How Target-Date Funds Can Use Equities for Stability

Target-date funds (TDFs) typically reduce downside risk by lowering exposure to equities under normal conditions. But recent turbulence has demonstrated that a selective use of defensive equities can help reduce volatility through especially challenging market conditions.

For most TDFs, glide paths routinely shift allocations from equities to bonds to preserve assets near retirement. However, market uncertainty from the coronavirus crisis has been far from routine. Just reducing equity levels still exposes investors to short-term losses beyond what they can stand—and for many at a critical point in their time horizon.

On the other hand, TDFs that selectively use defensive equities—companies with stable earnings and higher-quality cash flows in any environment—are better positioned to provide both return potential and protection from market turbulence. During the two most recent periods of volatility, for example, defensive equities offered substantial risk reduction relative to the broader market (Display).

A Glide Path Within a Glide Path to Manage Risk

A target-date strategy’s current allocations are based on the time left on its built-in clock. Current holdings for a fund with a 2020 target date will look very different from one built for 2050. But all glide paths almost always start with a higher risk profile than when they finish, with gradual adjustments from aggressive to moderate to conservative along the way. That’s because most investors have a higher risk tolerance when they’re younger and don’t need the assets any time soon. Closer to retirement, investors can’t afford to take a big hit.

Adding more types of equities at this point might sound counterintuitive to some investors, since they’re generally perceived as a riskier asset class. But some high-quality equities can boost stability, often with less downside than the broader market.