Perspectives : Investment | May 19, 2021

What's NOT in our target-date funds, and why?

Similar goal, different approaches

While most TDFs have a similar goal, the way in which they pursue that goal can differ substantially. For example, some TDF providers supplement their allocation to traditional asset classes (stocks, bonds, and cash equivalents) with alternative investments. Others employ strategic or tactical tilts within their portfolios.

Many of these strategies and asset classes have investment merit. They also have the potential to increase costs, introduce complexity, change the portfolio's risk-and-return profile, lower transparency, and/or reduce liquidity. These are all important considerations because TDFs serve a large and diverse investor population, many of whom are defaulted in by their employer and disengaged from the retirement planning process.

What's more, TDF providers typically have limited information about their investors' risk profiles or preferences. Our methodology is sensitive to these realities. When we evaluate any strategy or asset class, we believe it's important to do so through a TDF-specific lens. We consider who the intended investors are and whether any strategy or tactic can truly have a meaningful impact on improving the long-term probability of achieving retirement success.

Figure 1. Relative impact on TDF outcomes

Notes: The chart shows the impact of each population characteristic changing from low (25th percentile of broad population data) to medium (50th percentile). VCMM simulations are as of December 2019. Source: Vanguard.

IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Results from the model may vary with each use and over time. For more information, please see the Notes section.

Tactical asset allocation

Tactical asset allocation (TAA), a dynamic strategy that actively adjusts a portfolio's strategic asset allocation (SAA) based on short-term market forecasts, aims to improve performance by systematically exploiting perceived inefficiencies or temporary imbalances in values among different asset or sub-asset classes.

Many studies, including the seminal research by Brinson, Hood, and Beebower,1 along with Vanguard's research (The Global Case for Strategic Asset Allocation and an Examination of Home Bias), have shown that over time, strategic long-term asset allocation is, by far, the most important determinant of total return for a broadly diversified portfolio. The research indicates that more than 90% of a portfolio's return variability can be explained by the SAA.

The studies also show that while some TAA strategies can add value over the short term, on average, they have not consistently produced excess returns over longer periods. Given the long investment horizon associated with TDFs, coupled with the limited knowledge of individual risk tolerances, we believe focusing on a prudent SAA has the greatest ability to impact investor outcomes.

Static tilts

Another strategy employed across the TDF industry is to tilt the portfolio allocation away from market-cap weight. Although portfolio tilts take many forms, equity tilts are often made by size, style, sector, or location, and fixed income tilts are frequently based on credit quality, duration, or location.

While certain long-term strategic tilts are present in Vanguard Target Retirement Funds—home country bias, for example—there are several commonly used tilts that we don't currently utilize.

Equity size and style tilts

In an attempt to either enhance returns or improve diversification, some TDF providers will strategically over- or underweight certain market capitalization segments (such as large- or small-cap stocks) or an investment style (growth- or value-oriented stocks).

These tilts may have provided outperformance during certain periods historically, but they tend to be inconsistent throughout a full market cycle, and their long-term effectiveness is uncertain. In fact, most size and style tilts found in TDFs have been small in nature and have had no discernable impact on the long-run probabilities of retirement success.

Also, these tilts could benefit some participants but might be detrimental for others, depending on each investor's investment horizon or risk tolerance. We believe a TDF should remain focused on what's best for all its investors en masse.

Overweighting REITs

Real estate investment trusts (REITs) are typically used within TDFs as a public proxy for a direct allocation to private real estate. However, REITs are already represented in a broadly diversified equity allocation, so any additional allocation is beyond what the market consensus believes is their market value. (REITs have historically ranged between 1% and 3% of global market cap.) Additionally, although REITs may provide some level of long-term portfolio diversification, over the short term REITs are more highly correlated with stocks than with private real estate, and that correlation has increased in recent years. In fact, REITs' have underperformed the broad market during periods of high volatility.

Figure 2. REITs' correlation to U.S. equities

Source: FactSet, as of December 31, 2020.

Any additional allocation to REITs can represent a sizable overweight of a potentially volatile and concentrated sector. For these reasons, we maintain a market-proportional allocation to global REITs in Vanguard Target Retirement Funds.

Duration tilts

Given the low-yield environment investors have faced recently, it can be tempting for a fund to implement a tilt toward longer-duration bonds. While this tilt is likely to increase the yield of the portfolio, it also increases its sensitivity to interest rate changes. Generally speaking, the longer the duration, the greater the decline in bond prices when interest rates rise (and the greater the gain when they fall). Investors who tilt toward long duration bear the risk of relatively higher volatility. And our research indicates that lengthening the duration of a TDF's fixed income portion tends to reduce risk-adjusted returns.

