A number of prominent market commentators (see Mike Green at Logica Funds or Vincent Deluard of StoneX) have noticed that the growing passive investment target date fund complex has fundamentally changed how the financial markets work. While active investors invest according to a valuation metric, passive investors simply allocate capital without any reference to valuations. In recent years passive investors have steadily increased in influence and appear to be on an unstoppable march towards dominance.
A market dominated by active investors is mean reverting. When the market is too “cheap” then the active investors buy, and when it is too “expensive” then the active investors sell. These active investors – such as traditional long/short asset managers or any disciple of Benjamin Graham – will have different views of what valuations are, but they will agree that valuations matter.
On the other hand, passive investors don’t care about valuations. Their instructions are to invest the money given to them, regardless of price. For example, a typical 401k plan will receive a contribution at each pay period and invest it in the market according to a preset allocations, such as 50% in equities and 50% in bonds. That investment occurs regardless of any valuation metric. A market dominated by passive investors thus trends higher.
Passive investment vehicles have steadily grown in recent years as corporations set-up their employees with target date retirement funds. This has been providing a steady bid in the market, likely contributing to the slow grind upwards seen in major U.S. equity indices. But how influential are those funds?
What Does the Data Say?
Target date funds are legally organized as mutual funds, and thus must file form N-PORT with the SEC. Form N-PORT provides quarterly portfolio snapshots of the fund holdings, as well as monthly flow data. To the best of my knowledge, there are currently around 600 target date funds that collectively hold around $1.4 trillion in assets. I’ve collected the public filing of all of them and created the interactive dashboard below. (The dashboard is not broken; it may take a minute to load)
Target Date Monthly Net Flows are Small
The most apparent finding is that monthly net flows into the target date complex are relatively small – usually around $3-5 billion a month. This level of inflows is unlikely to make a difference to overall asset prices. Fund flows also appear to have notably weakened during the 2020 recession so that there are now net outflows.
Also note that while target date funds with retirement dates far into the future have persistent inflows as millennials enter the workforce and invest into their workplace plans, funds already in retirement have persistent outflows as retirees draw down on their investments. The target date funds in retirement have the highest levels of assets, followed by those about to enter retirement. These persistent and upcoming drawdowns will limit the level of net inflows.
U.S. Equities are the Single Largest Allocation, but not huge
Target date funds usually allocate on a glide path where most funds are invested in equities when the expected retirement date is far into the future, and gradually shifted into fixed income as the expected retirement date approaches. The chart below from the Investment Company Institute is a stylized illustration of a typical target date fund’s investment life cycle.
What is often missing in the discussion is that target date funds also allocate their investments across geographies. Their investments in equities are not just U.S. equities, and their investments in fixed income are not U.S. corporates or Treasuries. On aggregate, roughly 70 percent of total assets are invested in the U.S. assets. (Note that this is a rough estimate based on Bloomberg’s categorization of an issuer’s geographic location.) Investments in U.S. assets will include U.S. equities, but also Treasuries, TIPS, and corporate debt. Fixed income investments will feature prominently in target date funds that are in or near retirement.
How big of an impact are Target Date funds having on the major U.S. indices?
It’s not easy to quantify the impact of target date funds on the stock market, but sketching out their scale can help put contours on the answer. It seems that target date funds are exerting upwards pressure on the market because of their consistent and price in-sensitive buying, but that pressure is slight. This is because 1) fund inflows from millennials are partially off-set but fund withdraws by wealthier boomers approaching retirement 2) fund inflows are allocated across geographies and asset classes, so flows into U.S. equities are the single largest flow but relatively small in an absolute sense.
However, target date funds may have a more meaningful impact on equity prices through the re-balancing channel. For example, in March 2020 global equity prices declined significantly while Treasury prices increased significantly. The target date funds at that time would have been mandated to sell Treasuries and buy more equities at a large scale to maintain their asset allocation target. This suggests a model of target date rebalancing, taking into account asset allocations across class and geography, could be a profitable – especially during times of severe dislocations.