Ideas Made to Matter
Target date funds have ‘quantitatively large effects’ on stock prices
Target date funds are a staple in many workplace retirement plans. Often used as a default investment option, TDFs optimize risk when an individual is young and gradually adjust to a more conservative investment mix as retirement nears, effectively relieving investors of having to actively rebalance their portfolios between stocks and bonds.
The option has proved popular: The total amount of assets invested in TDFs increased to $1.4 trillion at the end of 2019 from around $8 billion dollars in 2000. There has been a similar rise in target date collective investment trusts (which some firms provide instead of TDFs for their employees) so that the total funds in target-date type funds is now well over $2 trillion.
With so much money tied up in TDFs, do they affect the markets? New research from MIT Sloan shows the extent to which they do — an effect that could become more pronounced as the investment option continues to grow in popularity.
“There’s an awful lot of money involved in this sort of trading,” saida professor of finance and co-director of the MIT Golub Center for Finance and Policy. Parker authored the working paper, “Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds,” along with professor of finance and entrepreneurship and Brandeis University’s Yang Sun.
To determine the effect that TDFs have on the markets, the authors first constructed a dataset of TDFs containing quarterly data from the CRSP Mutual Fund Database between 2008 and 2018. Then they created a dataset of monthly stock returns, prices, volumes, and market capitalizations from CRSP and S&P 500 membership from Compustat.
Using this information, the researchers were able to observe the impact TDFs had on various financial instruments as they automatically rebalanced to maintain their desired portfolio mix between stocks and bonds.
Here’s what the researchers found:
1. TDFs actively rebalance within a few months of a market fluctuation.
In order to identify the effect that TDFs have on the markets, the authors first had to prove that TDFs indeed worked as designed.
TDFs sell equity when equity does well in order to maintain a constant share of equity in a portfolio and create the desired stable share invested in different asset classes. In the course of their research, the authors found that TDFs do indeed rebalance their portfolio mix between stocks and bonds within a few months of a market movement.
“Our paper is about looking at whether target date funds on average indeed are doing this sort of trading,” Parker said. “The answer is yes — when the stock market goes up, TDFs sell stocks, and when the bond market goes up more than the stock market, TDFs sell bonds and buy stock.”
2. Investors tend not to move funds in or out of TDFs to offset this rebalancing.
Next, the authors had to determine that investors were using TDFs as intended — as a set-and-forget investment strategy. The authors wondered if it were somehow possible that when the stock market did well and TDFs sold equity, investors were pulling money out of a target date fund and putting it into an equity fund, thereby undoing the smart decision-making of the TDF. Parker said this wasn’t the case.
“People don’t trade to undo the proscribed trading behavior that the target date fund is doing on their behalf,” he said.
3. TDFs have “quantitatively large effects” on inflows and outflows from the mutual funds they buy and sell, which in turn is having some effect on the prices of the stocks these mutual funds hold.
In theory, the authors were aware that TDFs would affect the markets, but prior to their research, no one had quantified the impact of TDF trading on the flows into and out of mutual funds or on individual stock prices.
The authors found that individual stocks with high TDF exposure through mutual funds had lower returns in the quarter after they outperformed the market — evidence that TDFs were working as designed.
Specifically, when the stock market rose by 10% relative to the bond market, the average equity mutual fund saw additional investment flows that increased its size by 2.5% in that quarter.
But TDFs respond in the opposite way, by selling funds that hold stocks and buying bond funds. Trading by TDFs (and similar funds) offsets about 40% of the retail investor flows into the stock market, potentially reducing the stock market return by as much as 0.24%.
“When the stock market does well, equity mutual funds tend to get inflows from retail investors,” Parker said. “So target date funds are selling out of equity at the same time the typical retail investor is buying in.”
The findings demonstrate that TDFs are moving a significant fraction of U.S. retail investors to an actively “market-contrarian trading strategy” that trades against aggregate stock market momentum and fluctuations, the working paper states.
4. Continued growth in TDFs will decrease stock market volatility.
The authors speculate that TDFs may stabilize the stock market and reduce volatility. If stock prices rise because of positive sentiment or irrational exuberance, “then having the target date fund lean against that and sell stock when the sentiment gets high is a good thing for stabilizing the stock market,” Parker said.
He cautioned, however, that some changes in the stock market are driven by fundamental increases in the value of underlying companies. In these cases, there really isn't a good reason to sell, and “the stock market might become slightly undervalued if target date funds are selling out of real profit increases that ought to be raising the value of the stock market.”
Going forward, if TDFs become even more popular and make up a bigger part of the market, they will continue to reduce stock market volatility and tighten the correlation in returns between the stock and bond markets.
“I think TDFs are probably starting to have a little bit of impact now, but it's probably still small,” Parker said. “It could become more noticeable in the future if things keep growing at this rate. If this trend continues, they'll become increasingly important for the price volatility of the overall market.”