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This Time It's Personal

Because clients will hold target-date funds for decades, it's critical for advisors to judge the people who run the funds.

Laura Pavlenko Lutton, 12/08/2009

Target-date funds are complicated investments, so when choosing one for a client, it's challenge enough to find a fund that contains solid investments, appropriate asset allocation, and a sensible price. But it's important also to train a critical eye on the individuals and organization behind a target-date series. After all, most investors will hold these funds for decades, and over those years, a partnership with a lackluster management team or asset-management firm could compromise a client's nest egg.

Morningstar's Target-Date Series Ratings and Reports, which were introduced in September and are available in Morningstar Office, Direct, and Principia Mutual Funds Advanced, feature two sections of analysis that capture whether the team and firm behind a target-date fund series will be good stewards of capital over the long term. These sections-People and Parent-account for two fifths of the series' overall rating and incorporate qualitative and quantitative analysis. Morningstar's rationale for including these assessments-along with a more-traditional quantitative analysis that considers the target-date series' performance, portfolio, and price-stems from our experience with the Morningstar Stewardship Grades for mutual funds and some revealing data.

(View the related graphic here.)

Putting People into Perspective
Two components make up the target-date family's People rating. Three fourths of the rating is based on Morningstar analysts' assessments of the management team behind the series. The remaining 25% of the People rating is based on management's financial incentives to serve shareholders well.

Morningstar's qualitative analysis of the management team draws on decades of individual fund analysis. Morningstar analysts have been following the funds featured in many of the target-date series for years, regularly interviewing the management teams and determining how well they have executed their investment strategies in a variety of market conditions. That experience puts the analysts in a good position to determine whether those managers tapped for the target-date series are likely to serve sharehold­ers well over the long term.

The management analysis may seem complete­ly qualitative, but it is informed by some quantitative measures. We look at factors such as the fund managers' tenure and retention rates. Funds sponsored by companies that have long tenures and high manager-retention rates are more likely to have the same target-date team in place over the next several years. Meanwhile, firms with relatively low retention rates may suffer future turmoil.

Given the relative youth of target-date funds, there is little value in examining the length of manager tenure overseeing the various target-date series themselves. Evaluating the tenure of the managers of the series' underly­ing funds, however, can be more telling. Another revealing data comparison is the asset-management firm's five-year manager-retention rate. To calculate the manager-reten­tion rate, we look at managers named on the firm's funds at the start of the year. Then, we see what percentage remained at year-end. The five-year manager-retentionrate is the average retention rate over the past five calendar years through Dec. 31, 2008.

Among the fund families offering the largest target-date series, there's quite a range of experience, with the American Funds-which received a top People rating-the clear leader. For American's underlying funds in a target-date series, the average manager tenure on an asset-weighted basis was 23 years. On the flip side, at less than three years, the lowest manager tenure was at DWS. DWS received a bottom People rating. DWS' attempts to improve its fund manage­ment in recent years have led to many departures. It's unclear whether the teams in place now will stay the course or whether turnover will continue.

Performance Pays (Partially)
Because target-date funds are designed to be long-term investments, it makes sense to have their managers focused on the long haul, too. Funds that pay managers to deliver strong long-term performance do the most to align the managers' own financial goals with shareholders'. Conversely, managers who are paid based on short-term goals may assume unnecessary risk to achieve returns that are meaningless to buy-and-hold shareholders, and managers who get paid to grow the funds' asset bases may choose to go on a sales call rather than research a new investment.

Of the 20 pay plans we studied for our target-date series reports, only six of them-American Funds, American Century, DWS, JP Morgan, T. Rowe Price, and Vanguard-base most of the managers' compensation on generating peer-beating returns over the long term, which we define as four years or more. Disappointingly, four series received no credit at all for aligning their compensation plans with shareholders' best interests. These series-ING, MassMutual, Principal, and Wells Fargo-offer so little detail about their pay plans in filings with the SEC that it was impossible to tell what criteria were used in determining the bonus payouts. The remaining 10 series based their pay on short-term returns.

(View the related graphic here.)

Little Skin in the Game
In addition to assessing management's pay criteria, we also look at whether the target-date fund managers have invested in the series. Target-date funds are marketed as core holdings for investors, so we expected to see fund managers using these funds as the core of their own portfolios. Morningstar views best practices for fund-manager ownership as having the manager invest at least $1 million in a core fund that he or she runs. Not only does manager ownership demonstrate conviction in the investment process and in the fees charged, Morningstar has found that the more money a manager has placed into the funds that he or she runs, the higher the total returns are likelier to be.

