Although a relatively new development, the idea of Target Date, Lifecycle, or Glide-Path mutual funds has found a willing and enthusiastic audience in the defined contribution world. While the idea of offering plan participants a well-diversified investment appropriate to their goals and needs via a single investment is certainly appealing, the growth of this type of product has been a challenge for those attempting to independent, objective performance analysis.
The quandary that analysts face is that the asset allocations for a set of seemingly similar funds could in fact be widely divergent. What one fund company feels to be an appropriate asset allocation for, say, a 2035 investment could be extremely different from what another fund company feels would be appropriate for the same time horizon. More often than not, different asset allocations result in very different performance results, making peer-group comparisons of like mutual funds quite difficult.
Zephyr Associates believes William Sharpe’s idea of returns-based style analysis (RBSA) is ideally suited for analyzing pre-allocated portfolios, like Target Date funds. The core idea behind returns-based style analysis is that it is possible to replicate the vast majority of the performance of an active management strategy using passive proxies. The algorithm that Sharpe developed in his paper combines a palette of indices in every single combination and returns the one combination of assets that best replicates or tracks the performance of a particular mutual fund or manager.
Historically when people think of using RBSA, they think of defining funds along the large/small and value/growth spectrums. However, RBSA can also be applied to broad asset classes. For example one could run a RBSA on a number of Target Date funds using US Stocks, Foreign Stocks, Bonds, and Cash as being the independent variables. The result of this process is that the analyst can infer the asset allocation of a large number of Target Date funds very quickly and surprisingly accurately.
We explore this idea in a couple case studies on our website. The first study presents the idea in much more detail than listed here. The follow-up paper applies the RBSA idea to two actual families of Target Date funds to illustrate how this idea can be used in practice. If you’ve found yourself overwhelmed by Target Date funds, we recommend checking these out.
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