October 2023 / TARGET DATE INVESTING
How We Design a Blend Solution for Target Date Investors
Mixing active and passive investments in a target date solution.
- We are committed to delivering successful retirement outcomes through a range of target date solutions for our clients to help meet their needs and objectives.
- Our blend target date strategy is designed with a goal of delivering a lower fee profile and reduced tracking error with the benefits of our approach to active management.
- We believe the pursuit of lower costs must be balanced with the need for broad diversification and the potential for excess returns.
Given our leadership in the target date marketplace, we have a strong commitment to research and innovation to help meet investors’ evolving needs. Our target date suite is built on the principle that investor preferences should drive design. For that reason, we manage an array of solutions to meet the range of needs we know exist in the market.
A number of plan sponsors have sought out target date strategies that offer lower fees and reduced tracking error.1 Importantly, they are seeking solutions from providers that can restrain costs but offer a full opportunity set of asset classes that can potentially generate excess returns and greater portfolio growth.
In addition to delivering a strategy that combines the value of active management with the lower costs of passive management, we believe our approach to a blend target date strategy offers investors:
- A thoughtful glide path design tailored to help support investors’ objectives, which seeks to balance risk and return potential in line with our research on participant preferences and behavior.
- Enhanced diversification in asset categories that can only be adequately achieved through active management
- A suite of strong underlying building blocks.
- A robust tactical allocation decision‑making process that rigorously assesses market risks and opportunities.
- An experienced team that has managed target date strategies through multiple market cycles.
Solving for Client Needs
Plan sponsors often have unique needs and specific objectives in their selection of target date offerings. Lower cost solutions that couple the benefits of active and passive management are among them. We recognize that some passive investments can provide efficient capital market exposure in select sectors while also delivering significant cost reduction. Importantly, however, we believe our actively managed portfolios can generate excess returns and diversification through exposure to market segments in which passive management cannot drive desired outcomes.
The primary goal of our blended approach is consistent with that of our existing suite of target date solutions: to balance providing support for lifetime income with reducing volatility near retirement through a risk‑aware design. We firmly believe that a fully active approach presents the greatest opportunity to generate excess returns, but we also recognize that, for some, this goal must be balanced alongside other considerations. To that end, we sought to design a solution to meet plan sponsors’ needs without sacrificing participants’ outcomes.
Building a Blend Solution
We sought to design a target date strategy that blends T. Rowe Price’s passive and actively managed investments that aim to deliver a lower fee profile and reduced tracking error while maintaining many of the benefits of active management. Through an iterative evaluation process, we explored the trade‑offs between our active and passive strategies in terms of their potential impact on a range of outcomes, such as cost, excess return potential, and diversification, among other factors.
Fixed income and equity portfolios have divergent characteristics and are impacted by different factors, particularly when considering the implementations of a blended approach between active and passive investments. For that reason, we considered our approach to the broad asset classes separately.
Complexities—Index Replication and Tracking Error
The goal of a manager of a passive strategy is to replicate the performance of a benchmark or index the strategy is intended to track. The ease of replicating an index varies meaningfully across asset classes. Tracking error is a useful measure of how closely portfolios track their benchmark. In certain market segments, like U.S. large‑cap equities, tracking error of passive investments tends to be lower, as it is relatively easier for passive managers to purchase the securities that compose the index in the proportions needed to replicate index returns. However, in other areas, particularly in fixed income, tracking error tends to be a more notable challenge.
The Credit Suisse High Yield Index, for example, consists of over 1,200 distinct securities from multiple sectors.2 Many of these bonds are issued in relatively limited quantities and may trade infrequently, or not at all, in the secondary market. Further, new issuance, maturities, credit rating changes, and redemptions can continuously alter the makeup of a bond index, thereby increasing the difficulty of fully replicating the index and potential for tracking error.
Fixed Income—Improved Diversification
We believe in broad diversification within fixed income and, therefore, have implemented allocations across both core and diversifying fixed income sectors. As part of our design process, we evaluated the trade‑offs of active and passive investments across each fixed income sector in which we invest. For each sector, we evaluated a passive investment’s ability to achieve efficient exposure with low tracking error as well as the attractiveness of gaining that exposure passively.
Our Active Approach Offers Favorable Diversification
(Fig. 1) Regional diversification comparison
While passive investment strategies within certain fixed income market segments face significant challenges gaining efficient exposure, our research indicates that passive can be appropriate in other market segments due to the relative ease of benchmark replication and reasonably well‑contained tracking error within those sectors. For example, based on our analysis, we believe passive investments within the U.S. investment‑grade and U.S. Treasury sleeves can be employed. Additionally, we believe passive exposure to these sectors is more prudent given their high credit quality. This allocation to passive fixed income investments could also enable us to maintain an allocation to active equity while maintaining a similar mix of active and passive exposures across our portfolios.
