In another thread, I expressed disrespect for nominal bonds and especially, nominal bond funds, such as Total Bond. And I specifically dissed Target Date Funds. [viewtopic.php?t=422026]
Participants quite naturally asked: Do you have a better idea? If not … maybe go away and don’t bother us anymore.
Ahem.
This thread lays out my brainstorming. Your brainstorms are welcome in response.
Today’s products
Currently, Vanguard launches a new Target Date fund every five years with a 50-year life (e.g., TD 2070 launched after 2020). The investor picks a fund that matures on their estimated retirement date, say, age 65. Over the seven years that follow that date, each TD fund glides toward the 30/70 allocation used in the Retirement Income fund, into which each TD fund is converted. At launch, the funds start with about 90% stock, then glide toward just over 50% as the target date approaches, gliding more rapidly in the next seven years toward the 30/70 destination.
Other fund providers have their own mix of underlying funds/assets (not all combine international stocks and bonds as does Vanguard), but all use a glide path with a balanced allocation, allowing them to be the default fund choice under Labor Department rules for enrollees in a 401(k) or similar plan.
The Capital Market Line
If you don’t recognize the term, enter it into Google Images. You’ll get a quick primer if you click on some of the charts there.
The idea was that investors should buy a risk-free security (what a fanciful thought!), and otherwise hold the risk portfolio at market weights.
Each individual investor would then allocate funds between the risk-free security and the risk portfolio in accordance with their risk aversion, sliding up and down the capital market line connecting the risk-free rate (risk-free = 0% standard deviation, risk-free thus on the Y-axis) and the tangent portfolio, that point on the efficient frontier that could be reached by drawing a straight line from the risk-free asset to the efficient frontier, no overlap, no gap—tangent.
If you were completely risk-averse, you owned only the risk-free instrument. If you had no risk aversion, you owned the portfolio at the tangent point, 100%.
*And if you were a fictional creature of theory, you could lever up the tangent portfolio by borrowing at the risk-free rate, same as the United States Treasury does; one of several fantastical elements that caused the eclipse of the CML approach.
Most people, home economicus that they are, would have some partial allocation to the risk portfolio. The model allows them to dial their risk up and down in linear fashion, like a shuttle moving along a loom.
James Tobin got a Nobel prize, not least, for the separation theorem.
What happened to the Capital Market Line?
When first diffused in the 1960s, Treasury bills earned like 3% or 4%. And inflation—what’s that? The 1970s hadn’t happened yet.
So you had an intersection point pretty high up the Y-axis, giving a nice, mildly up-sloping line between the T-bill rate and the tangent portfolio, and the notion of linear risk-aversion made a lot of sense. You could risk nothing and make 4%; you could risk a little more and expect 5%; you could shove all your chips across the table and make 10%, albeit at considerable risk of loss, and lots of volatility.
Then inflation happened. Yah, T-bills, risk-free … but not free of that risk.
Ultimately T-bills soared toward 20% and as rapidly fell back. After the GFC, T-bills dropped toward zero.
Given volatility of that magnitude, to assume 0% standard deviation for the “risk-free” asset … was no longer credible.
In time, the idea of a risk-free rate that could be plotted on the y-axis, with zero standard deviation, fell out of favor. Naked emperor and all that.
Enter TIPS: the new risk-free security
A TIPS ladder restores a 0% standard deviation. The real return on each rung of the ladder is known in advance.
Very important: in a ladder, there is always one rung consisting of a bond that will mature in the next year—or even, six months. In a bond fund, those same bonds exist, but you cannot separate them out.
I replace Total Bond with the TIPS ladder as described below. The rest of the fund is invested in a Total Stock Market Fund.
How the new CML funds might work
The key insight, consistent with the glide path in TD funds, is that risk aversion is a strict function of age. Young people should be mostly in stocks (90%, in the 2070 fund at present), versus individuals approaching retirement, with stock allocation down to 50%+ (the 2025 fund, individual presumed to be in their mid- 60s).