In the case of target-date funds, however, manager investment is severely lacking. Of the 58 named managers of the target-date series that Morningstar studied, only two had investments greater than $500,000. One manager from TIAA-CREF had more than $1 million invested. Meanwhile, 33 of the 58 managers had no investment whatsoever.

In three of the 20 plans, managers had difficulty investing directly in the target-date funds. Even so, it is telling that few target-date fund managers have demonstrated their conviction in funds by making direct investments-particularly as the public message from fund companies about target-date funds is that they, more than any other type of mutual fund, are appropriate for all retirement investors. It appears that, to a large extent, the managers of target-date funds are not as confident about such claims made by their companies' marketing departments.

Proper Parenting
Another component of a target-date series' overall rating is the Parent score. Half of the score is tied to corporate culture, 25% to board oversight, and 25% to transparency. A rating can be docked up to 25% if the parent firm has a poor regulatory history.

Morningstar makes a qualitative assessment of the corporate culture at the asset-management company offering the series. A culture that exhibits best practices is one in which fund managers and analysts spend their careers at the firm, sharing in investor successes or failures. If the company's funds do well, then the company attracts assets, grows its revenue, and manager compensation increases over the long term. In contrast, a corporate culture that is in flux because of a change in control, new executive leadership, a regulatory scandal, a raft of shareholder redemptions, or the inability of top manage­ment to set a consistent strategic direction is a cause for concern.

Investing in target-date funds that are supported by investor-focused corporate cultures is especially critical given the decades that investors are expected to own the funds.

If a fund company's culture doesn't always put investors before profits, it's unlikely to produce a good shareholder experience. In fact, Morningstar's research has shown that fund firms that earn top corporate-culture grades as part of Morningstar's Stewardship Grades for mutual funds also have been some of the biggest winners of target-date assets, suggesting that investors are choosing firms that are good stewards of capital.

Data also suggests that firms with strong corporate cultures launch and merge away fewer funds. For target-date investors, choosing a series backed by a strong corporate culture makes it more likely that the series will undergo few additions and subtractions when it comes to the underlying funds. Vanguard, for example, earns an A for the corporate-culture section of its Stewardship Grades, and it has merged away just one fund since 2005 and launched two dozen funds (which is relatively low considering the firm's size). Vanguard is careful not to launch trendy funds beyond its core competencies and, therefore, has less need to merge funds away. It has managed its target-date series with similar prudence.

(View the related graphic here.)

Board Oversight and Regulatory History
There is also insight to be gathered from measuring the funds' governance. In assessing fund boards, Morningstar first looks for industry-leading standards for independence, specifically leadership by an independent chairman and at least 75% of the trustees as independent of the advisor. Board members are also expected to have significant investments in the funds they oversee. Lastly, there should be evidence that the board has taken concrete steps in the best interests of shareholders by negotiating lower fees, merging redundant and unsuccessful offerings, or pushing for manager changes or a subadvisory contract if a fund hasn't been run well.

Among the 20 target-date fund series that Morningstar evaluated, no boards satisfied all these best-practices criteria. Some scored highly for their independence and investments but could be doing more to serve shareholders. The Putnam fund board, for example, is run by an independent chairman and has a superma­jority of independent trustees, but the board hasn't always pushed back on trendy fund launches or sought industry-leading manage­ment teams. Meanwhile, other fund boards have produced good results for shareholders but fall short for independence or personal investments in the funds they oversee. This is the case with the Vanguard board, which is led by insider Jack Brennan, the firm's former CEO. Nonetheless, the board has served sharehold­ers with well-run funds sporting low fees.

The target-date families' regulatory compliance records are good overall, but there have been some noteworthy missteps. A handful of firms were involved in the early 2000s' market-timing scandal, and a division of ING was accused of paying a New York teachers union to endorse and promote ING annuity plans. For investors choosing a caretaker for their capital, it's not necessary to take on a series that's run by a parent that lacks focus on what's best for shareholders.

Need for Better Disclosure
The final criterion in the Parent section is based on how well the target-date series' advisor explains these complicated investments to shareholders. Based on the current information on fund companies' Web sites and in filings with the SEC, it's tough-if not downright impossible-for shareholders to understand how their target-date funds were designed and how they work. Target-date series would go a long way toward helping shareholders be better owners if they were to publish transparent, easily accessible information on the rationale that lies behind their decisions on asset-allocation and manager selection.

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