A new whitepaper raises three questions regarding the structure, management and cost-benefit balance of different fixed income strategies in considering an appropriate target-date fund for a DC plan.
The authors of the whitepaper — JP Morgan Asset Management’s Daniel Oldroyd, Portfolio Manager and Head of Target Date Strategies, and Harold Bjornson, Client Portfolio Manager Multi-Asset Solutions — explain that the fixed income allocation can be a key differentiator among target date strategies, but its structure and management do not always get the attention they deserve within the TDF selection process.
Is the fixed income portfolio sufficiently diversified?
The authors note that fixed income diversification is important because the relative performance of fixed income sector indices fluctuates across economic and market environments. An individual sector — for example, Treasuries—may have the highest return in some years and the worst return in other periods. On the other hand, a diversified fixed income allocation can help smooth returns over time.
Does the fixed income manager have the flexibility to enhance risk-adjusted returns?
The authors note that the broader the opportunity set and the less constrained the manager, the greater the potential to enhance returns. They explain that while active managers have a range of tools to help optimize the risk/ return profile of a TDF’s fixed income allocation, they also have the latitude to use their tools and skills in managing them in response to actual or anticipated changes in interest rates, inflation, spreads, the shape of the yield curve and the outlook for different industries, sectors, geographies and issuers. They see this in contrast to the composition of portfolios designed to replicate an index is largely determined by all the bond issues outstanding in the marketplace, which they say may have unanticipated consequences for passively managed strategies.
Can the TDF’s fixed income portfolio help weather a rise in interest rates or other changes in the economic and investment environment?
The authors cite the current interest rate environment as an excellent example of why plan sponsors need to understand the level of diversification and flexibility within their TDF’s fixed income allocation. “When interest rates change, the price impact can vary considerably across fixed income sectors, with long-maturity, low-yielding Treasuries among the most interest rate sensitive and shorter maturity, high yield securities among the least sensitive,” they note.
The authors conclude that the most appropriate TDF strategy may vary across plan sponsors, based on participant needs. However, they suggest that when selecting the best TDF for their participants, plan sponsors may want to focus on the contribution of the fixed income component — to ensure that it is structured and managed to deliver the strong risk-adjusted returns participants will need for a secure retirement.