These new CML funds have a 40-year life and they are keyed to starting age, not ending age. The 2025 Fund launch (earliest I can imagine my new idea taking hold) is targeted at 25-year olds, and more generally, “those in their 20s just starting out in their retirement savings.”
Here is how I envision the glide path. In year One, at the start point, notionally in January of the launch year, 99% of the fund is placed in a total stock fund and 1% purchases a 10-year TIPS.
In year Two, 98% is in the stock fund and another 10-year TIPS bond is purchased by shifting 1% out of stocks.
…
At the beginning of year Ten, 90% is in the stock fund and 10% is in a ladder of TIPS extending from 10 years to 1 years.
Just after the end of Year Ten, one TIPS matures. It goes toward the purchase of next year’s 10-year Treasury.
The idealized customer is in their mid-30s by this point, with huge amounts of human capital remaining. The ten percent allocated to the TIPS ladder scarcely serves for volatility damping. It won’t become important until it grows further.
From the eleventh year the allocation to TIPS continues to step up 1% per year. The purchase is always of a 10-year note, but from the eleventh year some of the funds to purchase come from the TIPS that mature that year.
*Of course, with the cooperation of the Treasury, purchases will be made every quarter as 10-year TIPS adopt that schedule. The 1% annual reallocation will phase in 0.25% at a time. For the first twenty years or so, the dividend payment on the stock fund will likely do the trick.
By the 20th year we have 80% in stocks and 20% in a TIPS ladder that extends from 10 years to 1 year. Put another way, at the outset of that year 2% of the portfolio is in a maturing TIPS bond with less than one year remaining; possibly, 0.5% maturing in three months, etc. As safe and liquid as a 90-day T-bill.
At the 20th year, participants who have been contributing for more than X years received a separability privilege: the funds can be split into the underlying stock fund and the ten-year ladder. The ladder is transferred as individual TIPS, allowing the participant to tap some portion of their savings for emergency use without taking a loss on that portion; what they do with remaining individual TIPS bonds is up to them. Later, they can sell all plus the stock fund and get back in to this or another fund in the series.
After twenty years our target investor is now in their mid-40s or a bit more. The separability privilege may be quite valuable. The amount of human capital remaining has declined significantly.
The 1% per year shift to TIPS continues. At the 30th year, the fund is 70% in stocks and 30% in the TIPS ladder. That ladder ranges from 10 years to one year in maturity, 3% of the portfolio each.
The target customer is now in their mid- to late-50s. Early retirement may have started for some. At the 30-year point, fundholders of more than X years are eligible to receive a free consultation from the firm’s advisory services. By this point individual circumstances will show a wide spread of outcomes. No one allocation can fit all needs. Increasingly, there will be individuals who want to exit the fund, with or without the separability provision.
Over the next ten years the allocation to TIPS continues to increase at 1% per year; when the 40th year is reached, the fund is 60-40 stocks and a ten-year TIPS ladder.
At that point the fund freezes its allocation. It merges with the other funds that have reached 40 years. All these follow a 60/40 mix with regular rebalancing (Peter Bernstein portfolio). The separability provision continues to hold. Another free consultation is offered. The firm will have other TIPS ladder products available and many fund holders will separate from the fund at this point.
Advantages
Holding a TIPS ladder provides more protection against ill-timed volatility. After the tenth year, a growing portion of the funds are always in a one-year TIPS.
That’s the key difference from today’s Target Date funds: the use of a short-intermediate ladder of TIPS. The performance of that ladder may not differ much from that of a total TIPS fund such as SCHP, or even Total Bond (in Sharpe ratio terms; the presence of credit in BND may give a raw increase in return, but the lower duration of the TIPS ladder, typically about 5 years, will make it less volatile, and probably less correlated with stocks, as has been true for VGIT).
But because it is a ladder, and because a sum matures every year, and because of the separability privilege, there is much greater liquidity to handle unexpected shocks, especially in the 40s and 50s.
And because of the inflation protection, it is a much better hedge against the mostly likely form of devastation to be visited on long-term savers here in the US: inflation.
The new design is true to the promise of fixed income: to lock in a known future amount, with the savings made ten years ago always available right now, holding its real value.
