Target-date series that farm out assets to subadvisors have no apparent edge over those that exclusively use in-house managers.
Over the past year, there has been public debate as to whether shareholders are best served by target-date series that exclusively feature the fund advisor's own managers. Few advisors employ best- in-class management teams across strategies and asset classes typically featured in a target-date series. What's more, investors in these "closed-architecture" series face considerable single-firm risk--particularly if all of a defined-contribution plan participant's retirement assets are invested in a single target-date fund.
Fund advisors have plenty of incentive to include their own managers in a target-date series. The advisors are familiar with the managers' investment process and have control over it, and they don't have to contend with subadvisory contracts and the regulatory burden of monitoring an outsider's trading and compliance effort. Perhaps the biggest incentive is financial: The advisors retain all of the funds' management fees, rather than sharing with a subadvisor. In fact, closed- architecture target-date offerings are susceptible to conflicts of interest. The advisor may select its own inferior managers or overweight asset classes that often generate higher returns in order to beef up profits.
Criticisms of closed-architecture target-date funds are valid, but it's important to consider who is frowning upon these funds. Consultants and asset managers who provide custom, nonproprietary, indexed, or other types of target-date investments are often the most vocal opponents, and they have their own business interests associated with open- architecture options. It's also worth noting that most plans that feature subadvisors are not exclusively subadvised. Among the largest "open architecture" target-date series, the advisor typically has kept 30% to 60% of the series' assets with in-house managers.
Proof Not in the Numbers
One argument that closed-architecture critics can't make is that the open model offers investors better performance. We analyzed the performance of target-date series from several angles: risk-adjusted returns, attribution, underlying Morningstar Ratings, and overall Morningstar Target-Date Fund Series Ratings. We found that open-architecture series have not demonstrated a meaningful performance edge over closed-model series by any measure.
First, we looked at the three-year risk-adjusted return of 37 target-date series. Only three of the series with the 10 best performances were either wholly run by subadvisors or were run by a mix of in-house managers and outside subadvisors. Moreover, two of the three (Wells Fargo and ING Index Solution) were index- based offerings that employed a single external subadvisor. Vantagepoint Milestone Series, which also was in the top 10, was exclusively run by subadvisors and taps managers from a wide range of firms. Out of the bottom 10 performers on a risk-adjusted basis, five series used at least some nonproprietary holdings.
The three-year risk-adjusted returns are heavily influenced by the series' glide paths. Funds with equity-heavy asset allocations were among the worst performers in 2008's market slide. To take the glide path out of the performance equation, we ran a performance attribution on 31 target-date series. By isolating the selection factor, we determined the impact of fund management's sector weightings, security selection, and tactical asset allocation. Once again, the data reveals no advantage to open-architecture series or nonproprietary target-date lineups. Of the nine series that have positive attribution for selection over the two-year period, two have nonproprietary structures. Of the 22 series with negative selection attribution, half are completely or partially subadvised.
We next looked at the Morningstar Ratings associated with 33 target-date series' underlying funds. The Morningstar Rating considers a fund's risk-adjusted performance relative to peers. We averaged these ratings across the underlying funds in a target-date series on an asset-weighted basis. In theory, an open-architecture series with the flexibility to choose any manager would have a higher- quality portfolio. But overall, open-architecture series did not have higher average asset- weighted Morningstar Ratings than those of closed-model series.
As a final test, we looked to the latest overall Morningstar Target-Date Fund Series Ratings, which we issue to 20 series. These ratings cover quantitative and qualitative aspects of a series' performance, fees, management quality, and stewardship practices. Among the 20 series, seven include subadvisors not affiliated with the series' advisor. None of those seven series earned a Top rating.
A Difficult Art
Several factors may explain why open-architecture target-date series haven't demonstrated a performance edge. For one, it can be expensive to hire subadvisors, and the series' expense ratio may act as a drag on performance. Also, several open-architecture series feature aggressive glide paths that performed dismally in 2008's downturn. Finally, it's not easy to choose and combine subadvisors that together will consistently outperform. Such portfolio construction is an art that's perfected over years and decades.
While the data does not suggest open-architecture series have a performance advantage, it also doesn't seem to have a consistent disadvantage. That said, one open-architecture standout is Vantagepoint, which has benefited from strong manager selection, a relatively conservative glide path, reasonable (though recently increased) fees, and a stellar and experienced investment culture.
Recently, target-date providers have introduced new open-architecture target-date series. As target-date fund performance records lengthen, open-architecture series may demonstrate superiority, but for now, Morningstar can't make a strong argument in favor--or against--this open-architecture target-date series' management model.
Josh Charlson is a senior mutual fund analyst with Morningstar.