Solving the Issues Caused by Target Date Funds

Due to the managers' flexible asset allocation mandates, locating an appropriate benchmark when comparing funds with similar objectives, but different allocations, can be troublesome. Not all is lost however, as RBSA provides fiduciaries the perfect tool to solve this problem.

We can use RBSA to create style benchmarks, which are unique combinations of the five indexes listed above that do the best job of mimicking the performance of the individual funds. Each of the eight funds has its own unique style benchmark based on the fund's return behavior. These unique, best-fit, style benchmarks provide fiduciaries the ability to identify the asset allocation decisions of each fund.

As you can see in figure 2, there are some fundamental differences in the allocations between the two fund families. Worth noting, XYZ Funds generally overweights U.S. equities, while ABC Investments overweights foreign equities across the board. Interestingly, U.S equities have outperformed foreign equities by a wide margin over the past 10 years, so one would expect the XYZ funds to outperform due to their overweight in the best performing asset class over the past 10 years. However, that is not the case, as the ABC funds outperformed while underweighting the best performing asset class. Generally speaking, the asset allocation decisions had less impact on the outperformance for ABC funds.

Next, we can use the unique style benchmarks to determine what effect the underlying investments had on performance. Using the style benchmarks allow us to neutralize the effects of the asset allocation decisions when comparing different performance statistics versus the best-fit style benchmark.

Figure 3 shows the impact that the underlying investments had on the overall performance. It is easy to see that ABC funds' outperformance is due to the selection of the underlying investments. Each ABC fund has superior alpha, excess return, and information ratio. Figure 3 also tells us that an investor would be better off investing in a set of ETFs, or passively managed investments that follow the asset allocation detailed in figure 2 for XYZ funds. Based on this analysis, the asset allocation decisions contributed positively to the performance, while the investments selected had a negative impact on XYZ funds.

When conducting this analysis, it is imperative that you have a best-fit benchmark so you can eliminate allocation biases and focus on the performance. As you can see, the r-squared for all funds is very high, telling us that the style benchmarks provide the best-fit benchmark for each product.