Participants quite naturally asked: Do you have a better idea? If not … maybe go away and don’t bother us anymore.
Ahem.
This thread lays out my brainstorming. Your brainstorms are welcome in response.
Today’s products
Currently, Vanguard launches a new Target Date fund every five years with a 50-year life (e.g., TD 2070 launched after 2020). The investor picks a fund that matures on their estimated retirement date, say, age 65. Over the seven years that follow that date, each TD fund glides toward the 30/70 allocation used in the Retirement Income fund, into which each TD fund is converted. At launch, the funds start with about 90% stock, then glide toward just over 50% as the target date approaches, gliding more rapidly in the next seven years toward the 30/70 destination.
Other fund providers have their own mix of underlying funds/assets (not all combine international stocks and bonds as does Vanguard), but all use a glide path with a balanced allocation, allowing them to be the default fund choice under Labor Department rules for enrollees in a 401(k) or similar plan.
The Capital Market Line
If you don’t recognize the term, enter it into Google Images. You’ll get a quick primer if you click on some of the charts there.
The idea was that investors should buy a risk-free security (what a fanciful thought!), and otherwise hold the risk portfolio at market weights.
Each individual investor would then allocate funds between the risk-free security and the risk portfolio in accordance with their risk aversion, sliding up and down the capital market line connecting the risk-free rate (risk-free = 0% standard deviation, risk-free thus on the Y-axis) and the tangent portfolio, that point on the efficient frontier that could be reached by drawing a straight line from the risk-free asset to the efficient frontier, no overlap, no gap—tangent.
If you were completely risk-averse, you owned only the risk-free instrument. If you had no risk aversion, you owned the portfolio at the tangent point, 100%.
*And if you were a fictional creature of theory, you could lever up the tangent portfolio by borrowing at the risk-free rate, same as the United States Treasury does; one of several fantastical elements that caused the eclipse of the CML approach.
Most people, home economicus that they are, would have some partial allocation to the risk portfolio. The model allows them to dial their risk up and down in linear fashion, like a shuttle moving along a loom.
James Tobin got a Nobel prize, not least, for the separation theorem.
What happened to the Capital Market Line?
When first diffused in the 1960s, Treasury bills earned like 3% or 4%. And inflation—what’s that? The 1970s hadn’t happened yet.
So you had an intersection point pretty high up the Y-axis, giving a nice, mildly up-sloping line between the T-bill rate and the tangent portfolio, and the notion of linear risk-aversion made a lot of sense. You could risk nothing and make 4%; you could risk a little more and expect 5%; you could shove all your chips across the table and make 10%, albeit at considerable risk of loss, and lots of volatility.
Then inflation happened. Yah, T-bills, risk-free … but not free of that risk.
Ultimately T-bills soared toward 20% and as rapidly fell back. After the GFC, T-bills dropped toward zero.
Given volatility of that magnitude, to assume 0% standard deviation for the “risk-free” asset … was no longer credible.
In time, the idea of a risk-free rate that could be plotted on the y-axis, with zero standard deviation, fell out of favor. Naked emperor and all that.
Enter TIPS: the new risk-free security
A TIPS ladder restores a 0% standard deviation. The real return on each rung of the ladder is known in advance.
Very important: in a ladder, there is always one rung consisting of a bond that will mature in the next year—or even, six months. In a bond fund, those same bonds exist, but you cannot separate them out.
I replace Total Bond with the TIPS ladder as described below. The rest of the fund is invested in a Total Stock Market Fund.
How the new CML funds might work
The key insight, consistent with the glide path in TD funds, is that risk aversion is a strict function of age. Young people should be mostly in stocks (90%, in the 2070 fund at present), versus individuals approaching retirement, with stock allocation down to 50%+ (the 2025 fund, individual presumed to be in their mid- 60s).
These new CML funds have a 40-year life and they are keyed to starting age, not ending age. The 2025 Fund launch (earliest I can imagine my new idea taking hold) is targeted at 25-year olds, and more generally, “those in their 20s just starting out in their retirement savings.”
