Using this information, the researchers were able to observe the impact TDFs had on various financial instruments as they automatically rebalanced to maintain their desired portfolio mix between stocks and bonds. In order to identify the effect that TDFs have on the markets, the authors first had to prove that TDFs indeed worked as designed.
TDFs sell equity when equity does well in order to maintain a constant share of equity in a portfolio and create the desired stable share invested in different asset classes. In the course of their research, the authors found that TDFs do indeed rebalance their portfolio mix between stocks and bonds within a few months of a market movement.
Investors tend not to move funds in or out of TDFs to offset this rebalancing. Next, the authors had to determine that investors were using TDFs as intended — as a set-and-forget investment strategy.
The authors wondered if it were somehow possible that when the stock market did well and TDFs sold equity, investors were pulling money out of a target date fund and putting it into an equity fund, thereby undoing the smart decision-making of the TDF. In theory, the authors were aware that TDFs would affect the markets, but prior to their research, no one had quantified the impact of TDF trading on the flows into and out of mutual funds or on individual stock prices.
The authors found that individual stocks with high TDF exposure through mutual funds had lower returns in the quarter after they outperformed the market — evidence that TDFs were working as designed. But TDFs respond in the opposite way, by selling funds that hold stocks and buying bond funds. The findings demonstrate that TDFs are moving a significant fraction of U. The authors speculate that TDFs may stabilize the stock market and reduce volatility. He cautioned, however, that some changes in the stock market are driven by fundamental increases in the value of underlying companies.
Going forward, if TDFs become even more popular and make up a bigger part of the market, they will continue to reduce stock market volatility and tighten the correlation in returns between the stock and bond markets. If this trend continues, they'll become increasingly important for the price volatility of the overall market.
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