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Ingredients matter: The critical role of underlying funds in target date
Rich Lang
Multi-Asset Investment Director
KEY TAKEAWAYS
  • Ingredients matter. Underlying funds that compose a glide path significantly contribute to a target date series’ success.
  • Underlying funds focused on income have produced strong results with valuable downside resilience. They also can generate strong outcomes in withdrawal scenarios.
  • Flexible global and multi-asset funds can make a glide path more adaptable to changing market conditions.

Discussions about a target date series often center on the glide path. Less attention has been paid to the ingredients used to create the glide path — the underlying equity and bond funds.


The quality of those funds can dramatically affect results and participant outcomes. Combining the right ingredients at the right points in the glide path can allow a series to pursue enhanced returns and improved risk management.


In most series, underlying funds essentially consist of broad, market cap-oriented strategies segmented by region, style and market cap. In our experience, adding another focus — income — to these market cap-based strategies has produced strong risk-adjusted returns for participants.


Historically, strategies pursuing income, rather than simply targeting low volatility, have not only helped to dampen volatility but also have provided downside resilience in challenging market environments as can be seen in the chart below.


Income Funds Have Generated Strong Results and Downside Resilience

Average Results Over Rolling 10-Year Periods for U.S.-Focused American Funds (for 40 Years Ended June 30, 2017)


Source: Capital Group, RIMES. Capture ratios are relative to the Standard & Poor’s 500 Composite Index. American Funds sample includes equally weighted U.S.-focused funds with at least 40 years of history. Growth includes AMCAP Fund® and The Growth Fund of America®; Growth & Income is The Investment Company of America®, Washington Mutual Investors FundSM and American Mutual Fund®; Equity-Income is The Income Fund of America®; Bonds is The Bond Fund of America®. These U.S. equity funds were chosen to be shown because they share a common benchmark. Average annualized return is a simple arithmetic average of monthly returns (annualized). Portfolios were rebalanced monthly.

By using this suite of income-oriented equity and multi-asset strategies, we are able to shift the equity exposure in the later phases of the glide path from growth-oriented funds to these historically less volatile funds. In this way, the series has been able to reduce volatility without sacrificing the higher return potential of equities relative to bonds, which is important in addressing longevity risk.


Income and multi-asset funds can improve retirement outcomes


Portfolios should behave differently in retirement, when investors need downside resilience and sustainable income. Our experience and historical results show that equity-income funds, or multi-asset funds that focus on income and capital preservation, can be well-suited to address both needs.


Some market practitioners discount the focus on dividends from equities, arguing that investors shouldn’t care whether total return comes from capital appreciation or dividends. However, in our view, companies that maintain or grow a dividend generally exhibit better discipline in managing their capital structure and generating value for shareholders over time.


With this approach, our multi-asset and income-oriented funds have fared better in a historical withdrawal scenario than indexes. They also preserved principal in most periods, which can go a long way in keeping participants invested.


Income and Multi-Asset Funds Outpaced Indexes in a Withdrawal Scenario

Percentage of Rolling 10-Year Periods in Which Ending Balance Exceeded Initial Investment (6/30/1997–6/30/2017). Assumes a 4% initial withdrawal rate, with a 3% annual inflation adjustment.


Source: Capital Group, based on Class R-6 shares. Blended indexes are: for Capital Income Builder®, 70%/30% MSCI All Country World Index/Bloomberg Barclays U.S. Aggregate Index; for The Income Fund of America, 65%/35% S&P 500 Index/Bloomberg Barclays U.S. Aggregate Index; for American Balanced Fund®, 60%/40% S&P 500 Index/Bloomberg Barclays U.S. Aggregate Index. Past results are not predictive of results in future periods. Portfolios were rebalanced monthly. The primary prospectus indexes for funds are: S&P 500 and Bloomberg Barclays U.S. Aggregate indexes (for IFA and AMBAL), and MSCI All Country World and Bloomberg Barclays U.S. Aggregate indexes (for CIB). Blended indexes are secondary prospectus benchmarks and are used here to account for each fund’s bond holdings. There have been periods when the funds have lagged indexes.

Global funds add value to a target date series


Glide paths need some asset allocation flexibility at the strategy level to adjust to changing market conditions. A series can add valuable flexibility by using global and multi-asset funds that can shift between stocks and bonds, or between U.S. and non-U.S. assets.


At Capital, we do this using a fundamental, bottom-up investment process. Managers in flexible funds make relative-value decisions both at the asset level and at the security level, adjusting the funds’ asset mix to a degree in response to evolving valuations and opportunities.


Our global funds contributed to our series’ valuable greater-than-index stance in U.S. equities in the last several years. When the series debuted, it held a larger position in international equities relative to its custom index. However, starting around September 2009, the U.S. equity exposure gradually rose to the point that the 2050 fund held a greater-than-index position around October 2011.


This higher relative U.S. equity exposure was partly due to the global underlying funds, which collectively increased their holdings of U.S. stocks around the same time. The other target date funds similarly increased their U.S. equity exposure. Recently, the weighting of international equities has begun to rise in the global funds.


In Recent Years, the Series Benefited From Higher U.S. Equity Exposure

U.S. Equity Weight Relative to Custom Index — 2050 Fund (June 2007–June 2017)


Source: Capital Group. Custom indexes are based on a combination of the S&P 500, MSCI ACWI ex USA and Bloomberg Barclays U.S. Aggregate indexes. Weights were based on the 10-year monthly average asset class exposure (as of December 31, 2014) of the underlying funds. For funds less than 10 years old, lifetime averages were used.


Rich Lang is the multi-asset investment director at Capital Group. He has 25 years of investment experience, all with Capital. He holds master's and bachelor's degrees from Loyola Marymount University.


Class R-6 shares were first offered on May 1, 2009. Results prior to that date are hypothetical based on Class A share results without a sales charge, adjusted for typical estimated expenses. Please see the funds’ most recent prospectus for more information on specific expenses. We offer a range of share classes designed to meet the needs of retirement plan sponsors and participants. The different share classes incorporate varying levels of advisor compensation and service provider payments. Because Class R-6 shares do not include any recordkeeping payments, expenses are lower and results are higher. Other share classes that include recordkeeping costs have higher expenses and lower results than Class R-6.

Bloomberg® is a trademark of Bloomberg Finance L.P. (collectively with its affiliates, “Bloomberg”). Barclays® is a trademark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Neither Bloomberg nor Barclays approves or endorses this material, guarantees the accuracy or completeness of any information herein and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. You may not redistribute the MSCI data or use it as a basis for other indices or investment products.

The S&P indexes are products of S&P Dow Jones Indices LLC and/or its affiliates and have been licensed for use by Capital Group. Copyright © 2017 S&P Dow Jones Indices LLC, a division of S&P Global, and/or its affiliates. All rights reserved. Redistribution or reproduction in whole or in part are prohibited without written permission of S&P Dow Jones Indices LLC.

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Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses and summary prospectuses, which can be obtained from a financial professional and should be read carefully before investing.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. This information is intended to highlight issues and should not be considered advice, an endorsement or a recommendation.