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A Much-Maligned Fund Group Bounces Back

After suffering in the bear market, 2010 funds regain some respect.

Josh Charlson, 01/04/2010

As the calendar turns over to 2010, the group of mutual funds built for investors intending to retire in or around that year has taken important steps toward restoring its tarnished reputation.

Target-date funds were subject to a maelstrom of investor ire and governmental scrutiny over the past year, and none more so than 2010 funds. In calendar-year 2008, that group of funds lost an ungainly 23% on average.

That was a tough pill to swallow for investors preparing to dip into their nest eggs or who mistakenly thought their investments were conservatively positioned so as to avoid most of the perils of a bear market. In fact, all of the target-date 2010 offerings provide some exposure to the equity markets, and those that are most concerned by longevity risk--the risk that investors will outlive their savings--tend to invest upward of 50% of assets in stocks. So, losses among these funds should not have been a big surprise. But the magnitude of some losses (with the hardest-hit fund cratering with a 41% loss) was certainly alarming.

While governmental agencies and Senate subcommittees were convening hearings on the target-date industry in 2009, many 2010 funds were making back a good chunk of their investors' money. And while it's too soon to say that 2010 funds have completely dug out of their hole or that the concerns expressed about them were entirely misplaced, the gains through November 2009 indicate that even with the shortest-dated target-date funds, investors have been better served by trying to take the long view.

Rebounding Returns
Through November, as the financial markets have rebounded sharply, the average 2010 fund has returned a healthy 20%, with the top performer rising 29%. It's no surprise to see that the funds at the top of the list are those that are trying to offset longevity risk with above-average equity weightings and, thus, incurred significant losses in 2008. John Hancock Lifecycle 2010 JLAAX, AllianceBernstein 2010 Retirement Strategy LTDAX, Hartford Target Retirement 2010 HTTAX, and T. Rowe Price Retirement 2010 TRRAX all fit this description.

Predictably, those fund companies that make guarding against market risk their first priority that held up best in 2008 have been laggards in 2009. Wells Fargo Advantage DJ Target 2010 STNRX and American Independence NestEgg 2010 NECSX, for example, which had the two best results in the group last year (losing 11% and 9%, respectively), occupy the bottom two slots in 2009. Vanguard Target Retirement 2010 VTENX, which plots a fairly defensive but not extreme glide path, has gained 18.8% for the year to date.PAGEBREAK

Full Circle
Now that the panic over 2010 funds has subsided, it's safe to take a step back and reflect on the implications of this group's performance patterns over the past two years.

One clear takeaway is that a glide path should not be judged solely on the basis of its short-term, or even intermediate-term, performance. Critics were too quick last year to label longevity-oriented glide paths a failure and to assume that glide paths intended to preserve capital near retirement were the only sensible approach. Similarly, prior to 2007, the drumbeat around longevity risk was loudest, while those worrying about the potential of market collapses could scarcely be heard above the din of the bull market. It will require full, multiyear cycles to determine the true worth of the varied approaches to glide-path construction.

A corollary to the previous point is that, over time, a lot of these performance differences will tend to even out. We haven't yet completed the current market cycle, but early evidence shows that the most conservative 2010 funds protect capital well on the downside but lag as markets rise, while the funds with more-aggressive glide paths endure greater losses but can make it back quickly. Performance variations will persist from year to year, but spans between winners and losers like we saw in 2008 won't be the norm over time.

It's instructive to look at the returns of target-date 2010 funds since Oct. 1, 2007, roughly the peak preceding the bear market. Through Nov. 30, 2009, the average 2010 fund has lost about 4.5% over that stretch. While any loss is unpleasant for investors approaching retirement, a 4.5% drop is far from catastrophic. And if one were to exclude the 15.6% loss by Oppenheimer Transition 2010 OTTAX, which experienced devastating risk-control problems in its fixed-income funds during the financial crisis, the range of returns narrows considerably. AllianceBernstein, with its aggressive glide path, lost 8% over the period, while MFS Lifetime 2010 MFSAX tops the group with an in-the-black 2.4% return. By comparison, the average moderate-allocation fund has lost 6.5% over the same time frame.

Of course, there's no guarantee that stocks will rebound that quickly after subsequent bear markets. Losses over multiyear periods would certainly prove challenging for retirees, so investors should keep in mind that, as currently constructed, no target-date fund is risk-free, even once the target date has been reached.

Pay Attention to Outliers
Usually, target-date funds follow predictable patterns, driven largely by their glide paths. But sometimes funds depart quite a bit from their expected behavior. Often, this should be a red flag to investors. Oppenheimer Transition, for example, hit rock-bottom in 2008 in large part because its bond funds imploded, but it hasn't charged to the front of the pack in 2009 as riskier assets have taken off. That's because Oppenheimer cleaned house extensively, moving to less-risky fixed-income securities while reconsidering its overall glide path.

On the flip side, Putnam Retirement Ready 2010 PRXRX has one of the most conservative strategic allocations, with only 27% of assets devoted to equities, yet the 2010 fund is near the top of the group this year with nearly a 24% return. Because the manager will allow the asset allocation to deviate significantly from the policy weights based on his team's assessment of market conditions, this target-date series has the flexibility to try to take advantage of market opportunities. As a result, however, it's much harder for investors to know with certainty how their money is being managed at any given point.

Sometimes a fund bucks the trends for good reasons. T. Rowe Price has long advocated high-equity weightings to fend off longevity risk, and its 2010 fund is near the top in 2009. Yet in 2008, its 27% loss was only a few percentage points worse than the group average. Through its cost advantage and, especially, strong security selection by the underlying fund managers, the fund has managed to outpace what you'd expect based purely on its glide path. Whichever direction a fund's performance skews, it's worth asking more questions about why it's not fitting into its round hole.

Know What You Own
A final inescapable conclusion from the controversy over 2010 funds is that there is a misalignment between investor expectations and the actual design of many target-date series. The biggest challenges facing target-date fund companies are devising ways to effectively communicate their glide path philosophies to investors and properly setting expectations for performance. Fund companies, plan record keepers, and employers still have a lot of work to do in this area. One area of confusion (among many) rests with the use of a single year in a fund name, which arguably leads investors to view the target date as an end date at which their nest egg converts into an extremely safe asset. Recent guidelines for target-date disclosure established by the Investment Company Institute provide some hope for improved industry practices, but in our view these standards don't go far enough.

There's nothing inherently wrong with a near-retirement fund that invests 60% of assets in stocks unless an investor expects it to behave like a fund with 30% in stocks. If investors know that a large short-term loss is a distinct possibility and know why that is the case--in particular, the understanding that their investment manager is looking ahead 10 to 20 years from the actual retirement date--then they will be less likely to pull their money at the wrong time. Plan sponsors and fiduciaries, meanwhile, need to make sure that target-date funds match the demographics of their participant base while improving education efforts. If target-date funds can successfully execute on this front, there will be a lot less second-guessing the next time the markets crash.

Josh Charlson is a mutual fund analyst with Morningstar.

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