RAFI Glide Path’s Upward Trajectory
So how well would a target-date fund using the FTSE RAFI® All World 3000 Index perform? To estimate the weight between stocks and bonds, we used the old guideline of holding the same percentage of bonds as one’s age. Our hypothetical investor is John Saver, a frugal 30-year old who plans to retire in 2020 at age 66. He starts salting away retirement money in January 1984 with a $10,000 portfolio that is invested 70% in stocks and 30% in bonds. Every January 1 he contributes another $1,000 while his stock weighting drops 1%. Thus, at the start of 1985, when John Saver turned 31, his bond weight increased to 31% and stocks were rebalanced to 69%. In comparison, the Dow Jones Target 2020 Index’s equity allocations hover around 90% from 1984 until 1990, when it slowly starts slipping, hitting the 44% mark in 2010. This sloping allocation gave the Dow Jones Index an advantage during the bull market that started in 1982.
The upshot: Currently, John Saver would have $308,000 in his 401(k) account if he had invested in a portfolio mimicking the Dow Jones Target 2020 Index. If he had invested in funds mimicking the FTSE RAFI All World 3000 Index and the Barclays Capital Aggregate Bond Index, his portfolio would be more than $50,000 bigger—an increase of nearly 20%—and with one-third less risk because he would have been invested in a less equity-centric portfolio.
These superior results could have been achieved with remarkable efficiency. The expense ratio for an age re-weighted blend of two broad index funds—the BarCap Aggregate and the FTSE RAFI All World 3000—would be 40 basis points—well below the average target-date fund expense ratio of 1.03%.7 There would be no active managers to hire and fire in each sleeve. Communication to plan participants—most clamoring for a simple explanation of how their nest egg is being invested—would be a breeze. Plan sponsors and their employees would not need to be rocket scientists to find a simple and effective path to retirement security.
An Asset Allocation Alternative
A systematic, disciplined, tactical asset allocation process embedded within today’s glide paths would represent a further step forward. With such an overlay, the glide path can be modified as market conditions (notably risky asset class valuations) change, ideally shifting the portfolio to a more conservative or aggressive bent. A simple exercise of comparing likely and probable long-term asset class returns and then allocating accordingly could have saved considerable pain in previous market storms. One doesn’t have to be clairvoyant—just sensible.
Let’s assume that when stocks beat bonds by a wide margin, things are likely to mean-revert (go back the other way). So John Saver looks back at the return for stocks and the return for bonds over the past five years. Every 1% difference in the annual returns triggers a 1% shift in his year-end rebalance.
When John got started, stocks beat bonds by 5% per year for the previous five years. So, instead of investing 70% in stocks and 30% in bonds, John started with 65% in stocks and 35% in bonds, taking a contrarian bet that markets could go the other way. A year later, stocks were still ahead of bonds, but the five-year equity average outperformance was now only 2% a year. So, instead of rebalancing to 69/31, he now rebalanced to 67/33.
This simple application—contra-trading against whatever has been best in the past five years—leads to 10% more wealth after a quarter-century. This additional $85,000 in returns means that he’s now 28% ahead of where he’d have been with the first generation glide path strategy, offering a far better prospect for a secure retirement.
The autopilot embedded in today’s target-date funds’ glide paths is far too rudimentary in a world of dynamically shifting risk premiums. Would a wise pilot announce, “Based on average weather conditions and airspeed, the flight from LAX to JFK takes four hours and forty five minutes. Rather than check the weather or air traffic, I will simply assume average conditions. See you in five hours.” Of course not! Conditions are rarely average—in flight or in the capital markets.
Asset allocation is a critical step in the asset management process, whose essence Benjamin Graham once described as “…the management of risks, not the management of returns.” No matter how diversified the portfolio, risk and reward aren’t linear. But target-date funds tacitly assume they are! Just because you are willing to take more risk doesn’t preordain higher returns, even over decades-long stretches. Rather, managing risk should be done either explicitly with active asset allocation of the glide path or implicitly through the natural contra-trading embedded in the Fundamental Index approach.