For target-date funds, hindsight was 40/60

• Near-retirement target-date funds may have benefited from having less equity exposure heading into the COVID-19 sell-off than they did heading into the 2008 global financial crisis.
• ESG views could have been integrated into equity and fixed-income allocations within near-retirement target-date funds without sacrificing return during our study period.
• Integrating low-volatility funds into equity and fixed-income allocations would have reduced drawdown risk in the period leading up to retirement.

The coronavirus pandemic has been unkind to most investors, and especially so for those closest to and early in retirement. The sequence of returns matters for those withdrawing income from their retirement portfolios. That is, large drawdowns early in retirement may have more impact than those occurring later. In this blog post, we look at how low-volatility and ESG investments, in equity and fixed-income allocations, affected drawdowns when markets were volatile.

Earlier, we demonstrated that we could increase the funded status of a hypothetical retirement goal by introducing a low-volatility investment into the equity allocation of a target-date fund. We also demonstrated that integrating ESG into the equity allocation did not adversely affect retirement outcomes. Neither of these changes altered the original glidepath – only the investments within the equity allocation were modified.

How did ESG and low-volatility allocations hold up in the current sell-off?

Before we answer that question, we first return to the 2008 global financial crisis. During that sell-off, 2010 target-date funds fell, on average, by almost 30% at their trough, as shown below. While that was a better outcome than more-aggressive 2020- and 2030-dated funds, one of the lessons from that crisis was that near-retirement funds carried too much risk due to high equity exposure.

Target-date fund performance through the global financial crisis

Monthly gross returns are sourced from eVestment for each target series with continuous returns throughout the period. Median return for each series is plotted.

Over the recent sell-off, it appears that those retiring this year with target-date funds as their retirement savings vehicle have, so far, been better positioned compared to those who retired in 2008.¹ Investment consultant Callan, for example, notes that near-retirement funds (2020 target date) had a 40% allocation to equity and 60% to fixed-income assets, on average.² This is considerably more defensive than the 50% allocation to equities that near-retirement target-date funds had during the 2008 global financial crisis, as our earlier research showed.

So, was target-date hindsight 40/60? To help answer that, we started with an allocation that is 40% invested in funds that aim to replicate the MSCI ACWI Index (equities), and 60% invested in funds that aim to replicate the MSCI USD IG Corporate Bond Index (fixed income). This serves as our base allocation.

Next, we replaced the equity and fixed-income sleeves with their low-risk and ESG counterparts. The exhibits below show the indexes used as the proxy for each allocation, and their ESG scores.

Indexes used for our hypothetical target-date fund

ESG scores of indexes used

MSCI ESG scores are as of February 2020. Fixed-income indexes shown in yellow bars; equity indexes shown in blue.

Comparing returns, volatility and maximum drawdown

For each allocation, we compared return, volatility and maximum drawdown over the period January 2015 to the end of March 2020. These dates are chosen to capture the common history for all indexes used.

We looked at risk versus return for each allocation, with and without March 2020. The severity of March’s equity sell-off was stark: there was an almost 2% drop in annualized return for each allocation. Yet, important relationships remained.

First, for both periods, the low-volatility allocation reduced overall volatility, while the ESG allocation maintained a similar risk profile as the base.

Second, the relatively small historical premium the ESG allocation had over the base prior to March 2020, persisted through March – in fact, it widened. Similarly, the low-volatility allocation went from slightly underperforming to significantly outperforming the base allocation when we included March’s returns.

Risk and return with and without the March 2020 drawdown

Returns are monthly, and gross (for equity) and total (for fixed income) in USD from January 2015 to March 2020.

It appears that integrating an ESG or low-volatility tilt into the equity and fixed-income allocations, at a minimum, did not have a negative financial impact during the sell-off. And at best, they provided portfolio resilience.

Next, we traced drawdown over the past five years, inclusive of March 2020. As the exhibit below shows, the ESG allocation had a similar drawdown profile as the base allocation. The low-volatility allocation, on the other hand, had a smaller drawdown than the base allocation in most periods.

Drawdowns across base, ESG and low-volatility allocations

Finally, we extended the window back to 2007 to examine the potential long-term drawdown benefit of the low-volatility allocation over the base allocation. In the exhibit below, a positive value indicates the low-volatility allocation had a smaller drawdown during that period.

The low-volatility allocation was most beneficial, predictably, during the market declines shown in the shaded regions. But, in almost 90% of the periods we looked at, the low-volatility allocation had an equal or smaller drawdown than the base allocation.

Low-volatility allocation drawdowns vs. the base

Target-date fund managers looking for ways to improve portfolios have by and large not turned to ESG and low-volatility investments. While the past is not always a prologue, introducing low volatility into equity and fixed-income sleeves would have provided a drawdown benefit, and ESG views could have been integrated without sacrificing return during our study period.

¹“Callan Target Date Index.” Callan.

²Tergesen, A. “Your 401(k) May Do a Bit Better This Time.” The Wall Street Journal, March 14. 2020.

Further Reading

Retire in Monte Carlo? Simulating retirement outcomes

Same target, different destinations

Goals-based Asset Allocation in WealthBench