Have you ever seen a shape sorter? It’s that toy where you match shape blocks to corresponding holes on the sides of the box. I was surprised to learn it’s still popular when my wife and I had kids.

My daughter is one now, and I must say, she’s a little advanced for her age. She’s pretty good at figuring out how to get the shapes into the right holes. Occasionally, she confuses the hexagon for the pentagon. Quite often, she’ll also take other kinds of blocks and try to fit them to no avail. You’d have to reshape the holes on the box to get them in.blog_shapestdf_09292016

Deciding which funds to include in target-date design is kind of like filling a shape sorter. You first design the target-date fund with a set of objectives and constraints. Once that’s done, you choose underlying funds that fit into the right spots.

For example, the glide path for Vanguard’s target-date funds calls for 90% equity in the early years, 50% at retirement, and 30% when the fund lands at its final allocation. This appropriately balances risk and return in a way that takes into account the equity risk premium and human capital for a broad range of investors. Our target-date funds have a 60/40 mix of U.S. and international stocks and a 70/30 mix of U.S. and international bonds. They begin to include short-term TIPS a few years before retirement, ramping up the allocation to about 20% of the bond exposure in the final allocation.

This top-down construction process defines our shape sorter box. Choosing funds that match up to these asset-class targets is the most straightforward way to decide which funds we should use to implement. This is analogous to using broad-based index funds in a target-date fund.

If we’re not careful, my daughter’s attempts to fit her other blocks into the shape sorter can be analogous to using many actively managed funds in a target-date fund. In some cases, such as risk-controlled, multi-managed funds, the pieces will slide in even though the design doesn’t exactly match up. In other cases, you might need to reshape some of the spots in the target-date box to get the pieces in.

This is where the analogy breaks down. With the shape sorter, you can tell right away if the pieces don’t fit. With actively managed strategies, you often don’t really know until after the fact. The first issue here is that you can get unintended style bets through some strategies. If you intend to overweight small-cap value, you should do so consciously—you should design the holes in your box for that objective. What you want to avoid is a manager’s stock selection bets turning into unintended style bets.

When using active funds to implement a target-date fund, you really need to add a few steps to the construction process. In particular, you have to take into account the unique risk traits of individual managers. And you have to think about how these risks interact with other managers’ unique risks. If we’re talking about risks introduced by fund selection, it’s critically important to use a feedback loop and take these risks into account in your glide path design.

Even if a target-date fund’s design calls for 90% equity exposure, multiple active managers could combine to produce 91% exposure, or 95%, or maybe even 85%. Individual managers could also take on style bets exposures that deviate from the sub-asset class design the fund targets, creating a gap between our expected return and risk and the actual portfolio’s expected return and risk. And it doesn’t stop there. Active manager positions should be expected to change over time. So the aforementioned analysis is not a one-time deal. It’s something that you need to revisit regularly.

This is not a judgment call on active in any way, shape, or form (pun intended). Rather, I point this out for two reasons. First, I offer it as a partial explanation for why we’re seeing such a large influx of cash flow to index-based target-date funds. Today over two-thirds of industry-wide cash flows are being directed towards index-based target-date funds.¹ You just don’t have to worry as much about unintended style bets with an index-based implementation.

Second, it’s important for plan sponsors considering actively implemented target-date funds to look at additional factors beyond what you need to do with an index implementation. You need to work closely with your target-date fund provider to accomplish this.

In a lot of ways, a custom target-date platform can be the ideal tool for this task. Why? Well, it allows for richer dialogue between the plan sponsor, the investment manager, and the consultant. This reduces the probability that a plan sponsor will be surprised by unknown exposures in the target-date fund. It also increases the likelihood that the plan sponsor will have confidence in the managers used and an understanding of the increased tracking risk embedded in the approach, both critical factors to successfully implementing active funds within a target-date fund.

¹ Sources: Vanguard and Morningstar, as of June 30, 2016.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.