The Unintended Consequences of Investing for the Long Run: Evidence from Target Date Funds

Abstract

We study how managers of funds created for the long run behave when shielded from liquidity constraints and their investors' short-term needs. We focus on Target Date Funds (TDFs) for which the investment horizon of investors changes deterministically over time and is not due to specific idiosyncratic characteristics of the fund that can affect investor demand and spuriously link the investment horizon and unobservable fund characteristics. Our evidence suggests that asset managers exploit reduced investor attention to deliver lower performance. This results in a hypothetical cumulative return loss of 21% for the average investor holding the fund for 50 years. We find that this underperformance is driven by fund families using TDFs to smooth the flow shocks by overweighting affiliated open-end funds in the TDF portfolio. It also results from the higher fees arising from investing in the affiliated expensive share classes. We use the Pension Protection Act of 2006 as an exogenous shock that made TDFs the default investment option within 401(k) retirement plans.

Keywords: Mutual Funds, Target-Date Funds, Retirement Savings, Mutual Funds Families, Open Architecture, Flow-Performance Sensitivity

JEL Classification: D12, D14, D91, G41, G51, J32