Target Risk Funds

• DOI: http://doi.org/10.1111/eufm.12098
• Published date: 01 September 2016
• Date: 01 September 2016

Target Risk Funds

Edwin J. Elton, Martin J. Gruber and Andre de Souza

Stern School of Business, New York University, 44 West 4th Street, New York, NY, USA

E-mails: eelton@stern.nyu.edu, mgruber@stern.nyu.edu, adesouza@stern.nyu.edu

Abstract

There is a vast literature which shows that investors don’t make rational decisions

in allocating resources among different investments. Target risk funds and target

date funds are two types of mutual funds primarily organised as fund of funds that

make the asset allocation decision for an investor. Both are used as options in 401

(k) plans and Individual Retirement Accounts. However they control for risk in very

different ways. Target risk funds have not been studied. This article is the first

comprehensive study of their characteristics and performance and how they

compare to target date funds as an investment.

Keywords: target risk funds, characteristics, performance

JEL classification: G11, G23

1. Introduction

There is a vast literature which shows that investors don’t make rational decisions in allocating

resources among both different types of investments and different individual investments.

1

While the bulk of the evidence concerns participant choices in pension funds there is reason to

suspect that this will be even truer for individual investors, for he or she is confronted with a

number of investment choices many times greater than those offered in a pension plan. Hence

there is a need for investment vehicles which make the asset allocation for an investor.

While there are many types of asset allocation funds which own both stocks and bonds,

two types are of particular interest because of their frequent use in retirement plans and

thus their major role in retirees’ultimate well-being: target date funds and target risk

funds.

2

These two types are also of interest because they both are almost always fund of

The authors would like to thank Yakov Amihud, Joel Hasbrouck, Anthony Lynch, John

Doukas, and an anonymous referee for helpful comments.

1

See Agnew et al. (2003), Ameriks and Zeldes (2004), Benartzi and Thaler (2001), Elton

et al. (2007), Huberman and Sengmuller (2004) and Liang and Weisbenner (2006).

2

The Investment Company Institute (ICI) presents statistics on asset allocation funds under

the name hybrid funds. They separately collect statistics on target date funds and target risk

funds as subsets of hybrid funds.

European Financial Management, Vol. 22, No. 4, 2016, 519–539

doi: 10.1111/eufm.12098

© 2016 John Wiley & Sons, Ltd.

funds and both purport to control risk by managing the amount invested in debt and

equity, but they do it in very different ways. Target risk funds (TRFs) are generally fund

of funds which attempt to hold the proportions invested in debt and equity constant over

time. These funds are sometimes called lifestyle funds. The name of the fund usually

contains reference to the intended risk, e.g., conservative, moderate or aggressive. Target

date funds (TDFs) change the proportion invested in debt overtime to reduce risk as a

specified date approaches. Both types of funds purport to control risk by controlling the

fund’s debt-to-equity ratio.

3

A lot has been written about TDFs, both in the popular press

and in the academic literature, while TRFs have been largely ignored. The attention paid

to TDFs has been fed by their recent growth and their increasing use as an option in 401

(k) plans. However, the theoretical models examining asset allocation over time provide

both supporting and contradictory evidence as to whether increasing the debt-to-equity

ratio over time is optimal.

4

In addition, time to retirement is not the only factor that

should be considered by the investor making asset allocation decisions: labour income,

wealth, and especially risk preference may be important.

The most comprehensive empirical study of the optimality of target date funds

increasing the ratio of debt to equity over time is Poterba et al. (2005). They include

labour income and non 401(k) wealth in their examination of the utility of wealth at

retirement. They simulate the time path of asset returns using historical index data as well

as data where the stock return is 300 basis points less than the historical return. They

show that a constant-debt-to-equity strategy, which is the strategy followed by target risk

funds has a higher utility of terminal wealth than the decreasing-debt-to-equity strategy

followed by target date funds. We will examine this subject later in the paper using actual

data on the performance of TRFs and TDFs.

Thus both theory and empirical evidence suggests that target risk funds which hold the

debt-to-equity ratio constant over time may be a viable alternative to target date funds for

inclusion in retirement plans. In fact in 2014, 43% of the assets in TRFs were held by

retirement accounts. In addition, target risk funds are important in their own right. In

2014 they had over US$394 billion under management. Their growth rate in the period

2008–2014 was 14.4% per year, while assets under management by all mutual funds

grew by 8.7% per year. It was not until 2009 that TDFs had more assets under

management than TRFs, and it was not until 2008 that there was a larger number of TDFs

than there were of TRFs. Despite the number of TRFs, their size, their reasonableness as

an alternative to target date funds in retirement plans, and their use in retirement plans,

TRFs have not been carefully studied.

This article is the first comprehensive study of the characteristics and performance of

target risk funds. While there have been a number of studies of other asset allocation

funds, these other categories of asset allocation fund do not in general attempt to hold the

debt-to-equity ratio constant and are not offered by a fund family alongside other funds

attempting to hold the debt-to-equity ratio constant at alternative levels. An additional

purpose of this article is to analyse whether target risk funds are a reasonable alternative

to target date funds. This article is divided into seven further sections. In section 2, we

describe the sample of funds used throughout this paper. In section 3, we examine the

3

See for example the glide path presented by most target date funds.

4

See Bodie et al. (1991), Campbell and Viceira (2002), Campbell et al. (2001), Cocco et al.

(2005), Madrian and Shea (2001), Merton (1969) and Shiller (2005).

© 2016 John Wiley & Sons, Ltd.

520 Edwin J. Elton, Martin J. Gruber and Andre de Souza