Target date funds suffer steep total return declines

Observations:

• In tandem, equities and bonds suffered steep total return declines during the first nine and trailing 12-months of the year to September 30th, and this has upended target date funds in the short-run.  Both conventional and sustainable target-date funds were impacted.  
• Target date funds are managed to an internal asset allocation glide path pursuant to which a fund’s targeted mix of equity and fixed income allocations becomes more conservative over time as the target retirement date nears.  This is achieved by shifting the mix of equity and fixed income investments on a regular basis, based on modeling to achieve optimal portfolio mixes and risk adjusted rates of return.  Asset class exposures vary from one investment firm to another.  For example, the Natixis Sustainable Future 2025 Fund, the next closest retirement date fund in the Natixis line-up, is intended for investors expecting to retire or to begin withdrawing assets around the year 2025.  57.34% of the fund’s assets are allocated to equities, both domestic and international, 40.69% to fixed income and 1.97% to cash¹. The elevated fixed income component is in theory intended to achieve stability in the portfolio.  This compares to the longest dated Natixis Sustainable Future 2065 Fund that is 92.33% allocated to equities, only 5.60% to fixed income and 2.07% to cash.  
• Bonds or bond funds fulfill various roles in target date portfolios, including capital preservation, diversification via the benefit of low or negative correlation to stocks that smooth out returns and protect investors against market swings, inflation protection using inflation protected bonds, and income generation.  This hasn’t turned out this way so far in 2022 or over the trailing twelve months during which equities and bonds became more correlated.  Stocks, as measured by the S&P 500, registered declines of -23.87% and -15.47% since the start of the year to September 30th and for the trailing 12-months while investment grade intermediate bonds, based on the Bloomberg US Aggregate Bond Index, gave up 14.6% during the same periods.  These results translated into significant declines for conventional and sustainable target date funds.  For sustainable target date funds in particular, results range from a low of -16.59% to a high of -26.38% for the longest maturity date in 2065.          
• The unusual outcome over the last twelve months should not lead investors to abandon target date funds, especially now that valuations are more attractive and offer upside potential going forward.  Still, fund managers may now be exploring further opportunities for achieving diversification, for example, by modeling the potential impacts of adding liquid alternatives, such as managed futures, merger-arbitrage, long/short and global macro strategies.
• Target date funds are ideal investment vehicles for overlaying sustainable investing strategies consistent with fiduciary responsibilities, given their long-term investment time horizon.  Still, of 2,525 mutual funds/share classes offered by 33 fund firms with total net assets of almost $1.4 trillion, sustainable investors are limited to four sustainable target date fund options (120 mutual funds/share classes in total) with $30.3 billion in assets, or 2.2% of the total (a fifth fund is scheduled to come on stream in the first quarter of 2023²).