Morningstar Finds Room for Improvement in Target-Date Funds

The survey, which draws on Morningstar’s research on 20 of the largest target-date fund series, found that, with target-date funds, investor returns over the past three years exceeded the funds’ total returns in every target-date category except for 2010, and far exceeded a shareholder’s experience owning a traditional mutual fund. Investor returns reflect monthly flows in and out of funds, and the returns earned.     

According to Morningstar’s data, more than $45 billion in new cash flowed into target-date funds in 2009.     

In response to past criticism, Morningstar found there was a general move among the fund families in the survey to cut costs by lowering expense ratios or introducing cheaper indexed series. In addition, several fund series took steps to reduce risk by lowering the funds’ equity allocations, and others introduced or increased exposure to subasset classes that they hope will smooth returns.      

However, these attempts to “improve” could have some negative effects. “Lower fees directly benefit investors, but changes to the funds’ equity exposure could leave the industry open to charges that it’s fighting the last market battle, and not positioning the funds correctly for the future. Indeed, some funds that were aggressively positioned in 2008 were whipsawed when they turned conservative prior to the market rebound in 2009,” said Laura Pavlenko Lutton, editorial director for Morningstar’s mutual fund research group, in a press release.     

Morningstar’s research has shown that the quality of target-date funds’ public disclosure varies considerably. Some firms include thoughtful explanations of their target-date funds in public documents and on their Web sites, while others have very little helpful information, Morningstar said.     

The report examined whether fund companies provided the disclosure recommended by its own industry association, and found only eight of the 20 currently meet all five of the ICI’s standards.
     
Morningstar also examined whether “open architecture” series had a performance advantage, and found no advantage or disadvantage to open architecture. About a third of target-date series Morningstar evaluated features open architecture, or managers who are independent of the fund’s adviser.

Understanding a Target-Date Series' Philosophy     

One area where Morningstar found target-date funds' disclosures lacking is a series' philosophy. Morningstar said there are several areas in which significant philosophical and pragmatic differences exist among the target-date series, and these areas are critical in fully comprehending the potential risks and performance behavior of a given target-date series and how that series compares with others in the target-date universe.

Those areas are:

• Longevity risk vs. market risk: Morningstar said those series that emphasize longevity risk will tend to invest more in stocks through an investor’s lifetime, including during retirement, in order to build sufficient capital to battle inflation and avoid outliving the investor’s money during retirement. Conversely, those series that emphasize market risk will generally invest more heavily in fixed-income securities, as ballast against market declines.
• Shape of the glide path: Many glide paths roll down equity allocations in a gradual, linear fashion, producing a consistent slope, while other firms main­tain a steeper slope to the glide path, in which equities are kept near or above the averages in the longer-dated funds but in the decade before retirement are dramatically slashed.
• Active vs. passive: Target-date series providers also determine whether to use passive or active management of the series’ assets, and the series often reflects the providers’ own management styles.
• Sub-asset classes: Morningstar said there is little consensus among target-date series about how to approach allocating among the subasset classes. Some firms take a basic approach, starting with domestic and foreign stocks, fixed income, and cash and then divvying up domestic stocks along Morningstar Style Box criteria, while others introduce special­ized subasset classes, such as emerging-markets stocks, foreign bonds, high-yield bonds, commodities, and real estate, among others. Typically, the specialized asset classes are intended either to provide greater diversification, and thus smooth a target-date fund’s volatility, or to combat the effects of inflation (as is the case with TIPS).
• Tactical allocation methods: Target-date fund series adopt three general approaches to tactical allocation, or deviations from the stra­tegic glide path: No tactical allocation is allowed; Modest deviations are allowed; and Active tactical allocation is allowed, where the provider sets aside a portion of the series' portfolios for active management.
• Target to or target through: A target-date series is either created to terminate at the time of retire­ment or intended to provide for the rest of the investor’s life. If a target-date series is structured as target to, then its allocations will typically level out once an inves­tor retires. If the series is target through, then its glide path will generally continue to evolve past retirement, typically reaching its landing point anywhere from 10-20 years after the target date.

Morningstar says glide paths will continue to evolve over the coming years as fund companies conduct more research and add newer, potentially more complex asset classes and strategies. "It will be all the more critical, then, that investors, advisers, plan sponsors, and other fiduciaries gain a full understanding of glide paths’ defining role in target-date funds," the report says.     

Morningstar's 2010 Target-Date Series Industry Survey can be accessed here.