Research Review | 2.20.13 | Portfolio Strategy Analysis

Target Date Funds: Still Off Target?
Marc Fandetti (Meketa Investment Group) | March 6, 2013
This article examines briefly the performance and composition of “shorter-dated” target date (“TD”) funds, defined by the author as those intended for participants within a dozen years of, or already in, retirement. Morningstar, which tracks 111 such funds, is the source of all data used. Such funds performed worse in the severe market crunch of 2008 – far worse in some cases – than investors were likely expecting. This is now widely recognized. More importantly – and disturbingly – shorter dated TD funds remain too aggressively invested in most cases, delivering performance (and exhibiting risk), on average, in line with pension funds.
Since pension funds likely have a longer-term investment horizon than most shorter dated TD fund investors, the average shorter-dated TD fund is almost certainly more aggressively invested than the average near-retiree/retiree can tolerate. However unlikely the prospect of a substantial stock market decline may seem in the exuberant present, the potential for large stock market losses remains. The next “bear market” will make retirement unattainable, permanently, for many.
A quick survey of shorter-dated TD funds reveals that there are disappointingly few choices for investors at or in retirement and seeking a relatively conservative TD option. Plan sponsors should consider alternatives, such as “custom” TD funds, when the shorter-dated TD fund component of a TD fund manager’s offerings exhibit pension-fund like risk and return.

Sensitivity of Safe Withdrawal Rates to Longevity, Market and Failure Risk Preferences with Implications for Asset Allocation
Adam Butler (Macquarie Group), et al. | March 8, 2013
Retirees face longevity risk, or the risk of living longer (or less long) than expected; market risk, or the risk of poor investment returns over the retirement horizon, and finally; failure risk, or the risk of running out of money before death. The authors examine the sensitivity of these three risks to asset allocation and Safe Withdrawal Rates, and offer a model to optimize these factors in order to minimize the three primary risks in the context of personal preferences. Finally, a forecast model is proposed to link Safe Withdrawal Rates to contemporaneous stock market valuations and interest rates, with strong statistical significance.
The 4 Percent Rule is Not Safe in a Low-Yield World
Michael Finke (Texas Tech University), et al. | January 15, 2013
The safety of a 4% initial withdrawal strategy depends on asset return assumptions. Using historical averages to guide simulations for failure rates for retirees spending an inflation-adjusted 4% of retirement date assets over 30 years results in an estimated failure rate of about 6%. This modest projected failure rate rises sharply if real returns decline. As of January 2013, intermediate-term real interest rates are about 4% less than their historical average. Calibrating bond returns to the January 2013 real yields offered on 5-year TIPS, while maintaining the historical equity premium, causes the projected failure rate for retirement account withdrawals to jump to 57%. The 4% rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment. Some planners may wish to assume that today’s low interest rates are an aberration and that higher real interest rates will return in the medium-term horizon. Although there is little evidence to support this assumption, we estimate how a reversion to historical real yields will impact failure rates. Because of sequence of returns risk, portfolio withdrawals can cause the events in early retirement to have a disproportionate effect on the sustainability of an income strategy. We simulate failure rates if today’s bond rates return to their historical average after either 5 or 10 years and find that failure rates are much higher (18% and 32%, respectively for a 50% stock allocation) than many retirees may be willing to accept. The success of the 4% rule in the U.S. may be an historical anomaly, and clients may wish to consider their retirement income strategies more broadly than relying solely on systematic withdrawals from a volatile portfolio.
Economic Valuation of Liquidity Timing
Dennis Karstanje (Erasmus University Rotterdam), et al. | February 27, 2013
This paper provides a comprehensive economic evaluation of the short-horizon predictive ability of liquidity on monthly stock returns, using dynamic asset allocation strategies. We assess the economic value of the out-of-sample power of empirical models based on different liquidity measures and find three key results: liquidity timing leads to tangible economic gains; a risk-averse investor will pay a high performance fee to switch from a dynamic portfolio strategy based on various liquidity measures to one that conditions on the Zeros measure (Lesmond, Ogden, and Trzcinka, 1999); the Zeros measure outperforms other liquidity measures because of its robustness in extreme market conditions. These findings are stable over time and robust to controlling for existing market return predictors or considering risk-adjusted returns.
Is Your Covariance Matrix Still Relevant? An Asset Allocation-Based Analysis of Dynamic Volatility Models
James A. Colon (Nuveen Asset Management) | February 27, 2013
Ever since Harry Markowitz published his seminal paper on portfolio selection, investors have incorporated estimates of future volatilities and correlations into their asset allocation process. While portfolio construction methods continue to evolve, many investors continue to forecast volatility using traditional approaches that are ill-suited to the time-changing nature of volatility. In this paper, I analyze the performance of seven different multivariate-volatility models using a new, risk-parity based approach to determine each model’s accuracy. I find that traditional, sample covariance methods perform poorly when trying to forecast short-term volatility, and that a more dynamic model often provides superior out-of-sample forecasts.
Asset Allocation in Private Wealth Management: Theory Versus Practice
David Schröder (University of London) | February 21, 2013
This study analyzes the responses to a representative survey of wealth advisors on private wealth management practices, and compares the advisors’ views to academic research in household finance. This study demonstrates that many wealth managers do not apply novel insights proposed by financial economists when advising their clients. Many practitioners focus on managing only the market risk exposure of their clients’ portfolios. Although financial research has stressed the importance of incorporating human capital, planned future expenditures and the investment time horizon into the investor’s asset allocation, these aspects are neglected by most practitioners.