Focusing on outcome
From a high level, the problem boils down to managing duration. Asset allocation vehicles such as target-date funds — which can be viewed as a version of 60/40 portfolio with an asset mix that shifts over time — typically emphasize equities for younger investors and allocate less to long-duration fixed income, which is an asset class often associated with addressing retirement spending needs.
As investors approach retirement age, target-date funds reduce equity exposure and increase fixed income, meaning that they add duration. Tyler Thorn, a multi-sector portfolio manager at PGIM Fixed Income, said that he believes this is the opposite of how duration should be managed.
“If you think about what your spending objectives are when you’re young, you have a lot of spending very far in the future, so your investment goal requires a lot of duration exposure,” Thorn said. “But as you get closer to retirement, the duration associated with those spending outflows actually goes down, which means you should have less duration exposure.”
A traditional target-date fund’s duration goes in the wrong direction, he added. “Instead of starting low and rising with age, it should start high and decline with age. To overhaul the 60/40 construct, you have to correct this duration mismatch.”
Another element at play when talking about duration is the conventional view that equates it to adding interest-rate risk, he noted. PGIM Fixed Income research, however, has shown that adding duration can not only reduce interest-rate risk for investors saving to meet future spending needs, but it can also improve performance. This is due to the historical consistency of positive term premia — the excess return over cash based on a bond’s duration — and the credit risk premia — factors for which fixed-income investors receive compensation, for example, rating downgrades or liquidity events, amongst others.
Correcting the mismatch
Clearly, portfolio construction needs to change in order to address the duration mismatch between 60/40 portfolios and investors’ projected retirement spending needs. Using target-date funds as a framework, McCartan suggested these steps:
Start younger investors with elevated allocations to equities and duration, i.e., more equity exposure and longer fixed income durations. Asset managers could achieve the latter by using a fixed-income benchmark with a longer duration.
Use futures contracts to achieve desired equity exposure instead of buying cash equities. This cost-effective switch could free up cash for investment in credit instruments, which — for active asset managers — tend to offer better alpha opportunities than equities.
Shift the emphasis to reducing exposure to both equity and duration as the investor gets closer to retirement. Both changing the benchmark and reconfiguring the duration mix of the fixed-income allocation can reduce the overall exposure to duration.</…….