Target date providers have been bracing for an eventual hike in interest rates through small tweaks in allocations and underlying funds in their portfolios.
Changes have been most pronounced in funds closer to their retirement target date, which have more fixed-income exposure than funds with longer investment horizons. Although alterations have been largely on the margin, some believe the ability to tactically position portfolios ahead of a rate rise gives active managers a short-term advantage compared to passive peers.
TDF managers have a handful of ways to hedge against rising rates while also maintaining the integrity of the glidepath, which governs how the mix of stocks and bonds in a portfolio changes over time. Moving into fixed-income positions with shorter durations and adding exposure to alternative or non-traditional bond funds have been the most popular strategies, according to Jeff Holt, multi-asset analyst at Morningstar Inc.
Franklin Templeton Investments has done both in its LifeSmart TDF series within the past year or so. The firm removed its Franklin Total Return Fund (FKBAX) and upped the allocation to its Low Duration Total Return Fund (FLDAX).
“We haven't been alone in that regard,” said Tom Nelson, director of strategic asset allocation research within Franklin Templeton's multi-asset strategies division. “I think [shorter duration] is probably more front of mind today with this anticipation of the [Federal Reserve] starting their tightening cycle.”
In Franklin's 2015-dated LifeSmart TDF, the allocation to the low-duration fund was 17.18% in the second quarter this year, up from 10.72% the year prior. Its duration is 0.8 years, compared with 4.31 years in the total return fund.
INTO INTERMEDIATE-DURATION BONDS
Fidelity Investments, the second-largest target date mutual fund provider, with around $190 billion in assets through 2014, has moved out of long-dated bonds to more intermediate-duration bonds in its actively managed series, said Brett Sumsion, portfolio manager on Fidelity's TDF series.
Over the past year, Fidelity has also upped its position in Treasury Inflation-Protected Securities to 25 basis points from zero across its longer-dated active TDFs — the 2025 fund and beyond. (The near-dated TDFs already had TIPS exposure.) It's an asset class that performs well in a rising-rate environment, and TIPS are relatively inexpensive to nominal bonds today, Mr. Sumsion said.
TDF providers haven't rushed to make portfolio alterations, but have done so gradually over time as the prospect of a move to raise rates by the Fed looks likely in the not-too-distant future.
Fed chairwoman Janet Yellen said last month that the U.S. central bank will likely lift interest rates from their current near-zero levels by the end of the year. The Fed is scheduled to meet in October and December, but many believe December would be the more likely time frame for any action.
“It's a very incremental change,” Mr. Sumsion said. “We're not doing a lot in the short run to react to what the Fed is doing today.”
American Century Investments lowered the allocation to its inflation-adjusted bond fund (AIAVX) and upped exposure to its short-duration inflation protected bond fund (APOAX) back in 2013, Mr. Holt said. In its One Choice In Retirement TDF (ARTAX), there's a 6% allocation to the short-duration fund, which has a duration of 2.3 years, and a 1.5% allocation to the inflation-adjusted bond fund, whose duration is 6.2 years, according to Morningstar.
Actively managed TDFs have a near-term advantage over their passively managed counterparts, which can't “bake in” views about rising rates because they track indexes, said Jeff Snyder, senior consultant at Cammack Retirement Group.
“Being able to adjust to these changes in the market are important,” Mr. Snyder said. “In the short run, if you are passively managed, you won't be able to adjust to the market changes as quickly, and that could impact participants close to retirement in terms of their preparedness.”
American Funds, one of the five largest TDF providers, isn't a tactical allocator in its Target Date Retirement series, so hasn't changed allocation amounts to funds in its glidepath, said Wesley Phoa, fixed-income portfolio manager at Capital Group, owner of the American Funds mutual-fund brand. However, “inside the funds there's been a lot going on,” he said.
For example, its Intermediate Bond Fund of America (AIBAX) is the largest holding in the 2015 TDF, at 9% of the portfolio. Within that bond fund, the portfolio is overweight TIPS compared to what it is typically — around 12% of the portfolio is now TIPS, but is normally in the mid-single digits, Mr. Phoa said.
That exposure has ramped up over the past two year or so, but mostly within the last 12 months, Mr. Phoa added. In part, the shift is because TIPS hold up better than nominal treasuries in a rising rate environment, he said.
Firms such as Manning & Napier have also looked to non-traditional or alternative bond funds as an interest-rate hedge. In late 2014, the firm added a 5% allocation to fixed-income managed futures for the first time within its nearer-dated TDFs, according to Morningstar. The position was carved out of the overall fixed-income bucket.
Franklin Templeton managers also upped exposure to the Templeton Global Total Return Fund (TGTRX), an unconstrained bond fund. Allocations to the fund reached 22.8% this year in the 2015 Fund, representing the largest holding, from just over 17% in Q2 2014. The fund has a duration of 0.66 years.
“Having the flexibility to go most places [in an unconstrained fund] we think offers greater opportunity for positive returns in an environment where we're not excited about treasuries overall and the broad bond market,” said Tom Nelson, director of strategic asset allocation research within Franklin Templeton's multi-asset strategies division.
Franklin's TDF alterations occurred across all funds in the series, not just the more conservative funds, but the effect would be most pronounced on the nearer-dated funds, Mr. Nelson said.
As of end-2014, there were eight TDF series with non-traditional bond allocations, up from five in 2012, Morningstar data show.