of TDF providers have announced changes to their TDFs’ international stock and bond exposures, it is important for plan sponsors to understand the implications of those changes and how their plan’s TDFs may be affected, says Kathryn Spica, senior investment analyst at Portfolio Evaluations and author of the paper. TDF providers can also use different tools when implementing these changes, from strategic shifts to tactical overlays to currency hedging, adding another layer to consider when evaluating the product.

Since 2007, the average international stock exposure across TDFs has moderately increased, from roughly 18% to 22% of assets. On the bond side, the average international exposure has grown, from less than 1% to 4% of assets

Those numbers are likely to grow further this year. For example, Vanguard, the largest mutual fund target-date provider by assets, said earlier this year it would increase its international stock stake to 40% of stock assets throughout 2015, up from 30%. In addition, after introducing international bonds to the portfolio for the first time in mid-2013, the firm is also boosting the international sleeve of its TDFs’ bond assets, from 20% to 30%. American Century, PIMCO, Prudential and Schwab are among other providers adding international bonds or increasing their international stock exposure.

Providers are continuing to rethink the global exposures of their TDFs for several reasons. One is to reduce the home country bias in their portfolios. While no provider has gone so far as to match the global market’s roughly 50% U.S./50% international stock split and 40% U.S./60% international bond split, over time the average allocation in TDFs has inched closer to that of the global market portfolio. For some providers, the strength of the U.S. stock and bond markets over the past several years is reason to think international markets may provide better opportunities going forward.

Not all target-date providers have moved at the same pace, and there is still wide variation in the range of international exposures across TDFs. No provider eschews international stocks completely, although there are still a few that do not utilize international bonds, or at least do not include a dedicated international bond strategy. In addition to the range of international exposures among different providers, there is also variation along individual glide paths.

Some U.S. stock and U.S. bond funds, while typically considered to be part of the TDFs’ exposure to U.S. markets, can also include exposure to international securities. For example, the longer-dated funds in MFS’ TDF series have a strategic allocation of 28% to international stocks. In practice, the funds have a larger allocation to international stocks, as several of the underlying domestic stock funds have some exposure to international stocks as well.

 NEXT: Currency fluctuations can be another risk factor

While most of the increases in TDFs’ international stock and bond exposures are strategic in nature, reflecting providers’ desire to have more global exposure in their products, some providers also have the ability to tactically allocate to international securities.

Investing internationally carries an additional risk from exposure to currency fluctuations, and plan sponsors should be cognizant of how their provider handles this exposure. For the most part, this function is managed by the underlying managers of each individual stock or bond strategy. Most stock managers do not hedge all their international currency exposure, as research has shown currency hedging generally does not materially reduce volatility or increase returns over the long term for stocks. For international bond exposure, however, most providers do hedge all or the majority of the currency exposure.

While the overall asset allocation of TDFs will continue to have the largest impact on results, it is important for plan sponsors to understand and be comfortable with the nuances of the sub-asset-class exposures within their selected TDFs.

As TDF providers in general take a more global stance, an evaluation of the international allocations and implementation tools used by TDF providers continues to be an important part of a prudent due diligence process.

“The Global Tilt in Target Date Funds” can be accessed through Portfolio Evaluation’s website.