Sub-asset allocations

Vanguard Target Retirement Funds provide the industry's broadest global diversification in the TDF space,2 covering nearly 90% of global liquid market capitalization. However, there are select sub-asset classes that, after rigorous research and review, we have decided to exclude at this time. We'll examine two of those allocations here: high-yield bonds and commodities.

High-yield bonds

As their name implies, high-yield bonds offer a higher yield than investment-grade bonds,3 largely as compensation for higher levels of issuer, liquidity, and default risk. They are primarily included by TDF providers as a way to potentially improve the returns of the bond portion of the portfolio.

Our decision to exclude high-yield bonds at this time is driven by three key reasons. First, high-yield bonds represent a small portion of the taxable U.S. bond market (about 6% as of December 31, 2020). At market weight, an allocation to high yield does not significantly alter the risk-and-return makeup of a broadly diversified portfolio, nor does it significantly impact long-term probabilities of success.

Second, high-yield bonds exhibit unique characteristics that could classify them as a hybrid asset class. Although debt instruments, their risk-and-return characteristics are more similar to equities because of the default risk associated with the firms and securities that constitute their market. These characteristics increase a balanced portfolio's downside risk during periods of equity market turmoil—exactly when you need your fixed income to provide ballast.

Figure 3. A hybrid asset class with significant equity market correlation

Source: FactSet. Data covers the period January 1991 through December 2020.

Third, our analysis shows that the funding source—fixed income or equity—is an important consideration in the decision to create exposure to high-yield bonds. When the allocation to high-yield bonds is funded from fixed income, as is typically the case in a TDF, we find that overall portfolio volatility increases but with only a modest improvement in returns.


TDFs typically invest in commodities through pooled products that create exposure through derivatives. Historically, commodities have provided diversification benefits to traditional assets, exhibiting low-to-negative correlations with global stocks and bonds. Often, they are included within a TDF as an inflation hedge.

At present, we don't include direct commodity exposure in Vanguard Target Retirement Funds primarily because we believe other asset and sub-asset classes provide a more attractive way to hedge inflation risk across the glide path.

Although the risk of inflation is always present, it's primarily in the later stages of their lives when investors should focus on direct inflation protection. This is because in the accumulation stage, inflation protection can be effectively provided from salaries and higher real returning assets, such as equities. Including commodities early in the glide path can potentially dampen returns during a period when direct inflation protection is not required.

Once in retirement, it is much more difficult to add to a portfolio through additional earnings. Therefore, investors should balance the need to preserve capital through bonds and cash with the need to preserve their purchasing power. Our research has shown that short-term TIPS can help manage inflation risk by providing a higher correlation to both expected and unexpected inflation with significantly less volatility compared with commodities—the latter being an important characteristic for investors who are near or in retirement.

Figure 4. Short-term TIPS have a high correlation to unexpected inflation

Correlation to expected and unexpected inflation Asset class volatility
Commodities 18.3%
TIPS 5.8%
Short-term TIPS 3.6%

Sources: Vanguard calculations for years 2003–2018, based on data from Bloomberg. We used the Hodrick-Prescott filter method to decompose unexpected inflation from expected inflation. We used these indexes for the asset classes: Bloomberg Commodity Total Return Index; Bloomberg Barclays US Treasury Inflation-Protected Securities (TIPS) Index; and Bloomberg Barclays US TIPS 0–5 Year Index.


Understanding what goes into a TDF and the rationale behind the allocations is a critical part of the due diligence process, but it can be equally as important to understand what has not been included. We believe the unique characteristics and needs of TDF investors should be considered when designing a prudent glide path and asset allocation.

We've outlined some strategies and allocations that we do not currently employ in Vanguard Target Retirement Funds. Given the rapidly changing investment landscape, we continually review our approach. Vanguard formally reviews these products annually to ensure our strategy remains world-class. As we have in the past, we're always looking out for investors, and we will make changes when our research uncovers a way to improve investor outcomes.

1 Brinson, Gary P., L. Randolph Hood, and Gilbert L. Beebower, 1986. "Determinants of Portfolio Performance." Financial Analysts Journa 42(4): 39–48: reprinted in Financial Analysts Journal (50th anniversary issue) 51(1): 133–38.
2 Source: FactSet, March 31, 2021. Broadest global diversification is determined by comparing the global liquid market coverage across target-date fund providers.
3 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.


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