What Too Much Risk Really “Looks” Like and Why You Should Care
Many investors think that having “too much” risk isn’t a big deal…
… until it hits “home.”
That’s the case for 6.2 million American who have invested roughly $224 billion in Fidelity’s Freedom Funds and who recently found out – the hard way – just how much risk the fund managers have taken on to boost performance… arguably, without telling them.
The Freedom Funds, in case you are not familiar with ’em, are Fidelity’s largest retirement fund grouping and worth more than $1 billion a year in management and fee revenue to the Boston-based financial services company.
Based on “target dates,” the Freedom Funds are supposed to be a one-size, easy to use investment that diversifies investment and automatically manages risks by reducing them as fund participants age.
When you’re young, for example, you might choose the Fidelity Freedom 2060 Fund as a way to set it and forget it for the next 42 years. Somebody only two years away from retirement, by contrast, may opt for the Fidelity Freedom 2020 Fund.
The appeal is terrific.
Over time you’re supposed to get great performance and decreasing volatility – risk by any other name – that ensures your hard-earned retirement funds will be there when it’s time to call it quits.
Three Reasons I’m Not a Fan of Target Date Funds – and You Shouldn’t be Either
First, so-called target date funds assume that everybody the same age has similar investment needs. In other words, one 62-year-old is the same as the next when, in reality, they usually have very different risk profiles and investment needs.
Second, target date funds are based on analysis of past data that make investing in them a lot like driving down the road backwards using your rear-view mirrors. Chances are you’ll do just fine… until you hit a few curves at which point you’re more likely to wind up in a ditch.
Third, fund managers have a reverse incentive to boost risk that is not clearly explained to investors, and even then, it’s reluctant. Bond rates have been so low for so long now, for example, that Fidelity’s fund managers have been unable to meet target fund date returns requirements by sticking to “their numbers” – meaning the preset allocations to specific investments that are supposed to result in highly specific growth and income by the targeted retirement date. So, they’ve compensated by going after far riskier investments than they should.
As long as markets rise, this is a bet that works. But, when they don’t… the “funds with high concentrations in stocks are a time bomb,” according to Ron Surz, president of research firm Target Date Solutions, as reported by Reuters.
I agree – chasing performance never ends well.
Consider where financial markets are right now.
Interest rates have been low for so long that the total expected return for bonds may be just 2% for the next ten years. If you’re a target date fund manager, the only way you can compensate for this and still hit your targeted returns by the stipulated “date” is to pursue increasingly riskier investments that juice your returns the way steroids juice an athlete’s results.
If the markets climb, that’s not bad because the larger numbers of stocks and other riskier investments you hold to make this happen will do very well. But, if they go sideways or decline, you and your clients are going to get clobbered because of the higher volatility associated with ’em.
Not to bag on Fidelity, but that’s exactly what happened last month.
According to Morningstar, the Fidelity Freedom 2020 Fund, which holds 60% of investors’ funds in stocks, fell 6% between January 26 and February 8. That’s worse than 81% of its peers which held an average of 40% in stocks over the same time frame. In other words, Fidelity’s 2020 Fund got whacked because it held a higher concentration of riskier stocks than comparable funds.
According to Reuters, the Freedom 2040 Fund did even worse, falling 9% which lagged 87% of similar investments for mid-career investors. It, too, held a far higher percentage of stocks than similar time dated investments offered by other financial services companies.
At Wilshire we used to call this “style drift” – a term meaning that a fund manager has deviated from his or her investment mandate in pursuit of returns. And usually, I might add, that wasn’t meant as a compliment.
Managers who chase performance often get away from their core strategies and dramatically change the risk profile of the investment funds they manage. What this means to you as an investor is deceptively simple – you think you’re buying oranges but, in fact, have a bunch of potentially rotten apples in your portfolio.
It also means you’re subjected to huge “event risk” – meaning that you and your money could get clobbered by events that are both unexpected and beyond a fund manager’s control… like a sudden correction. Especially if you are already retired or nearing retirement and don’t want to lose your asteroids if the market goes on a bender.
Michael Kitces, author of the The Kitces Report, a newsletter for financial professionals, lays this out very nicely in the following chart where you can see the tradeoff between retirement date risk and portfolio volatility risk quite clearly.
The big red bracket is exactly what you don’t want late in your financial life yet exactly what you get when there’s “style drift” or a fund manager tries to goose returns.
Figure 1 – https://www.kitces.com/blog/retirement-date-risk-how-sequence-of-returns-risk-impacts-a-pre-retirement-accumulator/
The problem I’m describing isn’t such a big deal if you’re a younger investor who has a lot of time before you retire and need the money. But it’s a ginormous problem if you’re only a few years out and cannot afford to see your 401k turn into a 201k.
So, now what?
I want you to do three things immediately if you own a target date investment from any financial services firm:
- Review the current investment allocation versus its expected target date allocation by going to the fund family’s website or using a third party research service like Morningstar. If the fund’s managers have 5% – 10%+ more equities than you’re supposed to, you’re at increased risk – so you need to fix that right away.
- Consider pairing back your holdings or investing in a competitive offering to get back in line with expectations. Many retirement plans, for example, have pulled money from Fidelity’s Freedom Funds and put them in comparable offerings from The Vanguard Group or T. Rowe Price Group Inc. (NasdaqGS:TROW), just to name two alternatives. Others have boosted allocations to bonds or other investments.
- Consider a “risk parity” fund or structure like the proprietary 50-40-10 model I pioneered in our sister publication, the Money Map Report. Click here for more information about it. That way you can still shoot for all the upside you want yet guard against the devastating market madness that will inevitably accompany an unexpected correction.
Until next time,
Chief Investment Strategist