401(k) Specialist Issue 2 - 2019 - 42

401(k) TARGET DATE TECHNIQUES
Pulling the 401(k) 'Factor'
Levers in Target Date Funds
By Editorial Staff
WHAT WILL THE next level (evolution, step)
in the target date space look like?
TDFs are undoubtedly effective, with
Morningstar giving them generally high marks
for absolute and relative performance in the
recovery since 2008. But what more can be
done to refine the product to better aid in
retirement outcome success?
Factor-based investing and the allocation
" tilts " it brings makes waves, but
how does it work with specific glidepaths,
and how much of a difference does it really
make?
" Factor-based equity strategies utilize a rigorous
quantitative process to select securities
that meet the plan participants' objectives
and filter out those unwanted exposures, " according
to a whitepaper from Northern Trust
Asset Management. " Integrating reputable
factor strategies into open-architecture TDFs
empowers participants to accumulate assets,
improves the long-term outlook for young
savers, and reduces the risk exposure for
those near or in retirement. "
The company's deep dive in the space
makes the case for a more active, tactical
process.
Michael Hunstad, NTAM's head of quantitative
strategies, spoke with 401(k) Specialist
about what factor-based target date funds
are, how they work and what Northern Trust
does differently.
Q: Why factor investing, and why now?
A: When you think of a target date fund it's really
an asset allocation, and it generates value
through that asset allocation. Factors provide
an additional layer of granularity to affect
that asset allocation. The innovation here is
that instead of just thinking about equity and
fixed-income as core passive benchmarks, we
now have a number of factor levers that we
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ISSUE 2 2019 | 401kSpecialist.com
can pull within the asset classes to craft much
better outcomes for the participants.
When you think about the overall target
date in the factor space, there's even a factor
lens. Take equity, for instance, there's usually
U.S. equity, international equity or emerging
market equity, but it's crude (other than a
geographic bet or bias that they have going
on). That's pretty much the extent of it. With
factors, we now can tilt the portfolio to value,
size, quality, low volatility, dividend yields,
etc. These are factors that have been shown
to outperform, but more importantly, they
provide additional benefit to the participants.
Q: So, it's the options available
to tilt the portfolio that make it
relevant now?
A: You just have a lot more levers to pull
when creating that target date strategy. The
key to all of this is that a participant in a target
date fund has time diversification on their
side. So, the 25-year-old participant with 40
years to retirement has a lot of time on their
side to reap the benefits of those factor premia.
They have the ability to withstand what
we refer to as factor cycles. Every factor can
and does go through periods of underperformance,
but if you've got a 40-year horizon,
it's no problem withstanding those periods of
underperformance.
There are different cycles associated with
different factors. Factors like size and value
tend to have very long cycles associated with
them; you have to be invested in size and
value factors for a reasonable period of time
before you start to essentially start to earn
that premia.
But as you age you want to shift, strategically,
into these shorter cycle factors like low
volatility, which is the shortest cycle factor
of all.
" The innovation here is that
instead of just thinking about
equity and fixed-income as core
passive benchmarks, we now
have a number of factor levers
that we can pull within the asset
classes to craft much better
outcomes for the participants. "
Q: What makes NTAM different in
its factor strategy?
A: The innovation within our own goal-engineered
glide path is that, from an equity
allocation perspective when a participant is
quite young, the bulk of their equity exposure
is to size and value factors. As they age and
the glide path matures, we're shifting that
allocation potentially away and ratcheting
down the size and value and adding more to
low volatility.
When you think about a target date, almost
all of the real risk is those last few years before
retirement. Even when you're 62 years old,
the bulk of the risk of that target date will be
equity risk. By allocating to low volatility and
being able to lower the risk of that portfolio
materially and lessen the probability of a
major drawdown, that just makes a ton of
intuitive sense.
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401(k) Specialist Issue 2 - 2019

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