The Trouble With Target Date Funds

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I'm not suggesting people try to time the market or, or use a lot of discretion or anything like that, but there are ways to allocate capital to different assets in a way that's a little bit more dynamic.

Welcome to the Barron's Streetwise Podcast. I'm Jack Howe, and the voice you just heard is Jared Woodard. He's head of the Research Investment Committee at BofA Securities, which is part of Bank of America, and his group has a new report on retirement that takes target date funds to task. We'll hear why. Plus, a scientific equipment maker called Waters Corp has a new CEO who's boosting returns. We'll speak with him. And have you heard of zero-commission brokers making money from something called payment for order flow? You might be surprised by what the founder of Interactive Brokers told me about that. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

I've got a hot tip for our listeners. Is it the new Top Gun movie? Even hotter, Iceman. I recommend that everyone check out the Numbers by Barron's podcast, which you're now hosting. These are short daily episodes that add context to key numbers, and I have an example of my own to show how it works. You ready? Roger that, Goose. Hmm, not actually in the new Top Gun. I would have accepted Maverick, Rooster, or Hangman.

I'm reading here Warlock.

Okay, the number is 2.4%. It comes from a new B of A retirement report, and it's the amount of yearly underperformance for target date funds over their nearly 3-decade history. Let me explain that. Target date funds are sometimes called life cycle funds. You buy one fund and it has your entire asset mix, and the mix changes over time as you approach retirement. I think of it as the Ron Popeil investment plan. He's the late founder of a company called Ronco, which is known for its rotisserie roasters. Ron used to do these infomercials, and when he came to his rotisserie tagline, the whole crowd would shout it with him. I'll turn the window up, I'll set it, and that's it. Here we're doing lobster. With target date funds, you just pick the fund that has your approximate retirement year in the name—Target 2040, for example. And then you set it and forget it. These funds now hold more than $3 trillion. They're huge in 401(k) accounts where they make up 42% of assets. There's just one problem: the funds don't seem to have done that well. B of A Securities looked at target date funds designed for 2040 retirement dates, and they studied the performance going back to 1994. Now, I don't own a target date fund, but if I had bought one, this would more or less have been my experience because I got my first salary job in the mid-1990s and I'll reach the typical retirement age by around 2040. It turns out that those target date funds trailed the S&P 500 by 2.4 percentage points a year. That on its own isn't so bad. The S&P 500 is all stocks, and target date funds hold a mix of stocks and lower return investments like bonds. They're supposed to give up a little return for the sake of safety, but the study also found that the target date funds had almost the same volatility as the S&P 500. In other words, investors got lower returns for a similar risk profile. It turns out that a simple 60/40 mix of stocks and bonds would have produced better results with much lower volatility. I don't want to overstate the case here. Target date funds have their uses. For beginner investors, deciding which funds to put retirement money into can be intimidating. Some savers are tempted to leave the money in low-return cash accounts. Studies suggest that target date funds can nudge these savers toward a more appropriate asset mix for the long term. But I suspect that many savers who could select their own mutual funds choose target date funds instead for the convenience and for what they assume will be better risk-adjusted performance over time. So I was surprised that these funds hadn't done better. To learn more, I spoke with Jared Woodard, the head of the Research Investment Committee at B of A Securities and the person in charge of the Retirement Report. I asked him, why have these funds underperformed? He gave 3 reasons that challenge conventional wisdom, not just on target date funds, but on investing in general. The first relates to international stock allocations.

For the past several decades, while Europe has been slowing, while Japan has been staying slow in terms of growth and in terms of corporate profits, while China has been slowing, while all these countries have failed to raise productivity, raise GDP, accelerate corporate profit growth, you know, at a time when the United States has done really much better, I think it's very safe to say an investor who had large allocations to those slower growth, lower productivity markets has underperformed.

Okay, but what if the US has just been on a decades-long winning streak and investment leadership is now poised to shift to other markets? Well, Jared says There are certain big-picture drivers that make a country's financial assets attractive over long time periods: a stable currency, limited risk of capital controls, decent economic growth, high worker productivity, lots of innovation and patents, and balanced demographics with a sufficient number of workers and consumers. In his view, the U.S. compares well against other regions. It also has companies with plenty of global exposure. Jared says he's still bullish on emerging markets, including China, but that for money invested in Europe and Japan, he would prefer trying to select the best companies rather than buying index funds. U.S. target-date funds can have a third of their money in non-U.S. stocks, and even for investors approaching retirement, they can have more than 15% in non-U.S. stocks, which Jared views as too high. Let's look at the second factor Jared says contributes to target date fund underperformance: bonds. Or more precisely, outdated assumptions about the ability of bonds to protect against downturns in stocks.

