ICI Viewpoints

Target date funds (TDFs)¹ have steadily become a mainstream option among retirement investors,² with some academics describing TDFs as “one of the most important financial innovations for the typical American retail investor” in recent decades.³

These strategies, which are popular for their broad diversification and automatic rebalancing over time,⁴ are garnering attention in Washington as regulators evaluate their status as a default investment option in 401(k) plans. They’ve also come into focus, as the dominant performance trends of recent years—e.g., equities over bonds, US over international, and mega-cap tech above all else—have caused some observers to question the attractiveness of TDFs and balanced funds in general. Adding to the debate, a working paper by Massa et al. (2022) purports that TDFs underperform to a staggering degree.⁵

However, when fully accounting for investment exposures, our research reveals that TDFs perform as well as other mutual funds on a risk-adjusted basis, consistent with research from published academic papers.⁶ It’s crucial for policymakers to consider these findings as they assess the merits of target date strategies as default investment options, particularly in a long-term context.

Why Factors Matter

Academic researchers have long studied fund performance, often using factor models to assess risk-adjusted returns—essentially, the difference between a fund’s actual returns and its estimated benchmark’s returns, adjusted for risk.⁷ Risk-adjusted returns are important because they provide a standardized measure of performance, making it possible to compare outcomes across different types of investment strategies.

But they’re only reliable when a fund’s factors—exposures to various asset classes and associated risks—are properly accounted for. If significant factors are misidentified or omitted, estimated benchmark returns—and consequently, a fund’s risk-adjusted results—will be inaccurate, leading to erroneous conclusions about fund performance. That appears to be the case with the working paper by Massa et al.

International Equity Exposure Is Important When Measuring TDF Performance

Why does Massa et al. find that TDFs underperform? Taking a closer look, we see that their study does not account for international exposures, even though TDFs have meaningful allocations to international investments (Figure 1).

Figure 1
TDFs Have Substantial Exposure to International Stocks
Percentage of total holdings, data centered around June 2024

Source: ICI calculations of publicly available SEC Form N-PORT data

Such an omission is problematic because, as illustrated in Figure 2 (left panel), a factor model that excludes TDFs’ international exposures shows a misleading underperformance of 2.2 percent.⁸

By contrast, we use both US and international factors to account for TDFs’ domestic and international equity allocations and find that these funds’ gross risk-adjusted returns are 0.2 percent (Figure 2, left panel), which is in line with performance estimates for other mutual funds in empirical studies.⁹ In other words, TDFs perform as well as other mutual funds on a risk-adjusted basis when one accounts for their substantial exposure to international stocks. It’s essential to recognize this fact given the significant outperformance of US stocks relative to international stocks since the global financial crisis (Figure 2, right panel). Failure to account for this differing performance creates the potential for false takeaways about long-term performance.   

Figure 2

¹ Data are estimated over the period between 2010 and 2020. For more information, see in Qureshi (2024) at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4618120.

² Indexes are set to 100 at year-end 2010.

³ Year-to-date, as of September 30, 2024.

Source: ICI calculations of ICI, CRSP, Morningstar, and Refinitiv data

Nevertheless, the recent divergence in performance between US stocks and international stocks may raise the question of why TDFs have any international exposure. The answer is that there are clear diversification benefits to holding both US and international stocks over the long run. Over the past five decades, there have been periods when US stocks outperformed and other periods where international stocks outperformed (Figure 3). Indeed, this is why many financial advisors recommend international exposure in long-term portfolios. It’s this broad diversification, combined with automatic rebalancing over time, that has helped fuel the widespread adoption of target date strategies. 

Figure 3
US and International Stocks Have Outperformed Each Other Over Time
Relative performance (percent) of US versus international stocks¹

¹ Relative performance is estimated as the difference between 5-year rolling average returns of the S&P 500 Index and those of the MSCI World ex USA Index. Positive values indicate outperformance of US stocks, while negative values indicate outperformance of international stocks.

² Year-to-date, as of September 30, 2024.

Source: Based on Hartford Funds white paper, “US and International Markets Have Moved in Cycles”  

Need for High Quality Research on TDFs

Because academic research often feeds into policy proposals, it’s crucial that assessments of TDF effectiveness be conducted carefully and reviewed with a critical eye. As regulators evaluate TDFs and their role in 401(k)s, we urge them to fully vet any academic papers presented to them and focus on those that paint a complete picture of funds’ risk/return characteristics.