By Brett Arends
At times of violent market moves, their impact can be far bigger than people realize
Did someone say free money?
Wall Street may be the only place in America where strangers will come up to you out of the blue and try to hand you free money. It doesn’t happen often, but it does happen. And some new research published by the National Bureau of Economic Research explains one of the reasons.
So-called target-date funds, those one-decision mutual funds that supposedly manage your investment portfolio for your entire career, are booming. At the last count they held about $3.8 trillion in U.S. investors’ dollars, more than one-tenth of the entire mutual-fund pool. These funds have a lot to recommend them. They give ordinary investors a single fund that will manage their retirement portfolio professionally from the day they start work to the day they collect their gold watch, lowering their equity exposure and raising their bond exposure slowly over time. There are many issues and questions about this entire strategy, but it is a lot better than most people will do on their own.
But such funds operate on autopilot, and they are constantly rebalancing to maintain the ratio of stocks and bonds that is supposedly appropriate for their various customers. When bonds rise too far, they sell some and buy stocks. When stocks rise too far, they do the reverse.
At times of violent market moves, their impact can be far bigger than most people realize. This is the subject of the new paper by Chuck Fang of Drexel University and Itay Goldstein of the University of Pennsylvania’s Wharton School of Business.
During the coronavirus market crash of March 2020, they find, the stunning collapse of the stock market within a matter of days forced target-date funds into a quandary. The plunge in stocks – by about 30% in less than three weeks – sent their portfolio balances haywire. (Such a fall is enough to take a portfolio from 60% stocks down to nearly 40%.) They were forced to react, quickly, by selling bonds so they could buy more stocks, in order to restore their stock exposure to its target levels. And that, in turn, spread the stock-market contagion to the bond market.
This explains why, at the most intense moment of the stock-market crash around March 20, U.S. Treasury bonds started plunging in value, too – even though they should have been rising.
Target-date funds – and other investors similarly pursuing autopilot portfolios – were required to flood the market with safe Treasury bonds so they could buy stocks.
“The bond market experienced tremendous turmoil during the COVID-19 crisis in 2020,” Fang and Goldstein write. “Safe bonds such as Treasury bonds and investment-grade bonds traded at surprisingly large discounts that were hard to reconcile with economic fundamentals.”
A major factor, they say, were the huge outflows from bond funds, which forced those funds to sell their underlying bonds.
Target allocation funds, they write, were a major contributor to outflows from bond mutual funds during the COVID crisis. Such funds owned only around 12% of all bond fund shares but accounted for 33% of all the bond-fund sales during the first quarter of 2020, they calculate. And other professional investors including hedge funds, anticipating this, joined in either to profit from the move or at least to avoid losses as the target-date funds caused bond prices to tumble.
“Total sales by TAFs [target-allocation funds] and other investors due to strategic complementarity explain $86 billion, or 48%, of the total outflows from bond mutual funds” during the early stage of the pandemic, they conclude.
With hindsight (and maybe not even: see here and here) it was obvious that the COVID crash was an over-the-top stock-market panic and that, yes, people should have been buying stocks instead of selling them at discounted prices. But no hindsight was needed at all to calculate that an economic slowdown was going to be good for bonds. So the most peculiar puzzle was the slump in the price of bonds. The role of target-date funds, and other autopilot investing, explains it. Someone offering you a higher fixed rate of interest on bonds, at a moment when the economy is in free fall, is someone offering you free money.
(Incidentally the absolute steal of that moment was in “closed end” bond funds. Closed-end funds are mutual funds that act like company stocks, with the result that the share price can swing even more wildly than the price of the underlying investments.)
(The craziest single gimme I have ever seen was probably in late November 2008, during the depths of the global financial crisis, when Wall Street banks and other professional investors stampeded to sell bonds to raise cash. As a result, even while the economy was cratering, you could buy inflation-protected Treasury bonds guaranteeing to pay you inflation plus more than 4% a year for seven years, and inflation plus more than 3% a year for 20 years. Barking mad. Free money. Made no objective sense.)
In the COVID crash the target-date funds did what they were supposed to do, and long-term investors were well-served by their autopilots. But it still means that, at certain times, and especially during periods of peak market turmoil, you can find investments at prices that make absolutely no sense whatsoever. Free money. Only on Wall Street.
-Brett Arends
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11-24-25 1514ET
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