03 Jun 2019
Paolo Surico, Professor of Economics, has been awarded a grant worth €1,135,940 from the European Research Council.
27 Mar 2019
Research sets out significant benefit of revising equity exposure of lifestyle funds on a quarterly basis, rather than simply according to an individual’s age, which is currently the norm
A tactical approach to asset allocation in lifestyle funds, which incorporates the use of short-term market data, could enhance results by up to 32% after taking into account trading costs, according to new research.
This proposed new model combines the long-term strategic asset allocation perspective of target date funds, such as lifestyle or default funds, with short-term market information. In this way, exposure to more risky assets can be increased or decreased according to anticipated future market returns to create an improved investment model.
This approach would be highly relevant to target date funds and passive (benchmark) funds, which are typically core to retirement planning.
The research was carried out by Francisco Gomes, Professor of Finance at London Business School, together with Alex Michaelides of Imperial College and Yuxin Xhang of RenMin University. It highlights the value of reviewing the asset allocation of target date funds on a quarterly cycle and adjusting the equity exposure accordingly – rather than simply making changes in the portfolio according to the age of the investor, which is currently the norm.
This quarterly approach underlies the research team’s investment model, which, they argue, creates more refined funds - described as ‘tactical target date funds’ – that deliver substantially greater gains for investors.
Dr Gomes explains: “Our extensive research enabled us to design a simple mechanical rule that could be easily implemented by asset managers and which could boost retirement funds by around a third for millions of savers. Crucially, such a rule could be readily applied to existing lifestyle and default funds.
He continues: “Given the massive decline in defined benefit schemes and the ongoing low interest rate environment, we believe our findings should be extremely helpful to fund managers. More importantly, our results could prove to be very good news to the many millions of people in standard defined contribution retirement plans, which rely on default investment funds.”
“Our research shows how a fund’s asset allocation can be amended in a transparent manner on a quarterly basis and focused on appropriate targets without the active intervention of discretionary asset managers. As the approach is automated according to defined objectives, it helps to keep costs in check. Similarly, risk is controlled through regular portfolio reviews."
Dr Gomes explains that the predicted gains are substantial – typically from 14% to 32% higher than expected retirement wealth generated by standard target date funds – even after including transaction costs.
The team also explored which type of investors might benefit most from their quarterly approach to reviewing and moderating equity exposure.
Medium to higher risk-averse investors were shown to be the biggest winners, as their assets could be moved out of, say, savings accounts (which typically have a low rate of return) and into the model tactical target date funds. This can be particularly relevant to people in the run-up to retirement when their assets are typically at their greatest.
“In summary, the introduction of a simple mechanical rule, which regularly updates equity exposure of a lifestyle fund, should lead to economically large welfare gains for a wide range of investors. However, those people who are net savers during their working life will be the ones who would gain the most.”
The research team also found that more complex variations of their tactical asset allocation model, which could be fine-tuned depending on individual investors, led to further increased gains after costs. Extensions to their model included short-selling stocks, introducing further refinements in the investment approach according to age, and continuing use of a fund post-retirement depending on an individual’s needs.
The research is presented as a discussion paper for the Centre for Economic Policy Research.
Methodology, in brief
The research involved three steps. First, the team derived the optimal portfolio for an investor that is saving for retirement and is using quarterly market information from both the stock market and the options market to forecast future returns. In the second step, they devised a simple portfolio rule that approximates the optimal investment rule and is easy to implement. Finally, through simulations, they compared the returns of this new strategy to those of a standard lifestyle fund for an investor saving for retirement.