The academic literature, the industry literature has all been using the last 20 or 30 years of economic data to arrive at the conclusion, a true conclusion, that bonds are a good hedge for equities. And then especially since the year 2000 or so, that's been true. It's not true this year. Past couple years, the correlation between bonds and stocks has been positive, and that's a big problem for a lot of conventional asset allocation approaches.

So what should investors do with their safe money? Keep it in cash? Jared says cash looks like a terrible deal with inflation over 8%, but it's a good deal if other asset classes are falling in value. In addition to holding some extra cash, Jarrett says investors should consider diversifying the types of risk they take with their bonds. Many investors load up on Treasuries and high-grade corporate bonds because they offer safety from default, but those bonds face elevated risk from inflation and rising interest rates because of their low yields. Here's Jarrett.

So what do you do instead? That was your question. Well, I think that you, you take different kinds of risk. Own things with exposure to the real economy, credit risk basically. It could be higher yielding corporate bonds, maybe the fallen angels that were downgraded and might get upgraded again. It could be leveraged loans, which are senior in the capital structure, still risky companies, but they have floating rate provisions. Those have done really well. It could even be emerging market debt, which is very volatile. It's not for the weak-minded. But again, if the returns are strong, which they are historically, and you scale your position size down a little bit, then the net effect in your portfolio can be really positive.

The third performance drag for target date funds, Jared says, is the way they follow rigid allocation and rebalancing rules. He says that's a step in the right direction for many investors, but that in his view, experienced investors might be better off adjusting for changing conditions.

I'm not suggesting that people try to time the market or use a lot of discretion or anything like that. But there are ways to allocate capital to different assets in a way that's a little bit more dynamic, maybe not right for every investor, but to just to kind of incorporate more of that information that we have about the economy and about markets. Maybe it's as simple as that choice you have to make, you know, every year or every 6 months, where do you put new money to work? Using the information you have at hand about where to put new capital to work can yield some pretty great opportunities. Not using that information isn't the end of the world,. But I think in the case of some of these different investment vehicles, there's just a, a bit of missed opportunity.

Thank you, Jared. In a moment, we'll check in quickly with two CEOs, one of which has been driving a sharp pickup in his company's stock returns. That's next after this quick break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help helps you shine. Morningstar, where data speaks.

Welcome back. Let's take a quick look at two companies, and what ties them together is absolutely nothing. And I'm against smooth segues on principle, so let's get awkward, right, Jackson? Is that your new tagline? It's no set it and forget it. Among the members of the S&P 500 index is a $20 billion Massachusetts company called Waters, ticker WAT. It doesn't get a lot of attention, maybe because it sells things that are unfamiliar to ordinary consumers unless their line of work involves ion mobility mass spectrometers or solid-phase extraction manifolds.

If you've had a cup of coffee this morning, a glass of water, or breakfast, chances are you've been touched by our products. We are a leading analytical instrument company that also has software and consumables and a whole bunch of service engineers that service these instruments.

That's Udit Batra. He became CEO of Waters in September 2020. Before he took over, the stock had underperformed And since he took over, shares have returned 57%, which is more than double the return for the S&P 500. That's one thing that caught my attention. Another is that the stock jumped 8% in a day following the company's latest quarterly report in early May. Okay, Udit was explaining what Waters does.

So we are in the business of taking highly complex instruments that are developed in research laboratories as a PhD student I also developed, and you can think of your garage, right? So you connect this and you connect that, and at the end it looks like Frankenstein, but it does what it needs to do. Now we take those instruments and we simplify them so they can come into a lab where you and I can use them with a press of a button. And these instruments are now used to release medicines, vaccines, therapeutics, test food, and we have roughly 150,000 of those around the globe today.

Waters does about 60% of its business with the drug industry and 30% with industrial customers including ones involved in food, materials, and environmental testing. Growth drivers include the rise of gene therapies and so-called mRNA vaccines and soaring demand for electric vehicle batteries. I asked Udit, what changes have you made since taking over as CEO? One of them is accelerating the launch of new products. I asked for an example of a new product and Udit gave me one, and I tried to follow along. Something about mRNA molecules getting stuck to metal surfaces during testing, which isn't a good thing. And Waters came up with technology that keeps them from getting stuck.

We're taking something that took 10 hours down to 5 to 10 minutes. So you could use our equipment right out of the box as opposed to waiting 10 hours to equilibrate the instrument before starting the use. So that's just an example.

How do you figure out— I feel a little self-conscious because you're talking about mRNA machines. I'm about to drink out of a mug that says Dad Joke Pro, but how do you—

Mine says nothing, so you can see.

How do you figure out that there are customers who need that product? How do you stay in touch and hear what's out there and hear where the gaps are and where you should be making things?

Look, we are super close to our customers, right? We have one of the largest service engineering fleets in the industry. We spend a ton of time collaborating with our customers. So for instance, during the the pandemic when Pfizer and Moderna were developing the mRNA molecules and they were getting stuck in separating these molecules and saying, hey, you know, one batch has to look like the next. How do I do this in QA? Guess who they called? Waters is the company they called. So we were on the front lines.