In more specialized fixed income sectors, our analysis suggests that an active management approach can be preferable, as index returns can be more challenging to replicate through passive portfolios. In these sectors—such as high yield and emerging markets debt—passive managers may not be able to purchase and hold some benchmark securities at appropriate weights, and there can be heightened liquidity risks. As a result, tracking error for a passive strategy in these sectors comparably can be as high as an active strategy, and performance may fail to appropriately track the stated benchmark.
Beyond simple inefficiency and high tracking error, we found that accurate index exposure in certain sectors may produce unfavorable outcomes. In some cases, the securities that dominate particular indexes may have potentially unattractive qualities:
- Within high yield debt, index representation skews toward the most highly leveraged issuers. This can expose investors to greater default risk and can also create sector concentrations.
- In emerging markets debt, benchmark representation is typically limited to sovereign issues, which reduces the opportunity set available to investors.
- In international developed debt markets, indexes tend to skew toward a high concentration of issuers in a limited number of countries, which increases idiosyncratic risk.
We believe target date strategies should have strategic exposure to these sectors, which provide important, long‑term diversification benefits. In our view, exposure to these sectors can be best achieved through an active management approach.
Equities—Potential for Excess Returns
Among equities, we found that the appropriateness of passive and active vehicles similarly varied across market segments and styles. In core allocations to U.S. and international developed markets equities, we determined that passive allocations could achieve efficient market exposure while restraining cost.
Active Management Maximizes the Potential for Excess Returns
(Fig. 2) Average annualized excess returns (net of fees)
However, we found that—given the magnitude of potential excess returns—desirable outcomes were most supported by combining these passive allocations with our active allocations to narrower, style‑based segments. We believe our active capabilities in growth‑ and value‑focused segments in the U.S. and international developed markets provide opportunities to maximize potential excess cost‑adjusted returns that may deliver value for plan participants.
For instance, passive investments in U.S. equities present opportunities to gain efficient market exposure at lower cost and minimal tracking error. We believe that a purely passive approach to the segment may limit the ability to generate excess returns. In particular, we have maintained a sizable allocation to U.S. large‑cap equities throughout the glide path, and we believe the magnitude of potential value added from our active strategies within U.S. large-cap equities outweighs the lower cost of a passive alternative.3 Given our sizable allocation and track record of generating excess returns net of fees within U.S. large‑cap equities,4 we believe it was prudent to utilize a degree of active management within the space. Our emphasis is on participant outcomes, and we have a high conviction on maintaining active allocations where we believe we can add significant value.
While efficient passive market exposure is available in certain market segments, we determined that investment opportunities in a number of sectors could also be enhanced though our active management approach. Passive options in emerging markets equities are less desirable, as they are generally viewed as largely inefficient markets and because indexes may skew heavily toward concentration in a few countries. Our suite of target date solutions also maintains an allocation to real assets equities, which can enhance diversification and provide a potential hedge against inflation. In our view, the universe of passive investments does not offer an adequate alternative for this allocation.
By including a blend strategy to our suite of target date solutions, we believe we can provide plan sponsors a unique alternative that stands out from the existing universe of investment options. The integration of active and passive strategies in our blended solution may offer investors the potential for lower costs and the opportunity to benefit from excess returns driven by fundamental research.
The 1-, 5-, and 10-year annualized net of fees total returns as of September 30, 2023 were 27.57%, 7.59% and, 11.86% for the U.S. Growth Stock Composite. The 1-, 5-, and 10-year annualized net of fees total returns as of September 30, 2023 were 13.70%, 8.26% and, 9.52% for the U.S. Value Equity Composite.
Past performance is not a reliable indicator of future performance.
Net of fees performance reflects the deduction of the highest applicable management fee that would be charged based on the fee schedule contained within this material, without the benefit of breakpoints. Net of fees performance returns reflect the reinvestment of dividends and are net of all non-reclaimable withholding taxes on dividends, interest income, and capital gains.
London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2023. FTSE Russell is a trading name of certain of the LSE Group companies. Russell® is a trade mark of the relevant LSE Group companies and is used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication. The LSE Group is not responsible for the formatting or configuration of this material or for any inaccuracy in T. Rowe Price’s presentation thereof.
The S&P 500 Index is a product of S&P Dow Jones Indices LLC, a division of S&P Global, or its affiliates (“SPDJI”), and have been licensed for use by T. Rowe Price. Standard & Poor’s® and S&P® are registered trademarks of Standard & Poor’s Financial Services LLC, a division of S&P Global (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”). T. Rowe Price’s product is not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P or their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.
This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.
The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.
Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources' accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date noted on the material and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.
The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.
It is not intended for distribution to retail investors in any jurisdiction.
USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.
© 2023 T. Rowe Price. All rights reserved. T. ROWE PRICE, INVEST WITH CONFIDENCE, and the bighorn sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc.