By Leland B. Hevner
President, National Association of Online Investors (NAOI)
Many students who attend investing education classes conducted by the National Association of Online Investors (NAOI.org) do so because they have an employer-provided 401(k) retirement plan and don’t know how to work with it. For many of these people this company benefit represents their first and only contact with the financial world and they are dangerously undereducated on how investing works. As a result, they look for guidance from an investment advisor who works for, or with, the Plan provider who typically recommends the purchase a 401(k) “default” investment called a Target Date fund. In this article I suggest a better investment type and discuss why.
Target Date Funds – Today’s 401(k) Default Investment
Target Date Funds (TDFs) are mutual funds that hold both Stock and Bond equities with an allocation of money to each asset class determined by the number of years until the investor’s retirement date – i.e. their “time-horizon.” Individuals with a longer time-horizon, e.g. 20+ years, are given a TDF with a larger allocation to Stocks that can provide higher expected returns but with higher risk. Individuals with a shorter time-horizon are given a TDF with a larger allocation to Bonds that has less risk but also lower expected returns. TDFs automatically change their stock/bond allocation over time with the goal of lowering risk as the target date nears.
TDFs were designated in 2006 by the government to be the default investment for 401(k) investors. In the absence of an investor requesting specific investments, an advisor will typically recommend a TDF that is deemed appropriate for the client’s expected retirement year. Examples of such funds are: “2030 Target Date Fund” or “2040 Target Date Fund”.
A problem exists in the fact that TDFs neither enable investors to take full advantage of the positive returns potential of the market nor to protect their savings from stock market crashes such as the one we experienced in 2008. There are several reasons for this. First, these funds are not “market-sensitive,” meaning that they are not capable of changing their holdings in response to changing economic and market conditions. As a result, the value of TDFs moves up and down with the tides of the market with the hope that the “up” is greater than the “down” in the long run.
Another problem is that economic conditions exist in which Bonds are actually more risky than Stocks – e.g. in periods when interest rates are rising. When this happens, the logic on which TDFs are based is destroyed.
As a result of these and other problems, the returns of TDFs are typically mediocre at best with a risk level that is far too high for a retirement investment. We can do better.
A Superior Default Investment – the NAOI Market-Biased Portfolio
Based on input from NAOI students who own, and are not satisfied with, Target Date funds, the NAOI has designed a higher return, lower risk 401(k) investment called the NAOI Market-Biased Portfolio (MBPort) that includes the recently released NAOI Dynamic Investment (DI) type.
Discussed in detail at this link, DIs are designed to automatically change the ETFs/Funds they hold based on a periodic sampling of market trends. As a result, they are “market-sensitive” and capable of quickly buying into uptrending markets and asset classes while avoiding or getting out of those that are trending down. Testing of Dynamic Investments shows that by being sensitive to market price trends DIs can provide significantly higher returns than TDFs with lower risk.
An NAOI Dynamic Investment Example
To understand how DIs work, let’s look at the NAOI “Core DI” that rotates between holding a Stock Index ETF and a Bond Index ETF depending on which is moving up most strongly in price at a quarterly review. The diagram below illustrates how a DI can automatically change its holding over time. Note that Q1 stands for Quarter 1, Q2 for Quarter 2, etc.
The table below shows the performance of this simple Dynamic Investment for the ten-year period from the beginning of 2008 to the end of 2017 as compared to a traditional “static” portfolio using industry standard Modern Portfolio Theory (MPT) methods. The Sharpe Ratio is a measure of how much return was received for each unit of risk taken and the higher the better.
Average annual growth 2008-2017
60% Stock / 40% Bond
How is the extraordinary performance of the DI possible? The answer is simple. NAOI Dynamic Investments are market-sensitive while MPT portfolios are not.
While the NAOI Core Dynamic Investment can be the only investment a person owns in his/her portfolio, most NAOI students are uncomfortable dedicating 100% of their savings to only one ETF (or mutual fund) at a time. And even though in the DI design the value of the ETF owned is protected at all times by a Trailing Stop Loss Order, this concern is understandable. To address this issue, the NAOI has created the Market-Biased Portfolio described next.
The 401(k) Default Market–Biased Portfolio
The NAOI Market-Biased Portfolio (MBPort) consists of three investments as illustrated in the diagram below. It holds one NAOI Dynamic Investment with a 50% allocation, one Stock Index investment (an ETF or a Mutual Fund) with a static 25% allocation and one Bond investment with a static 25% allocation. All NAOI MBPorts have this structure, but the ETFs / Funds used and the allocations to each can be changed by a dynamic-portfolio designer.
The NAOI “default” Market-Biased Portfolio configuration is described below:
- The first component is the NAOI “Primary” Dynamic Investment with a 50% allocation. It rotates among the following ETFs depending on a quarterly review of the price trend of each:
- RZG – SmallCap Growth Stock Index
- RPV – Large Cap Value Stock Index
- MTUM – Momentum Stock Index
- EDV – Long-Term Treasury Bonds
- The second component is a Total Stock Market Index ETF with a static 25% allocation as follows:
- SPY – LargeCap Value Stocks; SPY tracks the S&P 500 Index
- The third component is a Bond ETF with a static 25% allocation using a Long-Term Treasury Bond ETF as follows:
- EDV – Long-Term Treasury Bonds
Note that Mutual Funds that track the same indexes can be used as well.
This MBPort will hold either 2 or 3 ETFs at one time depending on the price trends of each ETF in the Dynamic Investment. The diagrams below show the allocations of the MBPort when Stock prices are trending up and when Bond prices are trending up.
You can see that at any one time the MBPort is “biased” toward either Stocks or Bonds. Below is an example of the ETFs that this investment can hold over multiple Quarters:
The green boxes show a Stock bias for that quarter while yellow boxes show a Bond bias. In all quarters there will always be at least a 25% allocation to Bonds in the form of EDV and a 25% allocation to SPY. In the green quarters the other 50% Stock allocation will be the Stock ETF in the Dynamic Investment that is trending up in price most strongly at a quarterly review. In the Bond-biased quarters there will always be a 25% allocation to SPY and a 75% allocation to EDV as this is the only Bond ETF in the Dynamic Investment.
Keep in mind that the MBPort changes its holdings based on objective observations of market trends and not on subjective human judgments and by doing so removes a massive risk element from the process. This is also a process that can be easily computer-automated.
TDF vs. NAOI MBPort Performance Comparison: 2013-2018
The Table below shows the performance of two actual TDFs as compared to that of the NAOI default MBPort just discussed. Note that in many TDFs, Non-US Stocks are included in the asset mix for diversification purposes. Testing by the NAOI shows no benefit for including them in an MBPort.
Shown for each investment in the Table is the Average Annual Return for each investment along with its Sharpe Ratio for the 5-year period from 2013 to December 2018 inclusive. The time period starts in 2013 as this was the year when the TDFs used were introduced.
You can see that the MBPort provided approximately three times the return with less than half the risk produced by either of the two TDFs.
Summary - A Better Retirement Investment Design
Target Date Funds are purposely designed to provide lower returns to investors as they near retirement; a time when investors need additional income the most. In contrast, NAOI Market-Biased Portfolios are designed to capture the positive returns that the market offers at all times while avoiding losses; time horizons simply don’t matter. This is why MBPorts, not TDFs, will be the preferred 401(k) investment in the future of investing.
More information on this topic is found at this link which also contains, at the bottom of the page, a form for signing up to receive NAOI product release updates.