Udit has made a lot of changes to his senior executive team and he has focused on the company's e-commerce platform. It used to do 20% of its business through e-commerce. Now that's up to 30% and Double that might be possible long term. A third change involves supplies, especially semiconductors, which have been hard for some companies to get in recent quarters. Udit addressed that problem by talking directly with the CEOs of chip companies and by being flexible.

So we had conversations with them to say, hey, can we get an alternate chip that you're making for your larger customers and we'll qualify it in our instrument, as opposed to always fighting for the same chip that we had qualified 20 years ago. And that would not have happened had I not spoken to the CEOs of these companies and said, hey, what else are you doing? And he said, look, I'm— it's not my problem. It's not you. My problem today is the car manufacturers or mobile phone manufacturers. I said, okay, what chips are you making for some of those guys, right? Why don't we try to qualify some of those in our products? And I think that type of conversation I would not have known to have a year ago.

At a recent Investor Day presentation, Waters outlined plans to shift to faster growth over the next few years by expanding its offerings and maybe doing some acquisitions if the opportunity arises. One more thing. I asked Udit if there was a transformative moment that got him interested in scientific equipment. And there was, and it involved an actual transformer for a video game machine back when he was a kid in India.

You remember the Atari, right? The video game, the true video games, right?

I have calluses on my thumb still.

So back when I was in 8th grade, my dad brought an Atari from the UK and he basically came in and he He brought it without a transformer, right? Something that you plug into the wall to convert AC into DC. So damn thing required 12 D batteries, and those are super expensive if you're in 8th grade, right? And so I would buy them once in a while, and it would run for an hour and a half, and the damn thing would go down power. You couldn't play more than 2 games of Pac-Man, right? I mean, who wants to do that? So I was in an electronics class, not a good student, but I begged my electronics teacher. I said, hey, you know, can we build a transformer together? And he said, "Okay, you stay after school. Once we've done it, you teach the rest of the class how to do it." I said, "Cool." And that transformer, by the way, changed the destiny of the Atari in our house, meaning it became the second most popular destination beyond a cricket field.

So the lesson is, back when my mother was telling me that I played too much Pac-Man, she was right about me, but you were in India also playing a lot of Pac-Man and it worked out well for you. Indeed. Thank you, Udit. One more company quickly. I had a chat recently with Thomas Peterffy. He's the billionaire founder and controlling shareholder of Interactive Brokers, ticker IBKR. He talked about how his brokerage company grew out of a market maker, which meant that many of its earliest customers were professional traders.

By word of mouth, people from the big bank and hedge fund trading desks opened their personal accounts with us, and that was followed by smaller hedge funds and registered investment advisors.

Today, Interactive Brokers caters to these customers with sophisticated tools and low-cost margin accounts. These customers in turn are still willing to pay small trading commissions averaging around 30 cents per 100 shares at a time when many brokers, following the lead of Robinhood, have cut commissions to zero. Interactive makes most of its money from commissions followed by interest. The company has recently seen strong growth in new accounts and in options and futures activity. What I was struck by is that Interactive offers its own account with zero stock commissions called IBKR Lite, which makes money from what's called payment for order flow. That's where brokers are paid by trading venues to supply them with customer orders. If your broker has no commissions or other account fees, the chances are good that it collects payment for order flow. The industry line on that has long been that it leaves the customer no worse off on their trades, but you wouldn't think that by listening to Thomas.

Our professional customers do not participate in that because They know that we can get them a better execution, and in spite of charging them a commission, they are better off than they would be otherwise. But we have IBKR Lite. We charge zero commissions, and just like any other broker, we sell the orders to Citadel and Virtue and the likes. I don't think that is good for the customer, but it doesn't make too much of a difference because We're talking about pennies.

Thomas says that if customers at zero-commission brokers trade only 10 or 20 times a year and get clipped for $2 a trade, as he puts it, it doesn't work out to a lot of money. But he says that these customers only think they're trading for free. Now, Interactive Brokers is a $25 billion company, which makes it less than one-fifth the size of Charles Schwab. That raises the question of whether it will get bought, but Thomas says he still works 7 days a week, 8 to 10 hours a day, and he'll have the final say. Do you have calls every other day of someone expressing an interest in buying the company? I mean, how have you spent this long as an independent company?

Well, I personally still own 73% of the shares.

That's a good, that's a good way to say it.

That's a good defense, right?

Thank you, Jared, Udit, and Thomas, and thank all of you for listening. Jackson Cantrell is our producer. Don't forget to check out his Numbers by Barons podcast. Jackson, give us a sneak peek of a future episode. Four. Oh, that's going to be a good one. Subscribe, rate, review, all of it, and Twitter me on Twitter. That's @JackHough, H-O-U-G-H. See you next week.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.