Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds

Over the past two decades, one of the most important financial innovations for the typical American retail investor has been the development and spread of Target Date Funds (TDFs, also called life-cycle funds). A TDF is a fund of funds that invests in a number of mutual funds so as to maintain given fractions of its assets in different asset classes, such as stocks and bonds. The specific asset allocation depends on the time until the investor’s expected retirement date, which is the fund’s target date. As time passes and its investors age, the TDF shifts the portfolio allocation automatically from higher to lower equity share, following the prescriptions of life-cycle models of optimal portfolio choice. The capital invested in TDFs and balanced funds (BFs) rose from under $8 billion in 2000 to almost $6 trillion in 2021, which is 22% of all funds invested in US mutual funds (about $27 trillion). This rapid growth was facilitated by the Pension Protection Act (PPA) of 2006, which qualifies both TDFs and BFs as default options in defined-contribution retirement saving plans. Similar strategies that automatically stabilize the share of an investor’s portfolio in different asset classes have recently been incorporated into a broader set of investment products, such as some automated advisory programs (e.g., model portfolios).

In our paper, “Retail Financial Innovation and Stock Market Dynamics: The Case of Target Date Funds”, we show that the rise of TDFs — originally designed to improve the diversification of individuals’ portfolios – has changed the flow of investor funds across funds and, now that they are big, started affecting the prices and returns of stocks. We focus on the fact that TDF strategies are macro-contrarian: after high stock market returns, TDFs’ strategies require that they sell stocks to return to their prescribed asset allocations within a short period of time. Historically, retirement and retail investors are either passive — letting their portfolio shares rise and fall with the returns on different asset classes — or they are active and tend to reallocate their assets into asset classes or funds with better past performance, a behavior known as positive feedback trading or momentum trading that can amplify price fluctuations. In contrast, by rebalancing to maintain age-appropriate asset allocations, TDFs trade against excess returns in each asset class, selling stocks and buying bonds when the stock market outperforms the bond market, and vice versa. The market-wide impact of this contrarian behavior was not the primary intent of the product design of TDFs which was simply to improve the individual-level portfolio choices of inattentive or unsophisticated retail investors.

We have three main findings. First, TDF are macro-contrarian. Following high stock market returns relative to bond returns, TDFs sell equity and buy fixed income mutual funds to move their portfolios back towards the desired stock-bond mix (and the reverse following low relative equity returns). An average TDF initially allocates 80 to 90 percent of its assets to diversified equity funds and the remainder to bond funds until 25 years before the target retirement date, at which point the equity share typically starts to decline smoothly over time to reach 30 to 40 percent 10 years after the target date. The amount of rebalancing by a TDF is a quadratic function of the desired equity share with a maximum at 50%. When the stock market returns 20% more than the bond market, a fund with a 50% desired equity share needs to convert 4.5% of its portfolio from stocks to bonds. In contrast, a TDF invested entirely in one asset class would not have to rebalance at all. Using quarterly data on TDF holdings during 2008-2018 and monthly returns, we find that TDFs rebalance across equity and fixed income mutual funds within a few months largely as predicted by their desired equity shares given realized asset returns.

Second, this macro-contrarian behavior stabilizes the funds flowing in and out of mutual funds owned by TDFs. Because of this rebalancing, following high relative equity returns, equity mutual funds with larger ownership by TDFs experience lower net inflows than equity funds with smaller or nonexistent TDF ownership. Thus, TDF ownership stabilizes the fund flows to equity mutual fund. Similarly, bond funds with higher TDF ownership experience bigger net inflows following high relative equity returns. Importantly, this result shows that pro-cyclical flows to and out of TDFs does not off-set the contrarian rebalancing within the TDFs. We show that at both the individual-fund level and at the aggregate level, the investor flows into equity mutual funds in response to excess stock returns are mitigated by TDF contrarian trading, and that TDF rebalancing in aggregate offsets about 20% of aggregate “trend-chasing” flows by retail and institutional investors in mutual funds.

Third, we find evidence that stocks with higher TDF ownership (through the mutual funds held by TDFs) have lower returns during and after higher market performance, consistent with the automatic rebalancing by TDFs, which leads them to sell stocks. Given the share of each fund held by TDFs and the stocks held by each fund, we calculate the (indirect) stock level holdings by TDFs. Stocks with higher indirect TDF investment tend to be larger with higher market beta, more liquid, and of higher-growth companies. Looking across all stocks while controlling for characteristics, greater TDF ownership is associated with lower individual stock returns in the same month as high stock market returns and in the following month. Specifically, when the excess return of the equity asset class is 1% in a month, stocks with a one standard deviation (0.7%) higher share of TDF ownership have a 2.8 basis point lower four-factor adjusted return in the same month. The timing of the price effect is consistent with the speed at which different types of TDFs rebalance; some large passive TDFs (which hold index funds in their portfolios) tend to rebalance within a day, while active TDFs (which hold actively managed funds) can rebalance over a month or two. In contrast to equities, rebalancing by TDFs does not appear to affect the prices of underlying bonds, potentially because funds engage in liquidity management that reduces the price impact.

These results imply that TDFs dampen the price responsiveness of the stock market. A back-of-the-envelope calculation suggests that, for TDFs and balanced funds today, this effect is currently too small to be statistically detected for aggregate market movements. However, if financial products that embed these strategies continue to grow, the size of this effect may grow. In that case, these strategies will both increase market efficiency by smoothing out sentiment-driven fluctuations and worsen market efficiency by dampening price responses to dividend news and investor effective risk aversion.

Second, because TDFs actively re-balance between stocks and bonds, they add to co-movement in returns between these markets. An implication of this is that TDFs propagate movements in interest rates from bond markets to stock markets, for example expansionary monetary policies such as quantitative easing. Again, this effect is likely very small now but would increase if retail investors continue to move money into these types of investment strategies.

Finally, our results suggest that to the extent that market momentum or other anomalies are (or were) due to trend-chasing by retail investors, these anomalies may disappear (or may have already disappeared) as more retail investor money follows market-contrarian strategies. Of course, all these effects may be mitigated by the responses of other investors or by TDFs themselves as their investment strategies evolve and/or respond to changing return dynamics.

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