With market volatility on the upswing, many are looking at new ways to help reduce the risk they take in their portfolios. One such product that has gained a lot of attention has been the TD Retirement Portfolios, which are the TD Retirement Conservative Portfolio, and the TD Retirement Balanced Portfolio. Combined, these funds have attracted nearly $2.5 billion in assets, and have consistently been at or near the top of the list of TD’s top selling funds since their launch.
At the core, they are conservatively managed balanced funds, with a focus on risk management. They invest in a mix of cash, bonds and equities, allowing the manager some flexibility to shift the asset mix around based on market expectations.
Where these portfolios set themselves apart is through the use of an options based strategy that is designed to provide downside protection while still allowing for capital growth. The funds invest in the TD Risk Reduction Pool. In very simple terms, this pool is using a “collar” options strategy that consists of three parts; exposure to the S&P 500 through individual equities and ETFs, covered call options, and protective put options.
The pool will invest nearly all of its assets in the S&P 500, providing the equity exposure. Next, they will sell covered call options. A covered call option allows the buyer the right to buy a stock or ETF at a predetermined price at a time in the future. The set price is referred to as the “strike price”. When the fund sells these call options, it generates premium income, which is used to purchase put options, which provides the pool with its downside protection.
While a call option allows the purchaser to buy a stock or ETF at a set price at a future time, a put option allows the purchaser to sell a stock or ETF at a predetermined price in the future. So, when the price of the stock or ETF falls below the strike price, the value of the put increases, offsetting the drop in the underlying stock or ETF, and protecting the value of the portfolio.
For every dollar of S&P 500 exposure, TD will purchase a dollar of put option protection. The covered call strategy is more tactical in its approach, and the amount of call options sold will be dependent on their outlook. When they see more upside in the markets, fewer options will be written, allowing for higher growth potential. When they see flat or a falling environment, they may write more calls to generate the extra premium income.
While the downside protection is a nice feature, it comes with a cost, which is the upside participation you give up. In the event there is a sharp rally, the pool will be forced to sell their S&P 500 holdings to the call option holders at the strike price, thereby capping the growth until more equities can be purchased. Through covered calls, they generate additional income for the pool, which is used to buy the downside put protection.
Performance is tough to measure with these funds for a few reasons. The first, obviously, is that with about a year and a half of returns, there really isn’t sufficient data on which to do a meaningful analysis. Second, given the option strategy used, the focus of the funds is really more on delivering modest returns with less risk. Judging by absolute and relative returns may not be the most appropriate. Finally, because of the way mutual funds are categorized in Canada, these funds get lumped in with Global Equity Balanced Funds, which is a bit misleading when looking at the peer group.
Performance to the end of January has been disappointing on an absolute basis. However, if I look at their volatility profile, they have been less volatile and offered stronger downside protection than what a more typical balanced fund has experienced in the same period. They have behaved as advertised in volatile times.
To their credit, TD has done a great job at positioning these funds as potentially suitable for investors who have just entered, or are just about to enter retirement. They may also be appropriate for very conservative investors looking for the potential for some growth, but are more worried about significant losses. Beyond that, I struggle to find an investor for whom these funds may be appropriate. In almost all cases where an investor has a medium to long term time horizon and average risk tolerance, a more traditional balanced fund or well diversified portfolio may be more appropriate.
These are indeed very interesting products. They use a unique approach and could potentially serve a need for more conservative investors.
My fear is that many don’t fully understand the tradeoffs the funds have made for the benefit of the strong downside protection, namely lower gains in rising markets. This could result in many disappointed investors down the road, when they see that their returns may lag a more traditional balanced fund over the long term. Considering all factors, I remain cautious on these funds.