Here is how I envision the glide path. In year One, at the start point, notionally in January of the launch year, 99% of the fund is placed in a total stock fund and 1% purchases a 10-year TIPS.
In year Two, 98% is in the stock fund and another 10-year TIPS bond is purchased by shifting 1% out of stocks.
…
At the beginning of year Ten, 90% is in the stock fund and 10% is in a ladder of TIPS extending from 10 years to 1 years.
Just after the end of Year Ten, one TIPS matures. It goes toward the purchase of next year’s 10-year Treasury.
The idealized customer is in their mid-30s by this point, with huge amounts of human capital remaining. The ten percent allocated to the TIPS ladder scarcely serves for volatility damping. It won’t become important until it grows further.
From the eleventh year the allocation to TIPS continues to step up 1% per year. The purchase is always of a 10-year note, but from the eleventh year some of the funds to purchase come from the TIPS that mature that year.
*Of course, with the cooperation of the Treasury, purchases will be made every quarter as 10-year TIPS adopt that schedule. The 1% annual reallocation will phase in 0.25% at a time. For the first twenty years or so, the dividend payment on the stock fund will likely do the trick.
By the 20th year we have 80% in stocks and 20% in a TIPS ladder that extends from 10 years to 1 year. Put another way, at the outset of that year 2% of the portfolio is in a maturing TIPS bond with less than one year remaining; possibly, 0.5% maturing in three months, etc. As safe and liquid as a 90-day T-bill.
At the 20th year, participants who have been contributing for more than X years received a separability privilege: the funds can be split into the underlying stock fund and the ten-year ladder. The ladder is transferred as individual TIPS, allowing the participant to tap some portion of their savings for emergency use without taking a loss on that portion; what they do with remaining individual TIPS bonds is up to them. Later, they can sell all plus the stock fund and get back in to this or another fund in the series.
After twenty years our target investor is now in their mid-40s or a bit more. The separability privilege may be quite valuable. The amount of human capital remaining has declined significantly.
The 1% per year shift to TIPS continues. At the 30th year, the fund is 70% in stocks and 30% in the TIPS ladder. That ladder ranges from 10 years to one year in maturity, 3% of the portfolio each.
The target customer is now in their mid- to late-50s. Early retirement may have started for some. At the 30-year point, fundholders of more than X years are eligible to receive a free consultation from the firm’s advisory services. By this point individual circumstances will show a wide spread of outcomes. No one allocation can fit all needs. Increasingly, there will be individuals who want to exit the fund, with or without the separability provision.
Over the next ten years the allocation to TIPS continues to increase at 1% per year; when the 40th year is reached, the fund is 60-40 stocks and a ten-year TIPS ladder.
At that point the fund freezes its allocation. It merges with the other funds that have reached 40 years. All these follow a 60/40 mix with regular rebalancing (Peter Bernstein portfolio). The separability provision continues to hold. Another free consultation is offered. The firm will have other TIPS ladder products available and many fund holders will separate from the fund at this point.
Advantages
Holding a TIPS ladder provides more protection against ill-timed volatility. After the tenth year, a growing portion of the funds are always in a one-year TIPS.
That’s the key difference from today’s Target Date funds: the use of a short-intermediate ladder of TIPS. The performance of that ladder may not differ much from that of a total TIPS fund such as SCHP, or even Total Bond (in Sharpe ratio terms; the presence of credit in BND may give a raw increase in return, but the lower duration of the TIPS ladder, typically about 5 years, will make it less volatile, and probably less correlated with stocks, as has been true for VGIT).
But because it is a ladder, and because a sum matures every year, and because of the separability privilege, there is much greater liquidity to handle unexpected shocks, especially in the 40s and 50s.
And because of the inflation protection, it is a much better hedge against the mostly likely form of devastation to be visited on long-term savers here in the US: inflation.
The new design is true to the promise of fixed income: to lock in a known future amount, with the savings made ten years ago always available right now, holding its real value.
Statistics: Posted by McQ — Tue Feb 06, 2024 11:09 pm — Replies 1 — Views 87