Mondial Looking in a different light at lifecycle funds

Lifecycle or "target date funds" attempt to provide investors with a one-stop solution to the challenge of asset allocation. If they worked they would be fantastic. You decide that you are going to retire in the year, say.

Lifecycle or 'target date funds' attempt to provide investors with a one-stop solution to the challenge of asset allocation. If they worked they would be fantastic. You decide that you are going to retire in the year, say 2020, and you invest in funds that are targeted at maturing in 2020, 2021, 2022 and so on.

The idea is that, while investors are young, their holding in risky assets is high, and as the investor ages and approaches maturity the weighting is switched towards lower-risk assets. It's a great idea if market volatility reduces as you age; a less than clever idea if it doesn't. Or so says Dr Anup Basu, a lecturer at Griffith University.

It's an interesting view and relevant to the Gulf in that, whilst lifecycle funds are not exactly a household phenomenon, the way they are managed is very common. The principle is that money is made in the early years as markets are volatile. In theory, by the time the investor is near to retirement, the asset allocation should be attuned to low-risk and more liquid assets as income will be expected shortly. The thinking has been a big success in the US where 'target date' funds have expanded from $2 billion in 1997 to a healthy $187 billion in 2007; additionally, the number of investment houses offering the funds grew from 4 to 37 over the period.

To test the concept, Dr Basu's team set about establishing a hypothetical pension model over a typical investment (pension period?), which he took to be four decades. The model included a 'contrarian' model of holding low-risk assets in the early years and swapping them into high-risk assets when nearer to retirement.

This article revolves around three of Basu's comments, with the more complete article being available in Infinance, the magazine for Finsia Members (you may need to find an Australian). Firstly, Basu says that by investing conservatively at such a critical phase (the end phase when there is most money available to invest), investors/financial advisers "sacrifice significant growth opportunities and can be counterproductive to the participant's wealth accumulation objectives. Most importantly, this does not seem to be compensated adequately in terms of reducing the risk of potentially adverse outcomes". In short: you miss the growth without the protection, says Basu.

However, the second comment suggests that the strategy of reducing risk near to retirement does make sense where an investor has "already accumulated wealth well in excess of their accumulation target a few years before retirement".

Thirdly, his "contrarian" models "which defy conventional wisdom" according to Basu by switching from conservative assets to risky assets as the investor ages, nevertheless, "produce far superior wealth outcomes relative to conventional lifecycle strategies in all but the most extreme cases".

The reason why these extracted comments arise for Basu is all down to the fact that the weight of money issue is just as important as the asset allocation in terms of pension performance.

The conclusion is that you need good performance with 'good weight'; getting good performance with 'low weight' (i.e. the early years when there have been few investment premiums) will rarely make a successful strategy. If you take all the risk in, say, the first ten years of a thirty-year savings horizon; and you make say 15 per cent per annum (converting to low risk/low returns later on); your absolute return would be far behind that of the same (contrarian version) if it were to make, say 10 per cent per annum over the last ten years because the later years carry more investment weight. That's the theory.

- The writer is chairman of Financial Partners/Mondial.