Most target-date funds are not as diversified as they could be, and particularly as they increase in popularity in 401(k) plans, their design needs to be revisited, according to Folio Investing.

Recent moves by several fund companies to include alternative and other nontraditional assets in their allocations is a step in the right direction, but does not solve their shortcomings, according to Folio Investing founder Steven Wallman.

“Most target-date funds apply an approach to asset allocation that can be enhanced,” Wallman says. “Our analysis shows that these funds are not as well diversified as they could be beyond stocks and bonds, thereby leading to a high exposure to risk from a decline in stocks.”

He continues: “Achieving true diversification requires much more than simply combining stocks and bonds in a portfolio. Financial research over the past two decades, and subsequent changes in strategic asset allocation by institutional investors, suggests that better results can be achieved by analyzing the relationships between sectors over time, and diversifying to a far greater extent than is traditionally done.”

Folio Investing’s own suite of target-date funds, launched in 2007, takes an institutional approach by looking at the “relational diversification,” or relationship between asset classes, in order to reduce risk, improve performance and deliver more consistent returns. In addition to stocks and bonds, the funds also invest in commodities, inflation-trading bonds (TIPS), real estate, infrastructure stocks such as utilities and other asset classes.

Folio Investing said its research found that other target-date funds lose 1% or more a year in performance due to inadequate diversification, and said that since their inception four years ago, the return of its 2010, 2020, 2030 and 2040 funds averaged 1.13% higher a year than the average return of corresponding target-date funds from three leading fund companies. Among all target-date funds, Folio Investing said, its funds’ performance has been 2.87% higher a year.

“The long-term impact of a performance improvement of 1% a year is significant,” Wallman says. “The Department of Labor and others have estimated that a 1% increase in return over an investor’s working lifetime results in almost 30% higher wealth at retirement. Target-date funds are the default core investment in 401(k) and other defined contribution plans. A more perfect design will improve the chance of a financially secure retirement for hundreds of thousands of Americans — and we can do better.”

Lee Barney is the editor of Money Management Executive, a SourceMedia publication.

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